2. CFA Institute
Research Challenge
January 11, 2015
Porter’s 5 Forces
University at Buffalo Student Research
This report is published for educationalpurposes only by
students competing in The CFA Institute Research Challenge.
Ticker – NYSE: SSS Recommendation – Sell
Sector – Financial Industry – Industrial REIT
Current Price: $91.09 (1/11/2015) Price Target: $83.09 (8.79% Decrease)
Numbers in millions except per share items. Source: Capital IQ and Team Analysis
Highlights
Fragmented Industry Ripe for Consolidation
The self-storage industry is surprisingly fragmented for an
industry where economies of scope are not really at play and scale
certainly is. Less than 15% of the industry is controlled by the 10
largest companies and less than 22% by the 100 largest
companies. Most self-storage properties are still owned by small,
private owner-operators that cannot operate at the same
profitability levels as the large firms like Sovran. The industry is
ripe for consolidation and Sovran will continue to play a major
role in this transition.
Competitive Advantages
Sovran has a competitive advantage over most of the self-storage
industry due to its scale as the fifth largest firm in the industry. It
is also advantaged due to its universal customer care center and
advanced revenue management system.
SeasonedManagement
Sovran’s Chairman, CEO, and COO are all founders of the
company with ~30 years of self-storage industry experience
apiece. The entire C-Suite has been with the company 15+ years.
We believe management is thoroughly candid and competent.
2011 2012 2013 2014E 2015E 2016E 2017E 2018E
Revenue 202.7 234.1 273.5 317 358.5 390.7 422.5 451.2
EBITDA 100.7 120.2 146.3 161.1 194.7 213.9 233 250.8
FFO/Share 2.37 3.24 3.79 3.89 4.43 4.41 4.55 4.76
AFFO/Share 1.95 2.82 3.38 3.49 4.03 4.02 4.16 4.37
NOI/Share 4.69 5.3 5.89 6.35 6.77 6.81 7.02 7.29
Rentable Square Feet 28.94 31.19 32.36 34.5 36.57 38.58 40.51 41.73
Dividends/Share 1.8 1.8 2.02 2.72 3 3.34 3.46 3.63
Sovran Self Storage, Inc.
Source: Team Analysis
Refer to the appendix for a full analysis
*Note that a high number means a better
competitive positioning for the category
3. CFA Institute
Research Challenge
January 11, 2015
Industry Profitability Peaking
Occupancy rates and REVPAF in the self-storage industry have
consistently improved since the financial crisis and are at all-time
highs. The Self-Storage Almanac estimates that industry supply
will finish 2015 up just 8% from 2010 despite ultra-low interest
rates and robust demand over the same period. A wave of new
developments is about 2 years from completion and outside capital
is beginning to take notice of the industry’s prospects and flow in.
Interest Rates Set to Rise and Pull Cap Rates Along
Interest rates sit at a 75-year low. The 10-year Treasury note
yields less than 2%. Continued economic improvement should
bring interest rates off their low as Sovran’s management, industry
analysts, and most investment professionals for that matter, have
expected for several years now. This should directly affect all
asset classes up the yield curve, including real estate capitalization
rates.
Business Description
Business Overview
Sovran Self Storage (NYSE:SSS), a real estate investment trust
(REIT), was incorporated in Williamsville, NY in 1982. It opened
its first facility in 1985 and held its initial public offering in June
1995. Sovran acquires, owns, and manages self-storage properties
that operate under the name “Uncle Bob’s Self Storage.” Sovran
has 1268 employees and operates 506 self-storage facilities in 25
states.
Rental Revenue
A large portion of Sovran’s revenue is rent received from
customers for the use of its storage units. Rent revenue should be
about 92% of total revenue for 2014. This is in line with
legislation stipulating that a REIT must derive at least 90% of its
income from rental income. Sovran currently has 503 self-storage
properties in 25 states under the name “Uncle Bob’s Self Storage.”
Sovran is a 20% owner in 28 properties under Sovran HHF
Storage Holdings LLC, 15% owner in 30 properties under Sovran
HHF Storage Holdings II LLC, nonowner on 17 properties it
manages, and lessee on 4 properties outside of its main line of
business. Approximately 37% of the company's revenue is from
properties in Florida and Texas.
Other Revenue
Approximately 8% of Sovran revenue is derived from
management fees on properties they do not wholly own.
Source: Company Documents
4. CFA Institute
Research Challenge
January 11, 2015
Ancillary Income
Additional sources of revenue are the rental of trucks to non-
customers and existing customers. The company also sells/rents
moving dollies, blankets, boxes, tape, locks, and other
moving/storage-related products. Sovran Self Storage also earns
commission on rental insurance made available through a third
party carrier. Incidental income is earned from billboards and cell
towers.
Operations
Sovran daily operations include a call center with 45 trained sales
representatives who handle over 30,000 inquiries each month and
a peak volume of 42,000 calls per month.
Marketing Initiative
Sovran deploys an aggressive internet strategy which enables
customers to receive real-time pricing, online transactions and
reservations, and mobile software. Currently 40% of traffic is via
mobile advertising while smaller fragmented companies rely on
yellow pages and less complex applications.
Growth Using Acquisitions
In 2014 SSS committed $800 million to acquire 124 new stores.
Management focuses on quality locations and are willing to
upgrade assets with climate control and modernization. A large
70% of the firm’s rental location has the ability to be upgraded
and these units will command a 20% pricing premium driving
growth. Sovran is also willing to sell non-performing assets that
had been acquired as part of a portfolio of stores.
Management Strategy
The current strategy by management is to avoid major coastal
markets. SSS is looking for 2nd tier markets, such as Charlotte,
Houston, and Dallas which carry more attractive valuations and
profit opportunities.
Industry Overview
Self-Storage Industry Overview
Self-storage companies allow those with limited space the ability
to store away thing they do not need immediately, but in many
cases are unable to bring themselves to throw out. Self-Storage has
grown rapidly over the past years and around 1 in 10 American
households use self-storage facilities.
Key Economic Drivers
There are a few factors that influence the self-storage business on
an economic level. First, as people collect more things that they
are not able to consume and are not willing to get rid of they use
Source: Sovran Self Storage Quarterly
Report (10Q)
5. CFA Institute
Research Challenge
January 11, 2015
the services provided by businesses in the self-storage industry. As
people continue to collect things throughout all seasons of the
year, these services are required at all times in the locations where
facilities are provided. Important to note, the recent recession only
impacted the self-storage sector slightly. This is due to the reason
that many individuals who were displaced from their households
into smaller living places with more affordable costs, such as
apartments still needed space to hold their excess items that were
originally in their households. Second, due to the short time period
in which a rental contract covers, people are still reluctant to spend
time on getting rid of the things they store in the storage facilities;
therefore many of the things that were placed in storage stay in the
facilities for long periods of time.
Self-Storage Facilities
Self-storage facilities are able to be classified as Class A, Class B
and Class C properties. These play a role in competitive factors
because the metrics that separate the three classes from each other
reflect varying amounts of risk and return. The varying classes are
graded based off a combination of location and physical
characteristics. Class A locations are located in prime locations
with easy visibility and ample drive-by traffic. The class A
facilities are relatively young; having been built within the last 15
years. These facilities are well maintained and include an array of
features including climate control, security and automated access
control. Second, Class B facilities, while being located in less
desirable locations than Class A sites, are still in good locations
with a modest amount of visibility and drive-by traffic. Class B
sites will typically be older than class A and will typically have
good security. They are not always as visibly appealing as the
Class A sites, but should be in good working condition. Lastly,
Class C facilities are typically 20 years old or older and are not in
high demand locations. Class C sites often are in of need
renovation and typically lack the newer security features available
at the newer Class A and Class B sites. In many instances the
locations of Class C facilities will be in areas with very little
visibility and little drive-by traffic. As such, Class C facilities are
much less expensive and are often marketed to those customers
who need to store their items using a less expensive method and
for whom price considerations are primary.
Fragmentation
The Self-Storage sector is a very fragmented area of business,
therefore placing the bigger REITS in positions where they can
easily be consolidators of smaller businesses in the same sector.
The four publicly traded self-storage REIT companies are Sovran
Self Storage (NYSE: SSS), Public Storage (NYSE: PSA),
Cubesmart (NYSE: CUBE), and Extra Space (NYSE: EXR). In
regards to the 2014 Self-Storage Almanac, of the approximate
amount of 58,000 facilities in the United States around 11% are
Sources: Company documents, Green Street
Advisors,Seeking Alpha
*PSA’s performance is used as a
representation for the self-storage industry
since historical data is limited
Sources: Company documents, Self Storage
Association,Green Street Advisors,Seeking
Alpha, Statisticbrain.com. As of 6/30/2014.
*Number of facilities with ownership interest
**Per Net Rentable Square Foot
6. CFA Institute
Research Challenge
January 11, 2015
managed by the 10 largest operators. With only a small percentage
of facilities being owned and operated by REITS, approximately
30,800 facilities are operated and owned by mom and pop owners.
Of the large operators, primarily the REITS, they have been able
to utilize their owned properties at levels of profitability that was
not possible a few years ago due to efficiencies of scale and well
as internal revenue management systems.
Self-Storage Future Growth
Relatively safe investments due to the nature of REITs, there are
still prevalent threats. Primarily those threats come from
Macroeconomic trends due to REITs having a very cyclical
nature, more specifically when the economy does well REITs tend
to do well. The primary factors that push future growth are
occupancy, rental rates, concessions, and acquisitions. For Sovran
Self Storage, occupancy rates are at a very high level,
experiencing rates in the lower to mid-90’s range. In 2011 SSS
had an 82% average occupancy rate and have recently increased to
90% and are projecting higher rates for next year. Due to these
record high occupancy rates we predict more of the future growth
to come from rental rates and acquisitions; due to these high
occupancy rates it will also be challenging for other players within
the self-storage to provide services unless already in the business,
therefore there is minimal immediate threat of new supply other
than the existing players. Among REITS, self-storage is a niche,
but in most cases for REITS performance and future growth is
more impacted by macroeconomic events rather than impacted by
business itself. Important to note, self-storage REITS are also
more resistant to recessions than other asset class areas, but
nevertheless downturns in the economy still hurt everyone.
Leverage vs Industry
Due to the tax laws surrounding REITs, around 90% of taxable
income has to be distributed as dividends to shareholders. For
Sovran Self Storage and other REITs, this means it can be difficult
to maintain retained earnings; therefore to grow Sovran Self
Storage must issue both debt and equity. Regarding funding for
future acquisitions which has a big role in future growth, Sovran
Self Storage matches funding with 60% to 77% being equity, with
the remainder being debt.
Investment Summary
We feel Sovran Self Storage is a well-managed, high quality
company with excellent prospects as an industry consolidator in a
highly profitable, fragmented niche of the US real estate sector.
Sovran is not the largest self-storage company in the US. That
honor belongs to Public Storage (PSA). The company also does
not rank supreme on key performance metrics like occupancy and
Sources: Sovran November 2014
Investor Presentation
7. CFA Institute
Research Challenge
January 11, 2015
REVPAF. That said, Sovran is sufficiently differentiated from
Public Storage and other prominent peers due to:
Geographic location – Sovran has avoided the volatile,
expensive California market and is located in just 25 states,
most of which border the East Coast and Gulf of Mexico.
Property profile – Sovran prefers high quality “Tier 1”
properties – typically multi-story structures with excellent
signage, HVAC, security, and humidity controls – in Tier
1/Tier 2 markets (ex: Jacksonville).
Further, we believe the extent of fragmentation in the industry is
such that Sovran can continue to grow and act as an industry
consolidator for several years hence even as large peers do the
same. The largest 10 self-storage companies control less than
15% of the industry.
Most self-storage properties are controlled by small, private
owner-operators. Sovran and other large peers have a significant
advantage over these firms. For one, scale allows them to spread
corporate overhead over a much larger portfolio of properties –
turning a much larger percentage of NOI into FFO. Sovran is also
able to invest in better information and customer service systems
to drive profitability. Its Customer Care Center handles inbound
inquiries for all of its owned and managed properties. It can
handle as much as 42,000 calls per month. Over 98% of inbound
calls are answered compared to 60% or less at mom-and-pop
shops, that according to Sovran. Its revenue management system
is also far superior to small firms, which often use little more than
reactionary judgment in setting prices. This allows the company’s
8. CFA Institute
Research Challenge
January 11, 2015
properties to sport higher occupancy rates and REVPAF than most
in the industry. As a result, the company can acquire a property at
a fair market rate from a smaller peer relative to current NOI,
substantially improve that NOI, and end up actually receiving a
bargain. Sovran’s management team is seasoned and understands
this. The company’s Chairman/former CEO and current CEO
have both been with the company since its founding and both have
30+ years of experience in the self-storage industry.
While we feel Sovran is a great company, we are somewhat
skeptical that the stock is an attractive investment at this point.
Sovran and its publicly traded peers’ stocks all sit at all-time
highs. Interest rates are at a 75-year low and have pulled cap rates
below their normalized level as well. Lack of supply over the last
few years has also brought self-storage industry occupancy rates to
an all-time high, but outsiders have taken notice and new capital is
coming into the sector with significant increases in supply
expected in 2 years. There is uncertainty when and to what extent
interest/cap rates will revert, but we believe they will at some
point and that that, more than anything else, makes Sovran a sell.
Financial Analysis
We have conducted an in-depth analysis of the company’s
financial statements and created a 3-statement model that
includes a complete Income Statement, Statement of Cash
Flows, and an abbreviated Balance Sheet. The model can be
found in Appendix Section 2. We included only an abbreviated
balance sheet reflecting our belief that the company should be
analyzed exclusively as a going concern. The company has no
debt repayments due until 2016 and we foresee it having no
difficulty meeting its interest payments in the meantime. It
has investment grade credit ratings and weathered the
financial crisis in 2008-09 without missing dividend payments.
It also remained profitable. As such we see a negligible risk of
bankruptcy over the next few years. The abbreviated balance
sheet is further supplemented through our addition of a
financing worksheet. As it is Sovern’s stated policy to pursue
growth primarily through acquisitions, this worksheet
provides a detailed analysis of the additional debt and equity
that we are projecting that management will issue each year.
We are assuming that they will seek to maintain a 70%/30%
incremental equity/debt ratio as has been used historically
and in accordance with management communications.
Our projections have been made through 2018 providing a full
5 years of projected data. This was completed three times
using a different set of assumptions that represent a ‘bull’ case,
‘bear’ case, and ‘base’ case. A detailed analysis of our base case
9. CFA Institute
Research Challenge
January 11, 2015
is depicted in Appendix Section 2. Section 3 then goes into the
assumptions that we used to create the 2 alternative scenarios
and we have included the income statement from each of
those models as well. A lengthy discussion is given there, but
briefly the model varies the interest rate outlook affecting
interest expense and the capitalization rate of acquired
companies. We also vary the occupancy percentage and rental
rate per square foot and the EBITDA margin of the firm. We
weight each scenario as equally likely in all applications of the
model. In general, we expect interest and capitalization rates
to increase, Sovran to continue acquiring properties at a
moderate rate, rental revenue to increase, and margins to
remain stable or improve.
Interest/Cap Rate Outlook
We believe cap rates will increase at some point in the future. It is
likely but unclear that this will occur over the next 4 years. In our
scenarios we assumed the following changes to both capitalization
and interest rates over the next 4 years:
· Bear - 200bp increase
· Base - 100bp increase
· Bull - no change
Valuation
REITs are typically valued based on FFO, AFFO, and NOI.
Traditional valuation metrics like net income are less meaningful
due to the inclusion of US GAAP-mandated depreciation &
amortization on land that actually appreciates in market value over
time. Sovran is no exception, as it owns considerable land
underlying many of its self-storage facilities. We valued Sovran
in three different ways. These methods rely on our models of the
company’s financials through FY2018. The numbers used in our
valuation represent an average, equally weighted, of the three
scenarios that we detailed in our financial analysis section. The
methods used to create our valuation were an analysis of
comparable companies, and then an IRR based model though 2016
and through 2018. The model, its assumptions are outlined in
detail in the appendix sections 4 and 5.
The first valuation method we used was comparative valuation
that assigned a multiple to FFO based on comparable companies
to Sovern. On this metric we found that Sovern is relatively
undervalued relative to its peers. Strictly applying what we think
is a fair multiple to our forecast of Sovern’s 2014 FFO results in a
share price of $105.40, an upside of 15.7% to the current price.
However, we are skeptical that such a price represents a true
representation of the intrinsic value of Sovern. As all self-storage
companies have seen material price appreciation over the last few
Source: Multpl
(www.multpl.com/interest rate/)
10. CFA Institute
Research Challenge
January 11, 2015
years it is possible that investors have been overly exuberant in the
multiples they have been assigning to the industry. Notably,
Public Storage trades at just a 4.5% cap rate.
Instead, we gave much more weight to our absolute-basis
valuation, where we calculated the IRR to be expected over the
next 2 and 4 years. This analysis concluded that an investor would
have received an IRR of 4.01% if they held the stock through 2016
and an IRR of 4.14% if they held through 2018. We believe this is
far too low. We elected to calculate a starting equity price that
would deliver a holding period return of 7.5%, a value that we
consider fair in light of current market conditions and other factors
detailed in the appendix. This gave us a fair value per share of
$85.37 and $80.80 if holding through 2016 and 2018 respectively,
or an average of $83.09.
Investment Risks
Market Risk
SSS is a publicly traded security and as such any investment in
SSS is subject to the broader swings in the market and the
market’s overall risk premium. This may change and could led to
gains or losses regardless of changes to the underlying business of
Sovern Self-Storage.
Interest Rate Risk
As a REIT the performance of Sovern Self-Storage is highly
correlated with the 10 year US treasury rate. This rate effects
nearly all aspects of an investment in SSS. It effects the cost of
future debt but also closely affects the capitalization rate that
investors are willing to pay to hold any real estate asset and
likewise will affect the ability of Sovern Self Storage in
acquisition of other storage facilities whose price is tied to the
broader interest rate environment.
Acquisition Risk
There is a risk that Sovern Self Storage is unable to continue
finding adequate companies at a reasonable price as it has been
able to in the past. Such a scenario could adversely affect Sovern
Self Storage’s ability to maintain its levels of income growth and
thus poses a risk to investors who are counting on such rates to
continue.
Industry Competition & New Construction
Historically the largest risk to the self-storage industry is from an
increase in supply of new stores. While new construction has
been subdued over the past few years, new construction could
increase at rates materially different from forecast rates of
construction and thus have a respective effect on price charged per
square foot.
11. CFA Institute
Research Challenge
January 11, 2015
Government Legislative Action
The REIT structure is a specialized tax structure that has been
created through an act of the United States legislature. As such,
all REITs face the risk that a subsequent act of congress could
eliminate or materially alter the structure. This action would cause
an unforeseeable in pact on the stock price of SSS.
Conclusion
Recommendation and Price Target
In thinking about setting our price target, we discounted the results
of the comps analysis and focused on the IRR valuation.
Although the comps analysis was informative and directed much
of our research, it is less meaningful in this case because some of
Sovran’s peers are notably better companies and deserve a
premium. Furthermore, it is possible that Sovran’s peers are
overvalued. For example, Public Storage trades at a 4.5% cap
rate. We then turn to the 83.09 fair price output of the IRR
valuation. The 8.79% downside it implies does not represent an
extreme move over 12 months. We also have more conviction in
this number due to:
Sovran stock and its peers sitting at 52-week and multi-year
highs.
Our bearish outlook on interest rates
Our analysis is grounded in extensive fundamental analysis.
Therefore, we assume this as our 1-year price target. Seeing
as it implies non-trivial downside for a quasi-fixed-income
security, we recommend that investors sell Sovran shares at
this time and price ($91.09, January 11, 2015).
12. CFA Institute
Research Challenge
January 11, 2015
Disclosures:
Ownership and material conflicts of interest:
The author(s), or a member of their household, of this report does not hold a financial interest in the
securities of this company.
The author(s), or a member of their household, of this report does not know of the existence of any
conflicts of interest that might bias the content or publication of this report.
Receipt of compensation:
Compensation of the author(s) of this report is not based on investment banking revenue.
Position as an officer or director:
The author(s), or a member of their household, does not serve as an officer, director or advisory board
member of the subject company.
Market making:
The author(s) does not act as a market maker in the subject company’s securities.
Disclaimer:
The information set forth herein has been obtained or derived from sources generally available to the
public and believed by the author(s) to be reliable, but the author(s) does not make any representation or
warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used
as the basis of any investment decisions by any person or entity. This information does not constitute
investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report
should not be considered to be a recommendation by any individual affiliated with CFASociety of Buffalo,
CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.
13. CFA Institute
Research Challenge
January 11, 2015
Appendix: Sovern Self Storage
Section1: Competitive Analysis
1. Porters 5 Forces Framework
1. Rivalry among Existing Competitors: 4
Much of the competition is separated geographically across the United States,
and although there are plenty of mom and pop store competitors, they don’t have
nearly the revenue management capabilities or the resources the larger REITs
have at their disposal. The 10 largest businesses own and manage a very small
amount of the total number of facilities in the United States and in many cases
due to inexpensive dollar contracts there can be little reason for there to be
pricing battles between the Self-Storage businesses.
2. Threat of New Entrants (Barriers to Entry): 2
The storage sector within real estate requires lower initial investment, which is a
contributing factor to the fragmentation within the sector. The requirements to
perform in this business area can be as simple as purchasing land to store items.
3. Threat of Substitute Products: 4
The threat of substitute products is relatively minimal, due to the closest
substitute products falling in the category of storage sheds, pods, and space at
home. It is important to note, substitutes such as pods may not be permitted by
certain living communities.
4. Bargaining Power of Buyers: 5
Self-Storage customers typically have very high switching costs due to the reason
that it can be very costly and time restricting to constantly move their items as
prices change. Many of these customers Self-Storage businesses face are also
very fragmented and don’t have the power to negotiate as easily, especially when
they need to store their goods somewhere.
5. Bargaining Power of Suppliers: 5
Historically, the only other parties that may have had contact with the prospective
customer were the intermediaries that put the customers and Self-Storage
businesses in contact, such as the yellow pages. These intermediaries are not
posing any type of forward integration threats into Self-Storage.
14. CFA Institute
Research Challenge
January 11, 2015
Section2: Financial Analysis
1. Model Structure
The model consists of four worksheets – Financing, Income Statement,
Abbreviated Balance Sheet, and Statement of Cash Flows, with inputs designed for
that order.
The Financing worksheet was necessary to supplement the traditional 3-statement
model because Sovran is very active in acquiring new self-storage facilities
through the issuance of new debt and equity and we wanted to capture the amount
of equity and debt that will be issued and its cost accurately. We forecast a change
in rentable square feet and assign a cost per square foot to compute the annual
financing needs of the company. We then consistently assume that 70% of this
incremental capital is raised via the issuance of new equity with the remaining 30%
debt in line with management communication. The company’s enterprise value
approximates these weights and the company aims to maintain this capital structure
by matching it in new issuances. We then derive an average annual share price
from trailing AFFO to get the number of shares issued. We forecast a change in
incremental interest rate to calculate incremental interest expense.
2. Financing Worksheet
15. CFA Institute
Research Challenge
January 11, 2015
3. Income Statement
The Income Statement begins with rent revenue, which is calculated from the
change in average rentable square feet, occupancy %, and rental rate per square
foot. We believe this is consistent with Sovran’s disclosures and common practice
in modeling REITs in general. Other Revenue (mainly management fees) is
modeled as a percentage change. All operating expenses are modeled as a
percentage of total revenue, other than Depreciation & Amortization, which is a
percentage of Net PP&E. Interest Expense is equal to the prior year amount plus
incremental interest calculated in the Financing Sheet. Diluted Shares
Outstanding is equal to the prior year number plus 0.50% to account for stock-
based compensation. We also add the shares issuances for the acquisition of new
properties as calculated in the financing sheet. To arrive at AFFO, we assume 40
cents of recurring capital expenditures per rentable square foot, based on
information provided in the CFA Challenge investor presentation.
17. CFA Institute
Research Challenge
January 11, 2015
4. Balance Sheet
The Balance Sheet is abbreviated and only includes: Gross PP&E, Accumulated
Depreciation, and Net PP&E. We did not need any other Balance Sheet
information for our analysis as we analyzed the company exclusively as a going
concern and there aren’t any non-core assets of interest. Gross PP&E is equal to
the prior year balance plus the (1) Net Acquisition of Real Estate Assets and (2)
Improvements line items of the Statement of Cash Flows. Accumulated
Depreciation equals the prior year balance plus Depreciation & Amortization and
Net PP&E equals Gross PP&E less Accumulated Depreciation.
5. Statement of Cash Flows
The Statement of Cash Flows does not contain many major assumptions. Net
Acquisition of Real Estate Assets is pulled from the Financing worksheet. For
Improvements, the 2014 number is an extrapolation of the company’s 2014 YTD
results and the numbers that follow are based on the prior year number plus the
growth rate of the company’s rentable square feet. The debt repayment in 2016 is
the only maturity in the next 4 years. Dividends paid are modeled at 92.5% of net
income. As a REIT, Sovran is required to pay out at least 90% of its taxable
income (different from US GAAP net income) as dividends. Absent the Taxable
Income number, we find 92.5% of Net Income to be a good approximation.
19. CFA Institute
Research Challenge
January 11, 2015
Section3: Scenario Analysis
1. Model Cases, Assumptions,and Outputs
Given the uncertainty around several factors that will have a major impact on
Sovran’s financials, including changes in cap rates and occupancy just to name a
few, we thought it best to come up with multiple modeling cases with varying
degrees of conservatism.
The table below presents our three cases and the assumptions of each:
Bear Base Bull
Macro
Assumptions:
10-Year
Treasury Note
Steadily rises ~200
bp over next 4 years
off 75-year low and,
in turn, cap rates rise.
Rises ~100 bp over next
4 years.
No change over
next 4 years.
Competition
in Self-
Storage
Industry
New
developments/capital
negatively impact
self-storage industry.
Competition from new
developments
negatively impacts self-
storage industry, but
somewhat less severe
and does not become a
factor until 2 years out.
Competition
decreases slightly
in self-storage
sector as new
capital has trouble
with zoning and
other aspects of
development and
major players
remain rational.
Model Items:
Acquisition
Costs
Remain constant as
the secular price
decline from higher
cap rates is
completely offset by
a flood of new
capital.
Decrease 2% per annum
over next 2 years with
rising cap rates and
little new competition
followed by -1% in
2017 and ’18 with a
continued rise in
interest rates and some
new competition.
Finishes 5.9% lower
than FY14.
No change with
constant cap rates
and absence of
incremental
competition for
properties.
Average
Share Price
Declines as cap rate
increase results in
multiple contraction
for most REITs and
rising interest rates
make fixed income
alternatives relatively
more appealing.
Decreases less
significantly as cap rate
increase is smaller than
in Bear Case.
Increases with
constant multiple.
Incremental Rises 200 bp from Rises 100 bp from No change from
20. CFA Institute
Research Challenge
January 11, 2015
Interest Rate Current weighted
average.
Current weighted
average.
Current weighted
average.
Occupancy Declines 400bp from
historic high >90%.
Remains flat at historic
high > 90%.
Steadily increases
to 93% in 2018.
Rental
Rate/SF
Inflationary pass-
through increase
slightly offset by
increasing
competition; 2%
increase per annum.
Inflationary pass-
through increase and
improvement in revenue
management system
slightly offset by
competition; +3.5% in
2015 and 2016, +2.5%
in 2017 and 2018.
Little inflation but
continued lack of
competition and
revenue
management
system yield 4%
annual increase.
EBITDA
margin
Relatively constant
2015-2018 at 53.8%
Relatively constant
2015-2018 at 53.8%
Improvement in
all categories to
58.9% in 2018.
23. CFA Institute
Research Challenge
January 11, 2015
Section4: Comparative Valuation
Now that we have fundamental metrics to base our valuation methods off of and
have explained the assumptions that we used to calculate these numbers, we will
value the stock.
We valued the stock on both a relative and absolute basis.
1. Comparables
Our comps analysis indicates moderate upside on Sovran shares of 15.7% to the
valuation level of its closest publicly traded peers. We note that all of the publicly
traded self-storage firms are trading at a very similar valuation range (23-26x
P/FFO). We find this unsurprising as all of the four publicly traded self-storage
firms are generally well managed with good prospects as industry consolidators
relative to their small, private, owner-operated peers. The one very notable outlier
is Public Storage with a cap rate of 4.5%. We believe this is due to Public Storage
being perceived by the market as the best-of-breed industry leader. It is by far the
largest self-storage company. This puts it in a better position to consolidate the
industry and gives the stock a liquidity premium over its peers. Impressively, it
has occupancy that is about 300bp higher than Sovran and rental rates/square foot
about 13% higher – that despite owning lower tier properties (for the most part
single-story boxes in suburban markets). It is also likely perceived as a safer
investment because the company does not operate its properties and avoids the
associated risks.
24. CFA Institute
Research Challenge
January 11, 2015
2. 5 Year Price Chart
These four stocks have all delivered outstanding returns over the past 5 years:
We believe they will continue to closely track each other and therefore think it
most valuable to determine the industry/secular-level factors that will largely
determine the prospective returns of these stocks. The most obvious and probably
most influential secular factors are cap rates in US real estate and, more broadly,
interest rates, as well as emerging competition in the self-storage industry. This
leads us to our second valuation analysis, which is predicated on current and
projected future cap rates.
25. CFA Institute
Research Challenge
January 11, 2015
Section5: Internal Rate of Return Valuation
1. Capitalization Rate Discussion
What Paul is talking about is we’re willing to pay, say, a 6 cap in Chicago for a
mature deal that has the normal upside, let’s say. If we’re doing a CO deal, we
would like to see a 9 cap 3.5 years out at maturity. That’s our risk for lease-up, I
guess. – Dave Rogers, Sovran CEO, Q3 2014 Conference Call
In the above quote, Sovran’s CEO essentially tells us what the company deems a
buy under current conditions in the self-storage industry. Sovran’s portfolio is
almost entirely mature properties and so one could infer that management would
be interested in repurchasing shares if its stock was valued at a 6% cap rate (16.7x
P/NOI). Sovran’s current market price actually values the firm at a 6.94% cap rate,
meaning it is moderately cheaper than management’s implicit fair valuation range.
This begs the question: Why is Sovran’s management team heavily issuing equity
to buy other properties at more expensive valuations when it could be repurchasing
its own shares at a lower valuation level. The answer is likely complex, but we
feel a few factors are at play:
There is an institutional imperative for Sovran to issue equity and acquire other
properties because it gives the firm a market identity as a growth company.
Repurchasing shares could cause the market to re-rate shares lower because the
stock would be viewed differently.
There is a fundamental difference between Sovran’s existing property portfolio and
those properties it is acquiring at 6-caps.
We believe this difference is most likely to be in occupancy % and rental rate per
square foot. In the firm’s presentation to the CFA competition teams, they
mentioned that many of the mature properties they acquire have occupancy rates of
87-88% and suboptimal pricing due to them lacking the support of a sophisticated
revenue management system such as Sovran’s. In other words, there is more room
for incremental improvement in the properties being acquired than those the firm
already owns. Hence, the following quote:
We issued a little more equity in 3Q than we had expected. We were trading at a
reasonable level compared to cap rates we were paying. We thought it made sense
to take advantage of that. – Andrew Gregoire, Sovran CFO, Q3 2014 Conference
Call
Management is admitting that its portfolio is less attractively-valued than other
properties in the self-storage market. This makes us comfortable conservatively
assuming that the portfolio’s current implicit cap rate is fair.
We then project out a change in cap rates to both 2016 and 2018 that accompanies
all of our modeling cases and weight each case equally to see the average IRRs to
be expected through 2016 and 2018 respectively.
27. CFA Institute
Research Challenge
January 11, 2015
4. Discussion of Fair Value IRR
We get a very similar IRR over both durations of just over 4%. The question
then becomes: what IRR is sufficient for Sovran’s equity? We think a 4% IRR
for most equities is insufficient. Evidence for this claim abounds. Public Storage
has many classes of preferred stock in its capital structure that yield more than
4%. The Series Q Cumulative 6.5% Preferred (Ticker: PSA PRQ) currently
yields 6.06%. It trades at about a 7% premium to its liquidation preference and
may be redeemed on or after April 14, 2016. In the case of rising interest rates
which we deem very likely, Public Storage probably would not redeem the
preferreds. So with Public Storage’s preferred, you are getting a security higher
in what many would argue is a better self-storage company’s capital structure,
with a significantly higher yield. Outside of the self-storage industry, most
equities should deliver better than 4% long-term returns. In Stocks for the Long
Run, Jeremy Siegel argues at length using extensive data that equities globally
deliver 6-7% real long-term returns and have done so for almost two centuries.
Adding 2.5% for inflation, that’s 8.5-9.5% per year, much higher than Sovran’s
4%. We thus feel the 4% IRR result indicates Sovran is overvalued.
It is imperative that we quantify the degree of overvaluation though. Although
equities should deliver 8.5-9.5% nominal annual returns over very long holding
periods (30+ years is Siegel’s operational definition), we feel US public equities
are currently priced rather richly and that equities will likely deliver less than 8.5-
9.5% annual returns over the next 2-4 years. Some would also argue that
Sovran’s equity is less risky than the typical equity because of the business
quality of the company, the stability (ignore 2008-09 for a second) of real estate
as an asset class over common equity, etc. We think this claim is reasonable. We
assume a fair expected IRR for Sovran would be 7.5%. We input a prices into
both our 2016 and 2018 IRR calculations, holding all other variables constant, to
determine the current share prices at which we would expect Sovran stock to
deliver 7.5% IRRs over the next 2 and 4 years.
29. CFA Institute
Research Challenge
January 11, 2015
7. IRR Valuation Summary
The result is a fair share price of $85.37 and $80.80 for the IRR calculations
through 2016 and 2018 respectively. The 2018 IRR is substantially lower due to
the longer time horizon spreading the capital gain over more years. We then
averaged these two numbers to come up with an average fair share price of
$83.09. We note that this implies just under 9% downside from the current share
price.
