Why Mobile Home Communities Are Superior Investments

Why Mobile Home Communities Are Superior Investments

By Laurence G. Allen, MAI

Introduction By GEORGE ALLEN, CPM: Most manufactured home community owners have known the truth for a long time, and I've been writing about it since the mid-1980's. Manufactured home land-lease communities are indeed a superior form of real estate investment.

Now along comes Laurence Allen (no relation to me), a respected real estate appraiser who specializes in evaluating this type of property. I think he makes a convincing case for this investment reality.Pay close attention to what he shares with us. Review his charts carefully. If you have any questions, you can get in touch with him by calling 810/433-9630, or writing to him at 2000 N. Woodward Ave., Suite 310, Bloomfield Hills, Mich. 48304.

Over the next few months, Larry and I will be in touch with the majority of U.S. and Canadian manufactured home community owners of multi-property portfolios, to survey their personal and corporate experience with the five key indicators that Larry outlines in his article.

The fourth annual International Networking Roundtable, held recently in Seaside, Ore., offered an opportunity for top manufactured home community investors, developers and managers across the country to learn and network together.

The event, which is organized each year by George Allen, draws together the principals and executives of the largest community businesses to talk about how they handle their investments. Participants complete a survey in witch they describe the key investment characteristics of their community businesses.

This article introduces these concepts to the entire industry as a means of providing a better understanding of the position of manufactured home communities as superior real estate investments.

To understand manufactured home communities as investments, several key concepts need to be explained. These concepts have often been applied to other forms of real estate investments, but have rarely been applied to manufactured home communities. So it's important to understand these concepts in the context of other real estate investment alternatives.

The five key indicators

There are five key indicators that investors can use to evaluate manufactured home communities in comparison to other real estate choices:

1. Free-and-clear equity IRR. The internal rate of return (IRR) is an essential indicator in evaluating real estate investment choices. The IRR is the total rate of return on a 100 percent equity real estate investment over a normal holding period. Most commonly, the holding period is 10 years. The IRR equates the present value of the net operating income, plus proceeds received upon sale of the investment at the end of the holding period.

2. Free-and-clear equity cap rate. This is sometimes called the overall capitalization rate or, simply, the cap rate. This amounts to the first year's net operating income divided by the purchase price. This is based on the formula: cap rate equals net operating income divided by value, or R=x. As with the IRR, the cap rate is usually calculated without financial leverage - in other words, on a free-and-clear basis.

3. Market rent change rate. To calculate the IRR an analyst must make certain assumptions about how rents, as well as expenses, will change over a normal holding period. The rate of market rent growth is a major determinant of the IRR. It is generally treated as a straight-line factor that is applied to the current market rents for use in deciding how much the rents should be increased each year during the holding period.

4. Operating expense change rate. This is similar to the market rent change rate in that it is generally treated as a straight-line factor used in predicting future expense levels, it is typically applied to the first year's operation expense level as an escalating factor. It can then be subtracted from future predicted gross income to determine the net operating income over the holding period.

5. Residual cap rate. This is similar to the free-and-clear equity cap rate, but this is the cap rate that should be used in deciding what the selling price for the property should be at the end of the 10-year holding period.

Net operating income is generally projected for 11 years. The net operating income for the 11th year is capitalized by the residual cap rate. It is often slightly higher than the free-and-clear equity cap rate because the property is 10 years older at the end of the holding period.

A hypothetical example

To better understand how these indicators can be used to analyze the investment potential of a manufactured home community, consider this hypothetical example, which was derived from a survey of community investors during the Roundtable at Seaside.

A community is purchased for $4 million, with a 75 percent mortgage at an interest rate of 9 percent and a 25-year amortization. Table 1 shows the projected income and expense figures over the 10-year holding period for this hypothetical manufactured home community.

Table 2 tracks the same income and expense projections for a comparable apartment project.

In the manufactured home community projection, the average rates for the five key indicators are as follows: free-and-clear equity IRR 14.78 percent; free-and-clear equity cap rate, 9.5 percent; market rent change rate, 5.0 percent; operating expense change rate, 4.0 percent; and the residual cap rate, 10.0 percent.

The average rates for the five indicators for apartment complexes, as calculated from the fourth-quarter Korpacz National Apartment Investment Survey, were as follows: free-and-clear equity IRR 10.56 percent; free-and-clear equity cap rate, 8.99 percent; market rent change rate, 2.93 percent; operating expense change rate, 3.84 percent; and residual cap rate, 9.31 percent.

For our hypothetical model of a comparable apartment complex, we rounded these figures off to: 9 percent equity cap rate; 3 percent rent growth: 4 percent operating express growth; and 9.5 percent residual cap rate. A comparison of these rates and other factors for the two examples appears in Table 3.

What the figures show

Several interesting facts arise from an analysis of these numbers. One is that for the manufactured home community, the 5 percent rate of income growth, along with a 40 percent operating expense ratio (OER) and a 4 percent growth in expenses, means that the net operating growth rate over the 10-year holding period is 5.63 percent.

When financial leverage is applied in the form of a 75 percent fixed-rate mortgage, a 15.3 percent growth rate in cash flow results.

The operating and financial lever-age also serve to increase the overall rate of return from a free-and-clear IRR of 15.3 percent to a leveraged IRR of 24.3 percent. Manufactured home communities are one of the few types of real estate investments that are capable of achieving this type of leverage and return.

For further indication of the superior investment potential of land-lease manufactured home communities, compare it with the apartment in-vestment.

For our hypothetical model, we assume the same $4 million purchase price, 75 percent mortgage, 9 percent interest rate, and 25-year amortization for both examples.

The slower rate of rent growth for the apartment complex produces negative operating leverage, so that the compound growth in net operating income is only 1.92 percent. Moreover, the IRR for the apartment complex is only 10.6 percent on the free-and-clear basis and 14 percent on the leveraged basis.

Clearly, the apartment complex comes up short in market rent growth, a key factor in determining investment success.

These indicators are important to understand when analyzing the investment potential of manufactured home communities, as well as other forms of real estate investment, such as apartments, shopping centers, hotels, factories and office buildings.

When measured by the five factors that are appropriate in evaluating the investment potential of manufactured home communities, this type of investment shows itself to be superior to most real estate investments.

Reasons for success

Thee primary reason that land-lease communities perform so well is their ability to produce positive operating leverage by increasing rents faster than expenses go up.

Manufactured home communities have historically been able to do this because of the higher barriers that discourage competitors from entering the market.

Difficulties in zoning, as well as the extensive time required to fill up communities are powerful disincentives to competitive development. This not only prevents most markets from being overbuilt, but it in fact insulates them from competition.

This state of affairs will probably not last forever. But in the meantime, investment in manufactured home communities can provide superior returns compared to other types of real estate investment.