A Low-Key Investment Strategy That Beat the Market with Half the Risk
Equity LifeStyle Properties (ELS) is the manufactured housing real estate investment trust (REIT) founded by Sam Zell. Since IPO on February 25, 1993, ELS returned 16.7% per year compared to the S&P 500’s 10.5%, through June 30, 2021. Even more impressively, ELS generated this performance with a beta of 0.5[1]. The smoother ride that ELS provided its investors can be seen in the graph of its calendar year returns below as compared to the S&P 500.
While the S&P posted five negative years since 1993, ELS had only 3. Further, the drawdowns for ELS were shallower. While the S&P 500 fell by -37% in 2008, ELS returned -12% that year. Even compounding 2007 and 2008 for ELS yields a cumulative negative return of -26%, much less odious than the market’s -37% 2008. ELS IPO’d for about $1 (split adjusted). Today, they are priced at $78. Further, they paid a cumulative $16 in dividends. Financial theory says you have to take more risk to generate higher returns. Historically, there have been myriad exceptions to this theory. ELS appears to be one. Can they keep it up?
ELS Community: De Anza Santa Cruz, CA
The Manufactured Housing Industry
Manufactured homes and their related park facilities are misunderstood. My Dad’s coolest friends live in a manufactured home park in Irvine. The husband in the couple is Australian, loves to sail, travels frequently, and is a lawn bowling enthusiast. He participates in his community’s lawn bowling league. Why do they choose to live in a manufactured home park? Community. And cost. At a time when housing is reaching record levels of unaffordability, manufactured housing remains within reach for most.
There are approximately 40,000 manufactured housing communities in the United States of America. 97% of these parks are owned by private individuals. There are three public REITS operating in the space, with ELS being a well-run example. The others are Sun Communities and UMH Properties.
As a symptom of our nationwide epidemic of NIMBYism[2], which is especially high in California, regulators simply will not approve more manufactured home parks to be built. Most mayors and local politicians do not want a mobile home park in their town. As we learned from our podcast guest and investor in the industry, TK Franz, only 10 new mobile home parks were constructed over the past 20 years. Really the only way to get a mobile home park is to buy an existing one from an individual operator.
Equity LifesStyle’s Business Strategy
As of June 8th, 2021, Equity LifeStyle owns and operates 200 manufactured home (MH) communities, 205 RV resorts, and 23 marinas. 65% of revenue is derived from the MH communities and 35% from RV parks and marinas. 91% of the company’s revenue comes from stable and recurring sources.
Equity’s business model is low risk because the customers own the units they place on the company’s sites. Whether a MH community member buys a home for $70,000 and permanently locates it on a slab in the community or drives their RV permanently or temporarily into an RV park, the customer is the caretaker for the unit. This removes any property maintenance costs from Equity’s income statement. Further, it attracts customers that are financially well off enough to afford to buy their homes.
Source: ELS investor presentation
Operating and Financial Performance
The stability and predictability of Equity’s business model shows up in their operating performance. The company averaged normalized funds from operations growth of 9% per year, with no negative growth years.
Source: MKAM and company materials
They amplified this 9% per year cash flow growth into 20% per year dividend per share growth, which filtered directly into share price appreciation of 18%. Equity’s dividend growth far outperformed the broad REIT universe’s -4% per year contraction over the past five years[3].
Source: MKAM and company materials
The dividend growth exceeded underlying cash flow growth for the reason you would expect, an expanding dividend payout ratio.
Source: MKAM and company materials
Valuation
The biggest risk we see to Equity LifeStyle Properties is that interest rates rise, and investors demand a higher dividend yield from ELS, raising its dividend yield by lowering the REIT’s price. Interestingly, ELS’s dividend yield has been remarkably stable. Investors have valued ELS for their dividend growth and predictability. As exhibited below, whether the US 10-Year Treasury yield has been 4% or 1%, ELS has consistently offered a dividend yield of between 1.25% and 2.75%. While we maintain ELS re-rating at a higher dividend yield due to rising rates remains its biggest risk, ELS has historically been immune from rate rises having a negative impact on its share price.
Source: MKAM and company materials
Expected Future Returns
Equity LifeStyle targets 4% same store revenue growth driven by rental increases. Increasing the monthly rent for a slab of land at a mobile home park is equal to an increase of $20-to-$30 a month. Thus, we think this rate of rental increases, slightly higher than historical inflation, is reasonable. The company will further drive revenue growth by building more sites on contiguous land to existing parks as demand grows. And by buying parks as they become available. We estimate that Equity can continue to grow funds from operations in line with their own history at 9% per year. Further, as they gradually increase their dividend payout ratio to be in line with Crown Castle (CCI) over the next decade, we calculated they can grow their dividend per share by 13% per year.
Source: MKAM and company materials
If the historically reliable 2% dividend yield valuation holds, this will lead to 13% per year returns for ELS. If the valuation were to be cut from 2% to 3% in a rising rate environment, this could provide a headwind of approximately -5% per year bringing the 13% return down to 8% a year. Given our expectations of below average S&P 500 returns over the next decade, and considering ELS’s risk being half of the S&P, we think an expected return range between 8% and 13% is very attractive. Further, this is a great diversifier that probably has little in common with the rest of most investors’ portfolios. We are moving some of our portfolio into manufactured housing.
[1] Beta measures the risk or volatility of a company’s share price in comparison to the market as a whole. For example, a company with a beta of 1.1 will theoretically see its stock price increase by 1.1% for every 1% increase in the market. Put differently, if you’re expecting the overall market to return 8%, a stock with a beta of 1.5 should return 12%. Definition courtesy of finbox.
[2] NIMBY = Not In My Backyard
[3] Source: S&P Global