Shares of Equity LifeStyle Properties (NYSE:THEM) have lagged the broader market this year, gaining just 8%, but they have outperformed many real estate stocks, with most apartment REITs, for example, posting losses. With its unique business model and asset allocation, ELS has significantly outperformed the national rent slowdown in 2023. Although the shares are relatively expensive, I view them as attractive given the likely rent growth in 2024 and margin expansion opportunities.
Equity LifeStyle owns 450 properties of manufactured home (MH) communities, RV resorts, campgrounds and marinas. Although the company operates in 35 states, 34% of its locations are in Florida, 11% in California and 10% in Arizona. It has 75,000 MH sites while its 225 resorts have 90,000 sites with 35,000 annual leases, the rest being seasonal, transient or members-only. Equity’s 23 marinas have 6,900 slips. From a revenue perspective, its MH unit is the main driver, and annual leases represent approximately 90% of its activity, of which only 10% is seasonal/transient.
This helps provide strong revenue visibility. Today, 2023 has been a difficult year for many homeowners. After extraordinary rent inflation in 2021 and 2022, rents have not only normalized, but according to List of apartments, rents are decreasing from year to year. We have seen household formation normalize and the supply of apartments has increased, helping to meet increased post-COVID demand. Rents remain high in absolute value, but their rate of change has slowed significantly.
Equity LifeStyle has managed to largely reverse this trend. In fact, MH’s rent growth was still 6.9% in October, with an occupancy rate of 94.9% as of 10/31. Manufactured homes haven’t seen a construction surge like apartments, which has helped protect them from supply pressures. Manufactured homes are also relatively inexpensive, making them an attractive “discount” play, especially for older customers. The average manufactured home costs about $127,000 and the majority buy for cash, reducing interest rate sensitivity.
Equity LifeStyle owns the land on which the manufactured home is located and the owner will pay rent for the parcel of land. In addition to its relatively low cost, ELS benefits from favorable demographic factors. 70% of its communities are officially 55 or older or have an average of residents 55 and older. In its key states, this population is growing strongly, creating continued demand in a well-stocked niche market.
It is well known that the country is aging and that more and more baby boomers are retiring. As you can see below, the largest cohorts of baby boomers are just entering their late 50s. As these Americans continue to retire, the pool of people who tend to value ELS’s product will continue to increase, which should generate sufficient demand to support rental growth.
Additionally, Millennials are the largest generation, and they are in their prime years of RVing and RVing. Interestingly, RV and marina rent is 3.6% higher than last year. While this is positive, annual base rents increased by 8.6%. In other words, we see a decline in small seasonal/transient segments. In 2021-22 we saw an increase in travel, with campervan sales also increasing as people began to move away from COVID restrictions. With the return of this activity to more normalized levels, we are seeing a slowdown in seasonal activity. While this has slowed growth, the fact that RV and marina rents continue to rise is a testament to the fact that annual leases are at the heart of Equity’s business.
These strengths are reflected in the company’s financial results. In the business third quarter, normalized funds from operations (FFO) was $0.71 per share, up 2% from last year. Core revenues increased 5% to $336 million. Although strong rental growth is driving revenue gains, conversion revenue has been somewhat weak. Indeed, real estate operating expenses increased by 5.1%, with utilities and payroll increasing by 1.2%. They represent almost half of the expenses. Repairs and maintenance increased 8%, driven by higher storm cleanup costs. Insurance expenses increased 10% while property taxes increased 12%. Rising insurance costs have hit the real estate sector and are likely to remain high. As real estate price appreciation slows, we should see property taxes decline next year, helping the company regain its margin.
I was particularly encouraged to see that rental income is growing faster in the fourth quarter than in the whole of 2023, according to the latest forecasts, which reflect that rental activity remains strong. The revenue tailwinds are not yet fading.
Even more so than Q4 2023, I am encouraged by the preliminary 2024 stocks, which are most relevant to future stock price movements. The company sent rent increases in October to half of its MH residents, with an average increase of 5.4%. Annual VR rates are up 7% at 95% of its locations. This pace is a little slower than in 2023, but it is still quite high, well outpacing apartment rents and overall inflation. With moderate labor costs and a likely slowdown in property taxes, we should see net operating income grow in line with revenue.
Beyond this favorable commercial dynamic, Equity LifeStyle has a solid balance sheet. It has leverage of 5.3x and its debt is well structured. 89% of the debt is due after 2026, with no maturity for 2024, which allows it to weather this period of high rates. Interest expense of $33.4 million in the third quarter was up from $29.8 million, but we’re not expected to see further significant increases until 2025, at the earliest. Overall, ELS debt has an average rate of 3.7% with an average maturity of 9 years, with manageable maturities over the next decade.
ELS is moderately increasing its unit count with 1,000 expansion sites planned in each of the next two years, modeled on a stabilized 8-10% yield. The company has $90 million in recurring investment requirements and approximately $140 million in discretionary investments. ELS has a dividend coverage ratio of 1.6x, leaving it with approximately $200 million in retained cash flow, meaning it can essentially self-fund all of its investment needs, rather than relying on debt markets.
The shares have a dividend yield of 2.5% and an FFO yield of 4%. Historically, the company has grown dividends faster than FFO as it has reduced its high coverage ratio. I view 1.5-1.7x coverage as a solid level to ensure sustainable dividends and flexibility to engage in growth investments. As such, I would expect dividend growth to more closely track FFO growth in the future in order to keep coverage close to current levels.
Equity LifeStyle has handled this rental market downturn incredibly well, thanks to its niche market and demographic tailwinds. As a result, shares are now trading at a higher valuation. I look for the company to generate around $2.95 to $3.05 in 2024 FFO, giving it a forward multiple of 23.5x. For comparison, the Mid-America Apartment (MAA) is trading at less than 15x.
The favorable winds which boosted results in 2023 should continue in 2024, as evidenced by the announced rent increases. Beyond 2024, the aging of the population and the high cost of traditional housing should be favorable factors for the company’s results for several years. In other words, ELS trades at a premium, but that premium is justified. With annual unit growth of around 1% and rent growth of 4-5% given these factors, ELS is positioned for FFO growth of 5-7%, or slightly more if it can recoup some lost operating margins in 2023. With a starting yield of 2.5% and dividend growth of between 5 and 7%, ELS can offer investors returns of around 8%.
I consider this to be a generally fair value, which means that the shares are held. Investors can receive a secure and fast-growing dividend. However, given its premium nature already present in its multiple, ELS is unlikely to generate a return of more than 15% for investors over the next year, absent a further rate cut. of interest. There is also no urgent need to sell, given this return potential, particularly if an investor has a large unrealized gain. If we saw a 5-10% pullback, I would start adding to a position, but at around $70, I view the shares as a solid position.