Investment Thesis

High unemployment rates and financial challenges among small businesses are two big problems that the markets are ignoring. Such problems may have negative impacts on the economy as a whole as small and medium enterprises (SMEs) make the majority of all businesses in America. PS Business Parks (PSB), which have a large tenant base of SMEs, is at risk as small business America struggles to recover. While PSB is an excellent company with desirable qualities, prices do not offer an adequate margin of safety. I rate shares a Hold.

The Elephant In The Room

Back in March, analysts and reporters were having a debate on which letter of the alphabet would illustrate recovery in the next few months or years: J, L, U, V, W, K? Economically speaking, we’re seeing more of an alphabetti spaghetti. E-commerce is having a J-recovery as people are smashing the “Buy now with 1-Click” button in Amazon (AMZN) than ever before. Airlines are having an L-shaped recovery with passenger traffic slowly increasing week-by-week. The entertainment and tourism industry is still in limbo and recovery should look like a U-shape once the vaccine arrives. Restaurants, on the other hand, may face the threat of a double-dip, W-shaped recovery if another lockdown were to happen. In short, we’re seeing disproportionate recovery across all sectors. All this is happening while the stock market is rallying to new all-time highs as if the pandemic did not really happen. So, equity market-wise, we’re looking at a V-shaped recovery… for now.

What is concerning is that the markets are ignoring the elephant in the room: sky-high unemployment rate. Yes, the number is improving from its high of 14.7% in April. However, weekly initial jobless claims have remained at about 800,000 for nearly two months, showing a significant deceleration in job recovery. As of September, the unemployment rate remains at 7.9%.

(Source: Yahoo Finance)

As noted earlier, recovery is not uniform across all industries. The hardest-hit industries were the leisure and hospitality (19.0%) and the mining and energy (14.9%) industries. On the other hand, the financial services (4.4%) and the education and health services (5.1%) industries were the least affected.

(Source: U.S. Bureau of Labor Statistics)

Geographically, gateway states such as New York, California, and Seattle are experiencing higher-than-average unemployment rates. The high costs of doing business associated, coupled with high exposure to the leisure and hospitality industry, make furloughs and layoffs uncommon in these states. Consequently, the unemployed may flee to sunbelt states where it is more affordable to live in, which also explains the lower unemployment rates in this region.

(Source: GeoFRED)

The improving unemployment rates since the high in April gives investors the illusion that the worst is behind us and that they should not worry about job recovery. While that may be true to a certain extent, unemployment numbers still remain at elevated levels, which the markets are clearly ignoring. Large, cash-heavy companies are generally well off given that they have better access to capital as well as government support. But what about small and medium enterprises (SMEs)? Let’s take a look.

The State of Small and Medium Businesses

SMEs, defined as companies with less than 500 employees, are a crucial component of the American economy. According to the U.S. Small Business Administration, SMEs make up 99.9% of all businesses in the U.S., employing approximately 60.6 million Americans, or 47.1% of the American workforce. Below shows the breakdown of employment by industry. As you can see, health care and food services have the most employment. However, both did not share the same fate during the pandemic — demand for health care workers remain high during the pandemic while restaurants suffer more due to social distancing measures and government-mandated lockdowns.

(Source: U.S. Small Business Administration)

Prior to the pandemic, SMEs’ performances were relatively strong. Based on a Small Business Credit Survey, there were 34 percentage points more businesses that experienced profitability than a loss. Revenue growth and employment growth were also positive throughout the past few years.

(Source: Small Business Credit Survey)

However, strong performance does not correlate to financial stability. Even before the pandemic, SMEs were already facing financial challenges (the survey was conducted approximately in the second half of 2018 through the second half of 2019). Only 34% of SMEs declared that they do not have any financial challenges during that period. While SMEs are generally profitable, financial stability is still a concern for the majority of them.

(Source: Small Business Credit Survey)

Prior to the pandemic, SMEs were generally profitable but still face financial challenges. But how about during the pandemic? A survey of 630 small business owners by the National Small Business Association paints a rather gloomy picture. In January, 15% of owners were not confident about the future of their businesses. In April, that number more than tripled to 48%, before going down to 26% in June. Only 23% of owners were very confident about the future of their businesses in June, as compared to 42% in January.

(Source: National Small Business Association)

This lack of confidence can be attributed to the reduction of customer demand for their products or services. Supply chain issues were also a major concern for businesses.

(Source: National Small Business Association)

80% of respondents have applied for some kind of federal lending program, such as the Economic Impact Disaster Loan or the Paycheck Protection Program. Fortunately, the majority of applicants have been approved and have received funds from various programs. Nonetheless, reduced demand and consumer spending will hurt SMEs in the near future. The lack of additional stimulus would also potentially bring several SMEs to an existential crisis.

(Source: National Small Business Association)

PS Business Parks: Strong Diversification Offers Protection

(Source: PSB Company Update — September 2020)

High unemployment rates and SME-related challenges are major headwinds for companies like PSB. PSB owns and operates multi-building business parks that consist of multi-tenant industrial, flex, and office spaces. Industrial spaces are characterized by a warehouse component as well as ample dock access; flex spaces have a combination of warehouse and office spaces; and office spaces are exactly what it sounds like — offices. The company owns nearly 27.5 million rentable square feet of space and as of Q2 2020, PSB’s total rentable square footage is broken down into:

  • Industrial — 66.1%
  • Flex — 22.5%
  • Office — 11.4%

The company also has a majority interest in a 395-unit apartment complex.

PSB’s strategy is focused on owning, operating, and acquiring large and diverse business parks in markets that have favorable attributes, such as above-average population, job, and income growth. As a result, PSB carefully diversifies their real estate holdings in major cities such as Seattle, Dallas, and Miami.

(Source: PSB Company Update — September 2020)

PSB is also very effective in diversifying its tenant base across different industries which give the company added protection against industry-specific headwinds, such as how the pandemic has negatively impacted the restaurant industry. In addition, PSB has a diversified tenant base with no one customer taking more than 3.3% of the company’s annualized rental income. The U.S. government is its largest customer, with 3.3% of annualized rental income.

(Source: PSB Company Update — September 2020)

As a result of management’s discipline and strategy to diversify the company’s portfolio across different property types, geographies, industries, and customers, PSB should not experience any significant downturn in occupancy due to the pandemic. Furthermore, PSB has a fortress balance sheet with zero debt and an A- investment grade rating which should allow the company to access capital easily and at lower costs than peers. Without a doubt, PSB has one of the best balance sheets and leverage ratios in the REITdom.

(Source: PSB Company Update — September 2020)

Not Out of the Woods Yet

However, one caveat with PSB is that it primarily targets SMEs, which makes the majority of its tenant base. As of Q2 2020, PSB has 3,627 small tenants, nearly three times their large tenant portfolio. PSB defines small tenants as those that occupy less than 5,000 square feet of space, otherwise, they are categorized as large tenants. Even though small tenants only make up 30.4% of total rentable square footage, it is worth noting that small tenants still make a substantial portion of the portfolio. As discussed previously, SMEs are already facing financial challenges even before the pandemic. Access to capital is also a limitation for SMEs. Thus, the health of SMEs is crucial to the success and growth of PSB, which is highly uncertain in today’s environment.

(Source: PSB 2020 Q2 Earnings Release)

(Source: PSB 2020 Q2 Earnings Release)

Another caveat to note is that PSB’s average lease term is very short compared to peers. PSB has an average lease term of about 3.5 years, which adds uncertainty to the company’s ability to generate consistent cash flow and retain customers. Through 2022, 45.1% of large tenants’ contracts are set to expire, representing 28.5% of total annualized rental income. This is even worse for small tenants where 68.1% of small tenants’ contracts are set to expire through 2022, representing 25.2% of total annualized rental income. Such a high concentration of contracts expiring soon may cause high volatility in near-term operational results.

(Source: PSB 2020 Q2 Earnings Release)

One last downside to PSB is due to the fact that the company is concentrated in major markets where the unemployment rates are much higher. All these factors together explain why occupancy rates have plummeted over the last few quarters. The question is how long this pandemic will persist and how long more do SMEs have to wait before additional stimulus is issued by the government.

(Source: PSB 2020 Q2 Earnings Release)

Valuation Not Attractive Enough

Despite all this uncertainty, I believe PSB is a solid company with a proven track record, strong balance sheet, and disciplined management — these give investors peace of mind holding onto PSB. Looking at the Industrial REIT sector, PSB has underperformed its peers due to its exposure to SMEs and offices.

(Source: TradingView)

Although PSB may seem to be more attractively valued compared to its peers, I believe is still trading slightly above its fair value. PSB’s historical 10-year P/FFO is 17.3x. Today, PSB trades at 19.5x P/FFO, a slight premium to its historical P/FFO. Why PSB is still trading at a premium? Reasons may include favorable growth trends in the Industrial REIT sector as well as PSB’s no-debt balance sheet. However, I would wait for a better margin of safety before buying PSB shares. Nonetheless, I will keep PSB in my watchlist and start adding positions should prices fall below the blue line.

(Source: FAST Graphs)

Conclusion

Industrial REITs have enjoyed a phenomenal run prior to the pandemic, spurred by growing e-commerce trends and the need for additional industrial space. The pandemic has accelerated such trends, with most Industrial REIT stocks enjoying a V-shaped recovery following the March sell-off. PSB, however, is lagging behind peers as the markets are pricing in a potential long-term headwind for SMEs as well as offices, which PSB has sizeable exposures to. A further delay in government stimulus would likely hurt SMEs which already have financial challenges coming into the pandemic. This may pose more pain for PSB in terms of collecting rent, especially from highly affected industries such as retail and food services. SMEs also have less access to capital than their larger tenant counterparts. Furthermore, lease terms are very short, giving tenants the option to vacate to preserve more cash, which of course adds more pressure to rent collection as occupancy rates fall.

Despite all these headwinds, rent collections have improved since the end of Q2 and remained strong at 95%, which proves the resiliency of PSB’s business model and its tenant profile. Strong diversification by property type, industry, geography, property, and business size may have cushioned the blow from the pandemic. Additionally, PSB’s strong balance sheet will help the company see through the pandemic. A zero-debt balance sheet may also provide PSB with the opportunity to issue debt or draw capital from its $250 million credit facility in an attempt to grow shareholder value through opportunistic acquisitions. Finally, a continual shift towards e-commerce may drive businesses of all sizes to take additional industrial space to store more goods, which will be a tailwind for PSB and other industrial REITs.

(Source: PSB Company Update — September 2020)

PSB has all the qualities of a great company: competitive advantage among SME industrial space, favorable business trends, and zero debt. The only thing missing at the moment is an adequate margin of safety. For that reason, I will wait patiently for a better price.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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