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.
