Equity LifeStyle Properties, Inc. (ELS) Q1 2012 Earnings Report, Transcript and Summary

Good day, everyone, and thank you, all, for joining us to discuss Equity LifeStyle Properties' First Quarter 2012 Results. Our featured speakers today are Tom Heneghan, our CEO; and Marguerite Nader, our CFO. In advance of today's call, management released earnings. [Operator Instructions] As a reminder, this call is being recorded. Certain matters discussed during this conference call may contain forward-looking statements in the meanings of the federal securities laws. Our forward-looking statements are subject to certain economic risk and uncertainty. The company assumes no obligation to update or supplement any statements that become untrue because of subsequent events. At this time, I would now like to turn the call over to Tom Heneghan, our CEO.

Good morning, everyone, and thanks for joining our call. Our results for the first quarter of 2012 continue to reflect our hallmark characteristic of stable and predictable cash flow growth. There are a number of topics I'd like to discuss before turning it over to Marguerite, who will discuss the numbers in more detail. Our guidance for 2012 was impacted by a number of items that would benefit from sharing our thoughts. We have recently entered into agreements with lenders to refinance 3 properties. In addition to the higher interest expense resulting from the additional debt, our guidance assumes near-term dilution since, absent any attractive investment opportunities, we will be holding well over $100 million in short-term investments through 2013 at negligible yields. Although we would love to use the cash to reduce our debt balances, the existing defeasance costs make that choice unattractive. This decision reflects our general philosophy of maintaining balance sheet flexibility and an awareness that access to capital has been and could be subject to some volatility in the current economic environment. We believe our balance sheet is in very good shape. Since I opened up the conversation about excess cash and a lack of attractive investment opportunities, I think it would be helpful to discuss our view of the current acquisition environment. We essentially see acquisition opportunities as falling into 1 of 2 general categories. High-quality assets typically focused on the baby-boomer demographic, located in Sun Belt retirement destinations or along the coastal United States. And all age properties located primarily in non-coastal markets. With respect to the first category, we have seen a few deals and have even bid on a few transactions. With sellers pricing expectations and/or offers from third parties have been in prices which we find difficult to pursue aggressively. These may be great assets, but we have difficulty adding 1 or 2 assets at the margin to our 400-property portfolio at cap rates that would be significantly below our current valuation. We prefer instead to remain alert to opportunities where we can acquire not only great assets, but also create shareholder value. We have historically been able to accomplish that goal and believe there will be future opportunities to do so as well. With respect to the all age property type, we would note that there are significantly more of these properties available, including some distressed situations and others where the seller's pricing expectations appear more realistic. However, at this time, we are uncomfortable making any large investment that would significantly increase our exposure to the all age property type. However, we would also note that the all age property type is returning to its former niche as a provider of affordable single-family housing. As a result, we expect to continue analyzing these opportunities. In any event, one thing is clear from what we are seeing in both the financing and acquisition environment. We feel very good about the Hometown transaction. We're also pleased to report the portfolio is operating in line with our expectations. With the assimilation of the portfolio complete, we will be focusing our attention on opportunities. Two current areas we are analyzing are investing capital to achieve occupancy increases and locations where we can push rental rates. We see both of these opportunities as taking time and contributing gradually to our future growth. In addition, our guidance now excludes the impact of acquiring one remaining property in Michigan, an issue which had previously been highlighted as potentially impacting 2012 guidance. I'd also like to discuss our treatment of rental operations. When we first started renting homes near the end of 2008, it was a response to the housing and financial crisis that was then unfolding. Simply put, we could no longer sell homes. However, we did see demand for our locations and our communities that translated into demand for rental housing. We hoped that the change would be temporary and that as the housing market cleared, we could return to selling homes to our customers. Now some 3-plus years later and over 4,000 rental homes, as well as an overall housing market that continues to face issues, we have concluded there is enough activity going on here that providing more information by grossing up our income statement for rental operations is appropriate. It is also important to note that the rentals have been an important tool in increasing our core occupancy, which has now experienced 10 successive quarters of sequential occupancy gains. In connection with this change, we will also follow NAREIT's definition of FFO and add back the depreciation related to the rental homes. This does not change our view that some amount of obsolescence occurs when owning the bricks and the sticks. However, we would also like to note that this obsolescence is the same as the obsolescence that would occur in other forms of income-producing real estate. In any event, we now provide enough information so that investors and analysts can make their own decisions with respect to how to treat our rental home activity. I'd also like to comment on our unexpected miss coming from member upgrade sales. As many of you know, we have made good progress on better utilizing the Thousand Trails footprint. Since 2009, we have increased our annual and transient RV revenue 7% per year on average in the Thousand Trails footprint. The upgrade sales had been a reliable and consistent contributor to our revenues and we believe it will continue to be that in the future. However, in connection with some product revisions, a decision was made to temporarily take the sales teams offline for training. In retrospect, this was not the best decision. The downtime caused some salespeople to seek employment opportunities elsewhere and the ramp-up to full staffing will be less than immediate. It will take well into the second quarter to hire and train a full sales staff capable of producing the consistent revenue contribution we have come to expect. On a more positive note, we are running pilot programs with RV dealers on both the East and West coasts where our membership products will be packed in with the sale of RVs. The test will run through the summer months but with about 250,000 RV sold annually, we are excited about the prospects of adding this distribution channel to our existing call center, online and property level capabilities. Combined, our existing capabilities are expected to contribute 9,000 new members, a 20% increase over memberships sold in 2011. Any contribution from new distribution channels will add to this increase. In summary, the trends in our business are positive despite an economic background that is not without issues. I'm going to ask Marguerite now to discuss the results in more detail.

Thanks, Tom, and good morning. I'm going to give some details on our guidance for the full year, report results for the first quarter of the year and finally, I will provide additional details on the remainder of the year. Our updated 2012 guidance range is $4.41 to $4.61. This updated guidance assumes the following: We closed on $155 million of refinancing in the second half of the year that we have already locked rate on. These refinancings will extend the maturities of almost $100 million of debt maturing in 2013 and '14 until 2022. We will have additional interest expense associated with these financings of $0.03 FFO per share in 2012. Additionally, our guidance currently excludes the one remaining Hometown asset in Michigan and as previously disclosed, this has an impact on our guidance of $0.03 FFO per share. Rental home depreciation will be added back to net income to calculate FFO. This is a $0.13 FFO per share add back for the year. For the fourth quarter and the remainder of the year, the impact of the decline in upgrade contribution was offset by operational improvement. These assumptions are added to the first quarter FFO per share of $1.26, which was $0.01 better than guidance, excluding the $0.03 per share rental depreciation add back to arrive at FFO for the full year. The supplemental package provides updated guidance on a line item basis. Core MH revenues came in better than we have projected at approximately 3.1% higher than last year. The base rental income increase includes approximately 70 basis points related to occupancy gains and 2.4% in rate growth. We had core occupancy gains of 39 MH sites in the quarter. We continue to see strong demand for rentals throughout the portfolio and we had made progress on reducing the cost of the home. Within our RV business, we had core resource base rental income growth of 2.5%. Our annual growth rate was 4.1% offset by a slight decline of 70 basis points in seasonal income and a 3.7% growth in transient income. Membership dues came in at $11.8 million for the quarter. In the quarter, we sold almost 1,300 low-cost memberships, a 29% increase from the first quarter 2011. We expect to sell 9,000 low-cost products this year. However, we did see an increase in attrition causing our dues income to be 2.2% lower than 2011. For the quarter, the revenue for right-to-use contract or membership upgrades was $2.2 million versus guidance of $3.8 million. The expenses associated with this activity declined from an anticipated $2.4 million to $1.6 million resulting in an $800,000 decline in net contribution from guidance. Each year, we sell between 3,000 and 4,000 upgrades to our existing member base. Since 2000, Thousand Trails has contracted with a third-party to undertake the majority of these sales. The launch of a new product impacted the first quarter sales and is expected to impact the rest of the year. As a result, we have adjusted our guidance for this line item for quarters 2 through 4. The projected right-to-use revenue decline is partially offset by savings on the sales and marketing expense line items. Although still early in the process of ramping up the sales teams, our current run rate for this sales activity is already in excess of guidance for the second quarter. Our supplemental provides added disclosure for the activity occurring inside of the Thousand Trails footprint. For the first quarter, excluding right-to-use contracts revenue and related sales and marketing expenses, Core property operating revenues were up 2.4%, Core property operating expenses were up 2.2% resulting in a net increase in. core NOI of 2.6%. Property management and corporate G&A came in better than expected at $16 million versus $16.5 million in guidance. We are pleased to report that the acquisition portfolio performed in line with our expectations contributing $25.3 million in property NOI. We expect the second quarter at the midpoint of our range to be almost $46 million in FFO with a range of between $0.96 and $1.06 FFO per share. We assume no change in our MH occupancy from the end of the first quarter. Core community base rent revenue is projected to be $68.3 million, which is a growth rate of 2.9%. For the quarter, in our RV business, we anticipate $30.1 million of core RV revenue, up 3% from last year. The annuals are a strong contributor to this with the growth rate of 3.5%. Our second quarter transient pace is in line with last year at this time, and our second quarter transient revenue represents almost 23% of the total core transient revenue for the year. Dues in membership sales are expected to be $15.1 million compared to $17.3 million in previous guidance as we continue to ramp back up the sales operation for the upgrades to our members. The associated sales and marketing expenses are anticipated to decline from $3 million in previous guidance to $2.5 million. For the second quarter, excluding right-to-use contracts and related commissions, Core property operating revenues are expected to be up 3.1%. Core property operating expenses up 2.5% resulting in a net increase in core NOI of 3.6%. we anticipate that the Hometown Properties will contribute just over $25 million in the second quarter in income from property operations. For quarters 2 through 4, we assume no change in our MH occupancy from the end of the first quarter and expect to show core community base rent revenues of almost $206 million, which is a growth rate of 2.7% for the remainder of the year. In our RV business for the rest of the year, we anticipate core RV revenues of almost $96 million, which is a growth rate of 2.2% for the remainder of the year and annuals continuing a strong performance of 3.4% growth. It is anticipated that about 47% of the full year transient income will come in the third quarter. Total core revenue from dues and membership sales are expected to be $47.6 million compared to $51 million in previous guidance. The associated sales and marketing expenses are anticipated to decline from $9 million in previous guidance to $8 million. For the rest of the year, excluding right-to-use contract sales and related commissions, property operating revenues are anticipated to be up 2.5% with expenses growing at 1.6% resulting in a net increase in property NOI of 3.3%. We expect the Hometown Properties will contribute about $76 million for the remainder of the year in income from property operations for a total of $101.3 million for the full year. Property management and corporate G&A is expected to be $48.8 million for the remainder of the year and $64.8 million for the full year. Other income and expense items are expected to be around $12.7 million for the rest of the year and around $18.6 million for the full year. Interest expense for 2012 is expected to be approximately $125.4 million. We expect our average debt balance to be around $2.23 billion. Our interest coverage ratio is 2.7x and our preferred distribution is $16.1 million. From a free cash flow perspective, we anticipate having almost $205 million of FFO after paying $80 million in dividend payments, $30 million in principal payments, $30 million in recurring CapEx and $35 million in rental inventory. We have approximately $30 million in free cash flow. We make no assumption about the use of free cash flow in our earnings models. Our 2012 FFO per share estimate at the midpoint is $4.51 and our share count is expected to average 45.5 million shares in 2012. Finally, I will provide further details on the financings I discussed when giving guidance. We locked rate on a blending extend, refinancing on approximately $85.5 million of debt at 5.1% with a 10-year term on 2 resort RV properties generating excess proceeds of $20 million. Additionally, we locked rate on the refinancing of 1,300-site MH property on a blending extend refinancing with proceeds of $70 million at a rate of 4.48% with a 10-year term, generating excess proceeds of $35 million. For all 3 assets, we received very attractive financing quotes. While we would like to take advantage of these attractive terms without their maturity, the defeasance costs due to the low maturity dates are significant. Over the next 3 years, we have $34 million, $116 million and $199 million, respectively, of debt maturing for a total of $350 million. With the recent financings I just discussed and our available cash on the balance sheet, we have provided for all secured debt payoffs through 2014. Additionally, we have a $380 million undrawn line of credit with approximately 4 years remaining. Now we would like to open it up for questions.

[Operator Instructions] The first question's from the line of Gaurav Mehta with Cantor Fitzgerald.

Going back to your initial comments on right-to-use contract, I was wondering if you could provide more details on what the new membership upgrade product is?

When we're talking about our membership upgrade product or our right-to-use product, I think it's important to first discuss the profiles of the members who upgrade. They've generally -- these are members that have been with us for a while, they really -- they like the lifestyle, they're -- economically, they're well-off and they're looking to enhance their experience within ELS and within the Thousand Trails footprint. And the upgrade offers the opportunity to enhance that experience such as increased flexibility of the number of parks they can visit, longer terms on their reservations, alternative vacation options, that type of thing.

And then the sales force training, was that to educate the sales force for their membership upgrade?

Yes. I mean, as Marguerite said in her comments, we've been dealing with a third-party operator to do a portion of our upgrades for the last 10 years. This is a fairly experienced operator and historically as we transition from one product to another, it's a rollout and it's done with time, say, 6 to 9 month lead time. This time around, it was not done that way. In fact, they took the sales teams off the field for sales training. It turned out that, that was not a very good decision in retrospect, as I commented. We expect that, as again as I commented, to get that sales team back up to full sales force level and continue to provide the upgrade to the Thousand Trails members. So we don't think this is an issue with respect to the membership per se, we don't think this is an issue with respect to even the third-party, we really think this is an issue that we shot ourselves in the foot on. We realized it. And the shame of it is it takes a little while now to actually get that sales force back up into full capacity because there is new sales teams that have to be hired, there's a hiring process, and once they are hired, there's a training process. So although we'd like to go back to the full team immediately, it does take some time and in our guidance, we provided for that to be through the second quarter primarily of this year.

Your next question is from the line of Jana Galen with Bank of America Merrill Lynch.

I think I caught in Marguerite's comments that there'd be about $35 million invested in rental inventory. I was just curious if that was across the portfolio, or are you really looking to focus on the Hometown Properties?

That number represents the whole portfolio.

It includes both new and used.

And as you look to kind of grow the rental business, where do you kind of see that going? And I guess, it will kind of be impacted on the results of the properties going forward?

We've been very successful with the rental program in our core markets in Florida and Arizona. We've recently been adding product to Colorado. But literally across the United States, California to the East coast, where we have initiated the rental product, we've seen demand and we've been able to occupy. We've experimented a little bit up in Michigan thus far. I think we purchased -- we're at a magnitude of 60, 70 homes. And we're seeing the same results up there in Michigan that there's strong demand for this form of housing in most of our markets.

And since clearly the demand is there, does this kind of change the way you're thinking about those all age potential acquisitions?

That's a great question. We look at the all age much different than we did 10 years ago. 10 years ago, we just thought it wasn't competitive against the single-family housing alternatives that were in existence and the ease with which you could get into single-family homes. We think that has changed. As I said in my comments, we think that the all age Manufactured Home Community business has returned to its niche of providing single-family -- affordable single-family housing. The big issue -- 2 big issues we see in getting in that business in a big way, one is that the dynamic that is at play with respect to being successful in that business is much more local in its focus. You have to be in the right markets. You have to know where job growth is. So just doing a macro bet that it's going to return as a single-family housing -- affordable single-family housing play, you could be right on the macro and wrong on the markets. There are some markets where there's still some challenges with respect to the all age business. And the second thing is, at margin, all occupancy in the business is achieved through community owners investing their capital. And that is an issue that we think we need to be mindful of and the question we're trying to figure out is, is that investment of capital to create that occupancy going to return itself in terms of improved value in the communities. And I'd say at this point, we're still looking at it, we're still trying to figure it out. But at this stage, I think our preliminary conclusion is that may be true. But even if that is true, does it belong in the portfolio that we have that is primarily age restricted and we struggle with that today, I would say.

Your next question is from the line of Eric Wolfe with Citi.

I'm trying to understand why so many salespeople would leave. I mean, is it just because they weren't getting paid the same amount, because they weren't making sales? I guess I'm just curious is how do you intend to see this sort of retraining and new product rollout occur versus what happened and why the salespeople left?

I wish I had a great answer for that, I don't. It was a decision that was made quickly. Frankly, there wasn't a lot of discussion on it and once done, these are sales people who relied for the most part on commission and when they're down, they're looking for how to make ends meet and they'll go find the next opportunity that's available to them, and that's what happened. So no excuses here. We shouldn't have done it. It happened. We're fixing it and I think that's all we can say about it.

Got you. And then you said that the impact is really just through the second quarter, wouldn't bleed too much into the third and fourth quarters?

Yes. Our guidance assumes that the biggest impact to ramping up is in the second quarter. As Marguerite said in her comments, the run rate we're achieving right now is already in excess of that guidance, so we're having some pretty good success getting things back on track. But again, it's still early in the game with respect to getting back to full sales teams.

Okay. And then on the underwriting for the Hometown transaction. I'm just wondering if anything has changed there other than the fact that the Michigan assets didn't close. So just that $0.03 that you talked about.

No. It's primarily Clinton. There are some pieces moving around. Any time you underwrite a portfolio of $1.5 billion, I mean, there's some movement as we start operating the portfolio but by and large -- net, net, net that portfolio's operating in line with our expectations and as I commented, we're very pleased to have done that transaction.

Okay. And then just one last question. The change in depreciation policy. I guess, what prompted that change at this point in time? Was this something that was suggested by your auditors, or did you -- was it something you were considering for a while and finally decided to make it more in line with what your peers are doing? How did you come to the decision?

It had been discussed internally for some time. It wasn't really pressure from the auditors. I mean, the auditors always kind of scratch their head when they saw this piece of our business being netted down in an ancillary section of our income statement. So that had been an issue outstanding for some time, but it wasn't really the driving force. I think the driving force was just a recognition that something that we thought was going to be stopgap measure doesn't look like a stopgap measure anymore. And to have it down in a section of the income statement, the ancillary in nature and netted just was less transparent than we would like to be. So that was our primary consideration for the relocation and the grossing up on the income statement. The secondary issue which is the treatment of the depreciation, we believe that this rental thing is more of a reaction to a difficult economic environment and not something we would want to do if we had the choice to do something else. And that there really is an obsolescence that occurs with respect to the rental homes and we tried to highlight that in the treatment of the depreciation. But we kind of felt like a guy who wanted to go to the beach and did the right thing by putting his bathing suit on. But when he showed up at the beach, it happened to be a clothing optional beach and we were the only ones wearing a suit. It seemed like the right idea at the time, but in retrospect, not anybody else was doing the same thing. So we've kind of adjusted back to what everybody else does and provided some information in our supplement and in our earnings release that allows investors to see what's going on with respect to the rental program to add the depreciation or treat the depreciation any way they want relative to FFO or add it back in, or subtract it out. The other thing that drove some of this discussion was in connection with -- we kind of reviewed how analyst's models were treating this and for the most part, we found that it was, in essence, not really being specifically addressed vis-à-vis valuation models. In other words, it was down in the ancillary and it was kind of forgotten about. We're bringing it back up and we think there are a variety of ways in which you can treat this. You can look at the amount of money we spent on the homes and say, do you think it's worth that or not, and make an adjustment. You can look at the number of homes that are out there and put a per value home on it and make an adjustment and that could be you think it's worth nothing, or you think it's worth something. But we're trying to force people to address that issue. Or you could take an income stream approach and throw a multiple on the income stream. But there are a variety of ways in which to address whether or not this rental activity is creating value for the company or not. And we're putting it out there so that everybody can see it and hopefully investors start to tackle this issue and challenge us as to whether or not this rental activity is a value accretion exercise for the company. We believe it's an opportunity for us to deal with an environment where would like to sell homes and can't, and still retain the stable core occupancy that we'd like to achieve.

Your next question is from the line of Paul Adornato with BMO Capital Markets.

Tom, was wondering if you could provide some insight into the current status of the retiree market? A couple of years ago, the thought was that the retirees were waiting to sell their homes and eventually going to sell their homes and retire into a retirement home. Is there still that logjam of folks waiting to sell their primary home? And kind of what's -- how long can that -- can the situation last?

Great question. Yes, we believe there is still a holding up of people making that decision to sell their home for a variety of reasons just in terms of the market and whether or not they could get the value that they think. I mean, to compare it to 6 years ago, people were selling their homes and taking that capital and coming down and buying homes in our community. That has pretty much dried up. I would say anecdotally, we see people kind of biting the bullet and making a decision to move down into one of our communities, but those are dribbles. And as a result, what we're really seeing is the demand for rental. And that's -- 2 things are going on. We're getting the customer who is in the local area, living in the local area, maybe had some issues with respect to his single-family residence and has looked at us as a way to do some balance sheet repair. When you can come into one of our properties, buy a used home for $10,000 to $20,000 and pay $500 or so in rent, you can do a lot of balance sheet repair with respect to your nest egg or your sources of capital. And the other one is we're getting a customer that historically has desired to be a renter -- never really wanted to be an owner. In our prior business methodology, we were never really pursuing that customer, so we're now getting some what I would call dedicated renters. The combination is enough demand for us to be able to continue increasing our occupancy.

Okay. That's helpful. And with respect to your view of the all age properties, I think you mentioned obviously that reinvestment by the property owners is essential to keeping up the occupancy in those properties. And so are -- how widespread are rent-to-own programs beyond the publicly traded companies that are out there?

Well, I mean, I think the industry is slowly but surely kind of coming to grips with this issue. Certainly the large operators who have access to capital have been either through an in-house loan program or through a rental program kind of sustaining and in some cases growing occupancy. But the traditional capital providers and it used be a lot, now it's a much smaller group, but the traditional capital providers to the Chattel loan, which is home-only financing, are slowly coming around to an acknowledgment that rental is an important piece of the business and some of those loan providers are also creating programs to lend against rental homes. So there is a kind of a slow shift in terms of the way people are viewing this issue. And I think slowly but surely, the issue is going to be something we're -- if you want to be in this business and you want to be a capital provider in this business you've got to grapple with this rental for the good and the bad. I think there's positives and negatives with respect to the rental program, as I discussed. And I think that's happening over time.

[Operator Instructions] And your next question is from the line of Andrew McCulloch with Green Street Advisors.

On the membership business, that's a small part of your company, but it increases complexity and given what you just experienced also increases the volatility of your income stream. Is there any thought of possibly divesting that business?

No, Andy. I mean, if you look at that -- the performance of that portfolio over time it has grown revenues, it's grown NOI. We like the business. If you kind of take a retrospective on it, I think the business is already returned all of the capital we've invested in it since 2004 and is still creating cash flow that's higher than when we bought it, even given the current kind of issue. So if I could find another portfolio that I could buy at a double-digit yield that will return all the capital in 8 years and still provide the same cash flow on a go-forward basis, I wish I could have that opportunity. So, no. We think the real estate is fantastic real estate and we like the locations. If you look at the customer, the customer is, by and large, our best customer from an economic profile. He's a younger baby boomer. He's got access to more net worth. So if you kind of look at all of the things that are related to that business, you find reason to like it. Now I do admit that it is a little bit more complicated than the MH business, for example. But actually I think having operated the Thousand Trails portfolio now for the last 4 years has actually sharpened us on a number of other issues that we could be more mindful of in our other operations, which is basically contact with the customer and customer relations. I think we've gotten better as a result of having to deal with the membership base. So long story, but I think we like what we're doing.

Okay. And then just switching gears, you talked a little bit about pricing for all age versus age-qualified assets. Can you expand on that in terms of what kind of cap rates you're seeing for those 2 groups?

Expand on it, I think you can buy all age assets at -- generically, I think there's been deals that have been done in the low 7's all the way up through 10. So there's a wide variety of cap rates. There's some distressed situations out there where a cap rate isn't even really calculable given the degree to which the cash flow has declined. But is providing the people who are buying those assets with a significant amount of potential occupancy upside if they have the capital to put the homes in. On the age restricted side, there's been assets in California, Arizona, Florida and the East Coast that have either had asking prices or have had offers and traded at cap rates that would be well below the cap rate on the Hometown transaction.

Okay. And then just one more question, I'll get back on the queue. Talk about the all age business returning to its roots but aren't its roots when people are buying homes in those communities, is there real demand in those communities from buyers or is the demand mostly on the rental side?

Andy, I take issues the way you phrased that question. When you're dealing with the all age business you're dealing with affordable housing kind of at its basic level. If you look at the profile of people going into those communities, they're going to be generally younger and they're going to be with an economic profile or an income profile around $25,000, $30,000 a year. So you're dealing with people who have limited income. To pretend back in the '90s that those people were buyers of the home because they got 100% financing, I think the industry kind of learned its lesson, and that was just really a rental program in drag and when those people could leave, they left. And they left to go to single-family home -- housing and I think the same thing happened with single-family housing. When somebody's making $30,000 and can step into something without having to pay for it and it's better than their current situation, I think you're going to see that happening. I think the lesson learned in the Manufactured Home Community business in the late '90s is the same lesson learned by the single-family home business in the 2000's and I don't think they're going to repeat those mistakes. But in any event, when you actually look at what happened in the business, you had a demand for the housing. To say that there was actual ownership back in the '90s when it was really just disguised rental, I think that's the reason why most of those homes got pulled out of the communities over the course of the 2000 through 2007 is that, one, they started to pull the houses to try and get whatever they could get on a recovery. I think the lesson kind of for the Manufactured Home Community business is control your housing stock. Know your housing stock because it's painful. It's painful to have to react to your houses going out of your community in a difficult economic environment and it's expensive to replenish that housing stock in the future.

Okay. But you would agree it's a very different business running a community full of rentals versus owners?

I'd say it's a very different business, but not in a way that would cause me not to want to do it, right? I mean, I would say that there are some issues that come into play when you're investing your capital in the houses. And that's the whole obsolescence game. So you don't have to ask me which community I would prefer, I would prefer to own a community that the land leased community where 100% of the homes are owned. Owned, meaning the existing tenant has capital in his house and owns it. I'd prefer that every day to a situation where I'd have to provide the incremental capital to provide the housing for that tenant. So, yes.

Your next question is from the line of Taylor Schimkat with KBW.

Just on the rental program. Thinking about the inclusion of the rental income NOI, does that suggest that you're leaning more towards expanding the rental program by investing greater balance sheet dollars in the rental homes? And I guess, along the same lines, any update in sourcing external capital to expand the rental program?

I think the decision to move it upstairs, I think, I've discussed. It really doesn't have anything to do with the decision to invest significantly more into the rental program. I think it's a recognition that we have invested a significant amount already and we just need to come out and provide some incremental detail on that. Our cash flow assumptions for 2012 include between new and used and incremental $30-some million in investing in the rental program. And as I said in my comments, I mean, the rental program has allowed us to gain sequential occupancy growth over the last 10 quarters. We've increased occupancy, I think, since the beginning of rental programs some 500-plus sites. So there's a good and a bad with respect to that. It's allowed us to do some things, but we do appreciate that it does involve capital. With respect to the second part of your question, our third-party operators or with the availability of the third-party capital providers, as I said, I think there are some traditional Chattel lenders who are now coming out with programs that will lend against rental inventory. The problem for ELS as we sit here today, that every program we've looked at that would provide incremental financing for rental or anybody we've talked to, to provide incremental financing on rental has always looked to ELS as a backstop. And when you look at programs where the interest rate is, call it 9%, 9.5% with significant amortization and at the end of the day, it's recourse back to ELS, we struggle with justifying doing that when we have a significant amount of cash on the balance sheet and the line of credit that would cost us 2%, frankly. But we are still looking for ways in which we can convince people to invest in rental homes without having ELS be the backstop.

Okay. And then, I guess, my next question then is on given that you've had some incremental occupancy increases sequentially over the last few quarters through the rental program and that there's $30-some million to be invested this year. Just trying to figure out why there's no incremental occupancy growth built into guidance throughout the year as a result of that.

As I said, the rental program is kind of a thing we're doing in light of the economic environment and one of the things that happens in our portfolio that we used to be able to replace with new home sales is some amount of holding obsolescence does occur in the portfolio. Just to replace the houses that go obsolete, you're talking order of magnitude 300 homes a year where you're buying new home to replace homes that are having to be pulled out of community because they're no longer habitable. And that's what's in our cash flow assumptions relative to guidance. We haven't really dialed up the cash flow usage to go past maintaining occupancy. Although we have in the past, invested more capital at the margin. It's just in terms of providing guidance, that's kind of our base level assumption.

Your next question is a follow-up from the line of Eric Wolfe with Citi.

It's Michael Bilerman. Tom, maybe just on the rental home. As you think about sort of return of capital versus return on capital, so you got $150 million invested in rental homes. Your FFO return now adding back the depreciation is 25%. Clearly, as you've talked about the obsolescence occurring, some of that I would assume a large part of the return is actually return of capital. But I guess, how are you sort of envisioning the return dynamics of this business?

We spend a lot of time internally kind of tearing at that question to try and read the tea leaves as to how do we appropriately use capital. I would say, the way we look at it with the depreciation was essentially to say we're getting no return on the incremental capital other than the site rents. That's kind of an easy way to look at it is that the use of capital to create a rental, the incremental cash flow you get out of that rental gets eaten up with expenses and obsolescence such that you end up with a break even to maybe even a small loss and what you're really doing is creating site rent.

And so what would the split then be? The site rent you're looking at something that's worth an 8% return and the rest is all capital over time?

8%, I mean, it's still -- I'd have to do the math, it's 500 -- $6,000, $7,000 a year on 40,000. I'm not sure that answers your question.

And as you think about over time, how much more money you want to put in? Do you have a target in mind, I mean, obviously it's from a, I guess, from a value perspective. You talked about wanting to give a little bit more detail and splitting it out so that analysts and investors would look at the value. I mean, how do you -- $150 million spent, I mean, how do you sort of view the value of those assets? Do you view it as $150 million, do you view it greater than that or something that a discount should be applied given the capital that would need to be reinvested to maintain that income stream.

I'd articulate what we did when we analyzed it from a -- putting a depreciation into the reduction of FFO, I think, that's not a bad way to look at it. That's kind of how we started. So what we have essentially said is that there's a base value for a home. Even in the environment today, you can sell a used home. Resells are occurring in our community on average between $10,000, $20,000 a year. Some of the homes we get back, we sell at -- call it $5,000 -- those are more like handyman-specials type things. So there is an active sale process going on in used inventory. And there is a value at which you can get transactions to go, let's call it somewhere in the $10,000 to $20,000. But in any event, we did depreciation with a residual value at some point in the future and depreciate it down to that residual value. And that ended up being the amount we put into our financial statements. It was close enough for government work for us in terms of trying to articulate what we thought was going on with the impact of the rental program.

Your next question is a follow-up from the line of Andrew McCulloch with Green Street Advisors.

Just on the market for Chattel financing, people have been talking for a very long time about Fannie and Freddie potentially getting into that business. Have you seen or heard any movement on that front at all?

No. I mean, there's a lot of talk but -- I mean, our view is we didn't think that was going to happen. There was a lot of effort made over the last X many years. A lot of people went to Washington to try and kind of convince them. There's all conversations about a duty to serve. Haven't seen it happen, don't think there is much of an appetite for it. So I hope it would happen, but I don't -- we're not thinking it's going to.

Okay. I mean just one quick modeling question back to rental homes for a second. What are your turn costs running per home in the rental program?

I think there's -- R&M is $1,000 or so per home and I think the capital piece of it -- it's a blended pool of new and used, somewhere, call it $500 or so per unit.

And we just got one more question, it's a follow-up from the line of Gaurav Mehta with Cantor Fitzgerald.

Just a quick question on the Chattel loan portfolio. I think you've previously made a comment that in case the loans do not perform, those homes could go into your rental program and it looks like your default rate for the first quarter of 2012 was higher than your actual guidance for 2012. So I was just wondering if you have seen that happen yet, meaning that the homes transitioning from the loan program into your rental program.

We have seen that happening and we're able to -- once the loans transition out of the loan program, we're able to rent them relatively quickly so you'll see the shifting between that interest income and then up into the rental revenue.

And we have no other questions now.

All right, everyone, thank you for joining us on our call. I appreciate your time. As always, if anybody's got any follow-up questions, Marguerite Nader is available. Have a good day. Take care.

Ladies and gentlemen, that concludes today's conference. Thank you for joining us. You may now disconnect. Everyone, have a great day.