By Francesco Marino
John Oliver, host of HBO’s “Last Week Tonight” has made a name for himself in late-night television. The British comedian has become a master pot stirrer through his brazen quips, witty antics and refusal to pull punches when addressing current events. This season, his satirical show put private equity under fire, specifically concerning investments in manufactured homes. Watch it here.
Since the collapse of the housing market, manufactured homes, more commonly known as mobile homes, have become increasingly popular in the US due to their affordability. However, the outspoken John Oliver claims that mobile homes are in fact not such a bargain. The argument being that living in mobile homes has become quite unsustainable in the past years. This is because of the simple fact that many mobile home owners do not own the land that their houses occupy. As lot fees steadily rise, budgets tighten for the already low-income groups who live in manufactured homes. According to Mr. Oliver, the smoking gun is the series of private equity groups, amongst which include banner funds such as The Carlyle Group, TPG and Blackstone, that have recently penetrated the industry by sweeping up manufactured home communities from the small family enterprises that previously owned them. The PE funds subsequently raise rents, squeezing residents’ pennies.
While John Oliver does make us laugh, as an unbiased academic community specializing in private equity, we must ask: is this a good take? Could this be a myopic perspective in an otherwise scrupulous political satire? It’s worthy of closer examination.
Speaking about its manufactured home park in Sunnyvale (California, not Nova Scotia unfortunately), The Carlyle Group was quick to deny allegations of profiteering, pointing out that rental increases were necessary to cover the $100,000 spent on capital improvements in the community. However, critics such as Mr. Oliver, chiding the firm for its predatory behavior, are unconvinced of this defense. In order to develop a premise, our investigation addresses the options available to mobile home owners, considers the real costs of operations and property upkeep in mobile neighborhoods and analyzes the reasons why private equity firms have decided to invest in the manufactured housing market.
Mobile home ownership: advantages and disadvantages
Today, an estimated 20 million Americans live in mobile homes, constituting roughly 6.4% of the US housing market. Since the financial crisis, the need for affordable housing has ballooned the demand for mobile houses. Indeed, manufactured houses cost on average 50% less than traditional houses with prices ranging between $10,000 to $200,000. This makes manufactured homes particularly appealing to low-income groups and three quarters of households living in mobile homes earn less than $50,000 with a median income of $30,000.
Although mobile homes offer attractive down payments and upfront costs, they present a myriad of drawbacks. Most disadvantages arise when mobile home owners do not own the land they live on. This phenomenon is common as, of the 8.5 million mobile homes in the US, approximately 2.9 million are located in land-leased communities. This makes residents vulnerable to changes in property rental prices.
At this point, a question arises: why don’t mobile home owners simply move to another community if they’re dissatisfied with rent prices… they are in fact mobile homes, right? The answer lies in the fact that mobile homes, contrary to what the name suggests, are not at all fully mobile. Most of these homes are attached to a foundation making them difficult to transplant – the cost of uprooting is proportionately high (approx. $5,000) which renders the entire endeavor uneconomical. On top of that, selling the home is not always an option because community owners often pose restrictions on home sales. More importantly however, selling the home is difficult because mobile homes, unlike traditional homes, do not retain their value over time but rather depreciate. The loss in home equity is especially significant for those that do not own the land. Realtors estimate that for every $100 increase in rent, a manufactured home loses $10,000 of its value.
The fact that mobile homes owners possess few alternatives in regards to moving away from their communities gives them little bargaining power vis-à-vis the manufactured home community owners and rental price hikes – home owners are forced to capitulate. If the intention is indeed to target a constrained customer base and siphon off non-discretionary income, this is indisputably a bad look for the private equity defendants. Yet we shall remain impartial until sufficient evidence is collected.
What makes mobile home residences attractive for PE investors?
The Carlyle Group was one of the first PE sponsors to invest in manufactured homes by acquiring two Florida communities in 2013 for a total of $30.8 million. Subsequently, in 2015, the company doubled down on its bet, buying a mobile home park in Sunnyvale, California for $180 million. Apollo followed suit in 2017 with its purchase of Inspire Communities – a developer, owner, and manager of manufactured housing communities nationwide – providing the fund ownership of 38 communities and approx. 13,000 home sites across the country. Finally, Blackstone entered the market by making a 14 park investment in July 2018 valued at approximately $172 million.
Mobile home communities are a coveted asset class for PE firms for a variety of reasons. Aside from a stable revenue stream from rent collections, what is most attractive for PE firms is the countercyclical nature of these cash flows. As demand for affordable housing tends to increase during periods of recession, PE firms are able to insulate returns from economic shocks. This allows mobile housing, according to the real-estate research firm Green Street Advisors, to offer the most favorable risk return profile amongst all property sectors (including apartments, office buildings, retail, hotels, industrial, and self-storage). The research firm goes on to highlight that the manufactured home sector was the only major real estate class to not experience a year-over-year decline in net operating income (NOI) in any year since 2000.
If we analyze the costs per unit of investment, we realize that mobile homes unequivocally outperform other real estate assets in most economic climates. The reasons behind this are that park owners purchase the land but not the housing units themselves, making the cost of the investment significantly lower. Furthermore, the sellers of mobile home communities are typically “mom and pop” enterprises. It is therefore not unusual to find owners who, being close to retirement age, are keen on cashing out their business and therefore may sell at favorable entry multiples. Finally, operating costs are lower in manufactured housing parks as well. Again, since mobile home owners have little wiggle room with respect to housing alternatives, the community owners are not incentivized to invest in the improvement of their communities, thus keeping maintenance costs low.
After identifying the factors that drove PE players into the market, we must develop a case in order to determine whether or not there is evidence of profiteering. To do so, we shall analyze Carlyle’s Sunnyvale community.
Capital expenditures are incredibly crucial to our investigation as they are Carlyle’s rationalization for increasing rental fees. Contrary to the “mom and pop” enterprises which formerly owned the community, when Carlyle purchased Sunnyvale it immediately decided to raise lot fees up by 7-8%, unless residents waived their right of first refusal, in which case rental fees would grow at a capped 4% annually. Residents of neighboring communities would typically experience lot fee growths of only 3-4% per year.
What we need to establish is whether or not the inflation of rental fees was in fact artificially implemented or grounded by reasonable expenditures. To do so, we will attempt to replicate Sunnyvale’s cash flows as best as possible. The goal is to gauge whether or not the community is profitable and can cover the capital expenditures without doubling rental growth. Required returns and hurdle rates will not be the standard of judgement, only the investment’s sustainability in terms of meeting short term liquidity requirements will be considered. We will use 2015 data from publicly listed REITs which had portfolios primarily made up of manufactured home communities for comparability
Equity LifeStyle Properties (the comparable with the strongest presence in California), had rental operations of 13,690 mobile home sites with a 86.5% occupancy rate and average annual rent of $8,721 in California as of December 2015. Based on this we can ballpark Carlyle’s 2015 turnover for Sunnyvale:
722 sites * 86.5% * $8,721 = c$5.5m
Using the average NOI margin of 58% we estimate NOI of $3.2m for Sunnyvale. The average REIT coverage ratio is 4.5x according to Nareit (2018) resulting in an interest expense of c$0.7m. Assuming a 35% corporate tax rate, this leaves approx. $1.6m of after tax income. Therefore, Sunnyvale’s $100,000 maintenance fees only amounted to c3% of NOI and c6% of estimated income. Deducting the capitalizations, the investment would still well outperform diversified REITs in terms of profitability – Reuters reports industry average EBITDA margins of c60% (the average NOI calculated for manufactured homes is a similar figure but measured net of depreciation and amortization). Based on these estimates, it appears as though Carlyle did have sufficient operating cash flows to sustain its maintenance capital expenditures without squeezing residents.
This is by no means an open-and-shut case however – our estimates exclude principal repayments (by assuming bullet maturity instead), which can be inconsequential or significant depending on leverage and maturity. We will not attempt to extrapolate the leverage totals or tranches of debt that Carlyle employed as this adds more assumptions to our already speculative analysis. It can be conjectured from our previous calculation that with normal levels of debt, there is ample intermediate cash flow to cover expenditures. In the court of morality, if Carlyle was aggressively leveraging Sunnyvale to the point where expenditures could no longer be serviced by normal operations, then the sponsor was indeed acting recklessly at the risk of its park’s residents. Based on this, (assuming the proxies are accurate representations) we establish that Carlyle did in fact act unethically by raising rents under the false pretenses that capital expenditures would endanger profitability and the mobile park’s sustainability.
The future of mobile housing
While perhaps in the wrong, PE funds’ predatory activity does not appear to be delictual within US civil law. In fact, private equity activity in mobile home communities is likely to intensify in the coming years. The rise in investments in mobile homes is supported by positive growth projections of the industry. According to research carried out by Evercore ISI in 2018, NOI from investments in mobile home communities is expected to grow by 4 percent to 4.5 percent annually over the next three years. This is because demand for affordable housing is anticipated to remain strong while the supply of mobile home parks remains limited as local governments are reluctant to grant permits for the construction of new developments.
While John Oliver’s PE bashing might reduce demand for mobile homes, demand for affordable housing will persist. If supply is fixed for manufactured housing due to local bureaucracy, then appropriate substitutes will present themselves. Mind you, the private equity players, while likely acting immorally, are simply doing what they are designed to do: exploit opportunities and market inefficiencies. Drawing attention to these investments will attract other institutional investors to supply the market. Once local monopolies are eradicated then rent prices will become competitive. The market will correct itself in the medium term.
As for the short term, fault inarguably lies with the government. Governments should loosen zoning regulations and pass laws granting residents the right of first refusal. Going even further, rental price ceilings could also be set proportionately to states’ mobile home residents’ tax returns. Alternatively, large groups and individuals could be barred from, or incentivized against, owning multiple low-income properties in order to break up monopolies and counter slumlord activity more broadly. In any case, this is a situation that requires a solution.
Editor: Eric Peghini
Author: Francesco Marino