In March, I wrote an article titled “Equity LifeStyle Properties – A REIT You’ll Love”. Back then, I liked that the stock had weakened as a result of higher rates. It offered buying opportunities. Since then, the market has dropped 12.5%. Equity LifeStyle Properties (NYSE:ELS) has remained fairly unchanged as it is up 50 basis points excluding dividends. This isn’t my way to brag – it is hardly something to brag about – but one of the company’s fantastic characteristics. Equity LifeStyle has a long-term history of outperforming the S&P 500 without exposing investors to high volatility – not even during the Great Financial Crisis. Its dividend yield is above 2.2% again, dividend growth has picked up, and its balance sheet can withstand higher rates and whatever economic turmoil we have to face in the months ahead. In this article, I will share my thoughts on a company that fits my strategy like a glove.
REITs Are Attractive Again
What do REITs hate? Higher rates and economic uncertainty. Right now, we have both. For the first time in a very long time, we’re in a situation where bonds are not a safe haven. In other words, we’re dealing with higher rates on top of economic uncertainty. We’re also dealing with a Federal Reserve eager to maintain an aggressive hiking pace despite economic challenges. While I am writing this, the long-term treasury bond ETF (TLT) is 34% below its all-time high. Higher rates have caused real estate stocks (IYR) to fall more than 19% from their all-time high. The S&P 500 is performing slightly better with a minus 18% performance.
The other day, I read an interesting article from fellow Seeking Alpha contributor Jussi Askola who wrote that
The current market environment favors REITs due to undervaluation and strong fundamentals.
Please read his article if you’re interested in the details as I will use just a few key points for this article.
As I’m a fan of statistics and backtesting strategies, one graph caught my eye. Cumulative total returns before and after increases in the Federal Funds Rate over the past 20 years show that REITs start to outperform after increases in the Federal Funds Rate.
According to Jussi:
REITs own properties that cater to universal human needs. While businesses come and go, the need for high-quality real estate will never go away. This means that REITs have the potential for secular growth and will never become “irrelevant.”
This stuff cannot be inflated away, and in the long run, the value of these assets is almost certain to rise as long as they are well-managed and conservatively financed.
In fact, REITs tend to generate the highest returns when inflation is high and interest rates are on the rise. This makes sense, because the positive impact of inflation on rents and property values is far greater than the negative impact of rising interest rates.
I wholeheartedly agree with this assessment, which is why I care for high-quality REITs that are able to withstand the one big risk that could ruin the upside: interest rates.
Moreover, the good news is that aggressive tightening has been priced in – or at least to a large extent. While the current Fed Funds Rate is 1.50% to 1.75% (target range), CME futures indicate a more than 90% possibility of rates above 3.25% after the February 2023 Fed meeting. That’s
In other words, the market is seeing at least another 150 basis points of upside.
These numbers are extremely volatile and subject to big changes whenever a major economic event happens.
Nonetheless, and to go back to Jussi’s comments, we’re now rather far in the hiking cycle if we incorporate higher Fed Funds expectations. This makes the risk/reward for investments that thrive when rates fall much better.
This brings me to the reason I’m writing this article: Equity LifeStyle Properties.
ELS’ Value Proposition
I love REITs that excel in competitive industries. So far I own just one REIT – in the self-storage industry (Public Storage (PSA)) – but ELS is on my list as well.
Equity LifeStyle, which I couldn’t buy because of restrictions at various brokers in Europe, is a residential real estate giant. The company owns manufactured housing (“MH”) communities, recreational vehicle (“RV”) resorts, as well as campgrounds and marinas in North America.
Founded in 1969, the company owns 446 properties covering close to 170 thousand sites in 35 states and a Canadian province. It employs 4,100 employees and generates 89% of its revenue from annual sources (rents, and related).
In my prior article, I highlighted the benefits of MH in light of recent macro developments.
Especially in light of exploding home prices in the US and the ability to work from home, MH has become a real alternative for people – not just the elderly.
Thanks to ELS, we have updated data on the difference between single-family housing and MH. In this case, the difference has grown. ELS renters pay roughly 26% less per square foot versus the average two-bedroom rental in its submarkets. The monthly costs are even lower in a market where the average single-family home in ELS markets has now broken $450 thousand.
While it’s not necessarily a good thing when people are “forced” to look for MH alternatives, we see that ELS does offer alternatives without exposing people to bad neighborhoods or other things that come with finding cheap alternatives in “traditional” markets.
Since my most recent article, the difference in average monthly costs has widened. Single-family housing has become more expensive – on average, almost $200 per month. This widens the cost difference to 60%.
As a result, the company has strong operating numbers. Its total occupancy rate is close to 95% with 54% of all MH communities having an occupancy rate of 98% or more. Over the past five years, the average rent growth is 4.2%, without large outliers in 2020 and 2021 as a result of higher home prices – providing MH communities with a bigger advantage over single-family homes.
Moreover, thanks to subdued inflation rates (in the past), the company was able to not only beat CPI every single year since 2001 when it comes to core revenue growth but also its own core expenses growth (since 2008), resulting in strong net operating income (“NOI”) growth on a consistent basis.
Going all the way back to 1998, ELS has achieved 4.3% annual NOI growth, beating the REIT industry average by 130 basis points – per year! – and outperforming the apartments’ average by 160 basis points.
Funds from operations per share have risen by 9% per year between 2006 and 2021.
This also means that the dividend history is something to brag about.
The ELS Dividend & Outperformance
ELS is currently paying a $0.41 quarterly dividend per share. That’s $1.64 per share per year or 2.2% of the company’s $73.45 stock price.
The Dividend Grades scorecard provided by Seeking Alpha doesn’t look spectacular. However, it depends on what you’re looking for. In general, a lot of REITs score low on dividend safety as aggressive investments mean new loans are needed to fund operations. The dividend yield also scores extremely low versus its peers. This, too, makes sense as REITs are generally speaking higher-yielding investments attracting high-yield investors. The REITs on my radar are often lower-yielding investments with higher growth rates. Hence, I’m glad that dividend growth is scoring rather high.
Over the past year, the average annual dividend growth rate was 14.3%. This dropped to 11.1% over the past five years, and 10.0% over the past three years. On March 8, 2022, the company hiked by 13.1%, keeping the double-digit trend alive.
In general, I care a lot about dividend growth companies as they tend to outperform the market. Sustainable dividend growth indicates that a company has the fundamentals to share its cash flows with its owners on a consistent basis. Moreover, this often protects investors against inflation.
It also helps when companies offer low volatility. This tends to add to outperformance as downside protection has a huge impact on long-term results.
I discussed both dividend growth and low volatility in this article if you’re interested in the statistics behind these claims.
You probably know where I’m going with this. ELS has a fantastic history of high returns and low volatility. Since 1994, the stock has returned 14.5% per year. This beats the S&P 500 by roughly 450 basis points. During this period, the max drawdown was just 39%. This includes the Great Financial Crisis, which did a number on a lot of real estate companies. The standard deviation is less than 500 basis points above the S&P 500 standard deviation. That’s impressive given that we’re comparing a single stock to a well-diversified basket of 500 stocks. Hence, the volatility-adjusted return (Sharpe ratio) is 0.68. Well above the S&P 500 Sharpe ratio.
ELS really has the characteristics of a “sleep well at night stock”.
This is also because of its balance sheet.
Equity LifeStyle Properties’ Balance Sheet & Valuation
A healthy balance sheet is always important. However, in this market, it matters more than at any point since the Great Financial Crisis.
The average 30-year mortgage rate is now close to 6%. the highest number since the big recession more than 12 years ago.
In the case, of Equity LifeStyle Properties, we’re dealing with a company that faces most debt maturities after 2031. The average maturity duration of existing debt is 11 years, with a weighted average interest rate of 3.5%. Even if rates were to double (not a prediction, just an example), the company could dial back investments (need for funding) and rely on its existing assets. No major refinancing is needed for at least 10 years.
Only 15% of its debt is due over the next five years. On average roughly half of industry debt is maturing over the next five years. This gives ELS an edge over its REIT peers. Moreover, just 22% of its debt is fully amortizing.
With regard to the valuation, this is what I wrote in March:
Last year, the company did roughly $490 million in normalized FFO (funds from operations). That’s +17% compared to 2020.
The price/FFO ratio is 27x using the $13.4 billion market cap. It drops to 24.8x if FFO is able to rise to $540 million this year (10% growth).
In all fairness, both these numbers are not cheap but they are fair given the strong growth rate.
After incorporating recent developments, I’m estimating that the stock is trading at roughly 26x FFO/share.
That’s not cheap, but I stick to what I said in March:
Personally, I like the current sell-off and the 2.2% yield. If ELS maintains 10% annual dividend growth, we’re looking at a yield on cost of 5.7% in ten years. Yes, there are yields that pay that now. But ELS will more than likely come with similar capital gains per year if history is any indication. In the future, we can still sell ELS and move our (expected) profits into high-yield stocks if we need a higher yield.
Real estate stocks haven’t done so well this year. Higher rates and a risk-off scenario pressured stock prices. However, we’re at a point where the risk/reward is becoming attractive for real estate stocks. An aggressive hiking cycle has been priced in, providing real estate stocks with a basis to outperform the broader market – historically speaking.
In this case, I like Equity LifeStyle Properties. The company has a fantastic business model owning MH and RV communities across the US and Canada. The company has high recurring revenue, strong revenue and net operating income growth, and the strongest balance sheet of any REIT I’ve researched in a very long time.
Hence, the company is in a good spot to maintain long-term double-digit dividend growth and it can protect its shareholders against rising rates.
The 2.2% yield isn’t very high. However, ELS has a history of outperforming the market with low volatility. I believe these characteristics make ELS one of the best REITs on the market.
(Dis)agree? Let me know in the comments!