Description

Sun Communities:

I’m bearish on SUN COMMUNITIES (SUI), a growth REIT that holds 119k mobile home sites in various forms and locations.  The market is pricing in future rent increases in excess of historical rent increases.  Replacement value of the sites is roughly $30k-$40k per site, yet the price for buying them in this reit structure is $83k per site.  There are only 3 names in this reit niche - the other 2 publicly traded competitors trade at $55k-$70k per site.  These other two have higher dividend yields and less debt.  For SUI, the number of shares outstanding has increased steadily every year (while revenue per share has decreased).  All of their operating profits go to G&A and interest expense - as a result they issue shares and more debt in order to pay dividends.   

They present themselves as growing and profitable because they use real estate metrics that are only appropriate for “land only” type deals - business models that have high operating margins and low ongoing cash requirements.  In reality, SUI actually has high expenses that get excluded from industry standard measures like FFO, AFFO, EBITDA and NOI.

Here’s what their business looks like on a  ‘per site’ cash basis (annual):

RENT received:  $5697

- “Investment in property”*:  $1904  <— really should be *maintenance capex

- Operating Maintenance: $1683

- Property Taxes:  $377

Total Cost per site:  $3964

= Cash profit per site:  $1733

*”investment in property” really should be classified as “maintenance capex” as I did above for several reasons: (1) it is routine - averaging $2200 per site over the last 5 years, (2) it is unclear if it directly leads to an increase in rent, (3) it is roughly the same as the depreciation expense, (4) they have another cashflow line item that called “acquisition of new properties” that does directly result in additional sites - a legitimate investing cash outflow that is not included here.  Regardless, this “investment in property” outflow is ongoing.  Without it I can’t see how rents can keep going up - which is an absolute requirement to justify current valuation.  

So, if they make a growing $1733 cash per site, and have 119k sites that is still a nice core business.  However, they have very high G&A and interest payments to cover before the shareholders get any.   After paying bondholders and management, that leaves nothing for shareholders.  That hasn’t stopped them from paying shareholders $2.60 per share (a 2.88% yield that is largely a return of capital, funded by new debt and new shares). 

Why is this happening?  Several reasons:  (1) Mobile home sites have a decade long history of 4-6% rent increases.  They’ve had some of the highest returns in commercial real estate.  There are limited investment vehicles in this space - investors are naturally excited by their defensive nature.  They passed rent increases on to tenants during housing crisis, (2) Living in a mobile home has a good value proposition for tenant/owners.   The stigma is slowly lifting.  Fannie/Freddie are about to start lending in this area which could increase affordability.  The market sees this as an easy, cash flowing growth story that will persist until they are equivalent with higher quality, permanent housing, (3) On the surface SUI compares favorably to other reit structures that legitimately exclude depreciation from their measure of profitability.  

The company presents many bullish presentations on the economics of their business which you can read on the company website or from Merrill Lynch.  Interestingly, Merrill has a $93 price target and helps them with their capital structure.  After becoming the largest underwriter in their recent share offering, Merrill took the unusual step of moving up SUI two steps from SELL to BUY.   

A more realistic way to look at their business is to focus on site rent (why this thing is a reit!).   This is the profitable, ongoing part of their business.   They have 2 other sources of profit: (1) “home sales” which are at an all time high but contribute little profitability ($.33/share) and (2) ancillary services which contribute even less.  If you don’t like that I didn’t include this in my valuation keep in mind that I didn’t include ongoing transaction costs (which really should be in G&A).  The transaction costs have historically eclipsed profits from home sales and ancillary services.

Over the last 5 years, rents have been going up nicely, 6% per year but yet there still hasn’t been anything left for common shareholders.  

To cover the current dividend distribution and G&A costs: rents will need to increase by 6% a year and costs contained at 3% growth for the next 6 years - at that point they would JUST be able to cover their 2.88% dividend yield.  In the meantime, they’ll have to issue shares or bonds just to pay dividend.   For the record, they’ve never been able to contain their costs to 3% growth per year in the past.  G&A has grown double digits.

In their recent sales presentation, they say the value proposition for living in a mobile home is that it costs the tenant only $890/month vs. $1100/month for living in a similar apartment.  In order to just cover the small dividend they will need to see the cost of living in a mobile home equal the cost of living in an equivalent apartment.  In order to get a SUITABLE (5% cash on cash return) for investors they will need the price of rent increase 10% per year for 5 years such that living in a mobile home costs 15% more than living in a similar apartment.  They can not grow their way out of this expensive valuation - they need ongoing price increases for investors to receive a decent return.   As Merrill is quick to point out, the mobile home industry has already achieved a decade long run in steadily increasing site rents.  It is just like Mr. Market to price in even more future increases.  

Replacement value estimate:

I took the first 20 listings of mobile home sites for sale on Loopnet.  The average price per site is $38.6k.  Some of the properties include extras.  Over the last 5 years, SUI has added sites for $31.6k per year which aligns somewhat with what I see on Loopnet.

Comps:  

If you buy SUI shares you are effectively paying $82.3k per site, while other comps are much less:

I encourage you to look at some mobile home parks from Google Earth.   I realize there are numerous restrictions and limitations to starting a new mobile home park.  However, when you see vast expanses of unused rural land with a an occasional mobile home tract that is jam packed with mobile homes - it makes you wonder if the scarcity of mobile home sites can persist.

On the bullish side, Merrill just did an industry primer called “Not your grandfather’s trailer park.” 

Catalysts:

higher interest rates

unsustainable capital structure & payout

Catalyst

higher interest rates

unsustainable capital structure & payout