The purpose of any investment is to end up with a profit. So, when choosing the right mobile home park investment, it is imperative that you properly determine both the current and potential value of the park to ensure that you are getting the best deal possible.
There are five basic indicators to use in evaluation mobile home park investments, particularly in comparison to other types of real estate investments.
The internal rate of return (IRR) is the total rate of return on a 100 percent equity investment over the typical holding period of 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. The IRR should be calculated without any financial leverage, on a free and clear basis.
The Equity Cap Rate
Also called the overall capitalization rate or cap rate, it is the equivalent of the first year's net operating income divided by purchase price. As with the IRR, the cap rate is usually calculated free-and-clear.
Market Rental Rate
To calculate the IRR you must determine how rents and expenses may change over the holding period. Market rent growth is a major component of the IRR.
Operating Expense Rate
Like the changes in market rental rates, it is imperative to project changes in expense rates throughout the holding period.
Putting the Indicators to Work
The best way to see the above referenced indicators in action is to apply them to a real world situation. Consider the following hypothetical example:
A mobile home park is purchased for $4 million, with a 75 percent mortgage at an interest rate of 9 percent and a 25-year amortization. In the manufactured home community projection, the average rates for the five key indicators are as follows:
- Free-and-clear equity IRR 14.78 %
- Free-and-clear equity cap rate of 9.5 %
- Market rent change rate of 5.0 %
- Operating expense change rate of 4.0 %
- Residual cap rate of 10.0 %
For the purpose of this example, let’s compare the numbers if we had, instead, invested in a comparable apartment complex. The average rates for the five key indicators are as follows:
- Free-and-clear equity IRR 10.56 %
- Free-and-clear equity cap rate of 8.99 %
- Market rent change rate of 2.93 %
- Operating expense change rate of 3.84 %
- Residual cap rate of 9.31 %
It’s in the numbers
The indicators for our mobile home park investment show that the 5 % rate of income growth, coupled with a 40 % operating expense ratio (OER) and a 4 % growth in expenses, means that the net operating growth rate over the holding period would be 5.63 %. When applying the 75 % fixed-rate mortgage, a 15.3 % cash flow growth rate results. Together this indicates an overall rate of return from a free-and-clear IRR of 15.3 % to a leveraged IRR of 24.3 %
Compared to our apartment complex purchase, the slower rate of rent growth produces negative operating leverage resulting in a compound growth in net operating income of 1.92 % while the IRR for the apartment complex is only 10.6 percent on the free-and-clear basis and 14 percent leveraged.