A Trailer Park With Upside

| About: Sun Communities (SUI)

Summary

SUI has a solid financial history and plenty of growth opportunity.

Annual statements are difficult to analyze due to accounting practices.

Great company to hold but offers little margin of safety.

This article includes an analysis of Sun Communities REIT (NYSE:SUI), including historic cash flows, business operations, risks, and a forecast of 10-year future cash flows for the business. The present value of the business cash flows is then discounted at the 10-year US Treasury bond rate, allowing readers to assess this business against other similar investments. A safety margin is introduced with respect to expected cash flows to identify the minimum entry price. I do the same thing for each business I review, allowing investors to compare using the same yardstick.

Description of business:

Public since 1993, SUI owns and operates a real estate portfolio of 339 communities in the US and Ontario, Canada. Its portfolio consists of 85 recreational vehicle (RV) only communities, 227 manufactured housing (MH) only communities, and 27 dual MH and RV communities. Yes, trailer parks. Now before thoughts cross your mind of this, consider that SUI owns quality properties. In spite of the negative view on this real estate segment, I've heard from private real estate investors that if done properly, it can be a great investment. Let's have a look and see how lucrative it is.

MH and RV Business Model

The MH and RV real estate business model operates slightly different from the traditional apartment building business model. In the apartment building model, the strategy is usually to acquire undervalued properties and upgrade the building and its units to increase rents and lower costs such as heat and electricity through installing more efficient infrastructure. These improvements are called capital expenditures (i.e. capex). Of course, improving occupancy rates helps as well. If done right, the increases in rent and decreasing costs will more than offset the cost of capital.

Apartments are generally valued using a CAP rate. You do this by capitalizing the annual net profits of a building (before any financing costs) by dividing net profits by the CAP rate. Therefore, you can increase value of the asset by increasing profits and/or decreasing the CAP rate. CAP rates are mostly influenced by external factors such as demand and market conditions, but you could change the CAP rate by changing the business model, property type, or class. Once a building has increased in value, capital can be taken out through refinancing or you could simply sell the building after several years for a profit and buy another turnaround building.

In contrast, MH and RV park investors acquire undervalued property, improve the landscaping, infrastructure, and existing housing modules (upgrade or replace with new) and then sell the individual housing modules. The park then collects rent from the owners of the housing units to cover infrastructure, landscaping, and profit (external costs to the housing modules). You can think of this as similar to a condo, where you own the housing unit and pay a condo fee. The difference from a condo is that the land and infrastructure is not owned by the tenant pool. The goal of this business model is to recover a significant amount of capital through reselling the house modules and reinvesting it into buying another undervalued park. This can be repeated over and over. There is also an opportunity to become a market maker by buying and reselling pre-owned housing modules when a tenant wants to move out of the park. Of course, RV parks operate under a different model where tenants are paying rent for a parking spot and utilities hook-up (more like a hotel).

Analysis

I always start with analyzing the historic distributions and changes in book value. What I'm looking for in a REIT is growing distributions and book value per unit year over year. Before I start to pluck out numbers blindly into my spreadsheet, I like to look for weird big numbers. The first one I found was an asset worth over -$852 million called "accumulated depreciation" (2015 annual report). This line was hidden from the balance sheet before 2015, but details could be found in the notes. The big question you have to ask is: "is this depreciation a real cost or not?"

I have seen very little accumulated depreciation in other REITs. However, SUI may be spending significantly more capex to renovate its properties. If the depreciation is associated with a pure tax deferral by depreciating the property's acquisition cost, it may not be a fair dilution of the net asset value. However, there may be a reasonable amount of the acquisition costs associated with depreciating infrastructure that represents true costs. Another thing to note is that depreciation can make your debt ratio look bad when it's not.

Schedule III to the 2015 annual report highlights the initial land and asset cost for each property, specific capex, and accumulated depreciation. It appears as though management is not depreciating land value, but the complete infrastructure, building costs, and capex are depreciated. I had a look through the amounts, and it looks like the accumulated depreciation for each property is about the same as the capex (give or take).

The second question: "Is the book value a reasonable representation of the true value of the assets?" What I didn't see in the annual reports was an attempt to re-valuate properties on the balance sheet. After you invest capex into property, the value of that asset should go up. Imagine you have a $100K house and invest $50k into it for a flip. On the market, it may be worth $150k or even $200K now. If you depreciate the capex over several years, the book value of the property could eventually get back to $100K. This approach to accounting can make it very difficult to determine the actual asset value held by the REIT. An approach I like better is to revalue assets yearly based on its fair market values and update the balance sheet. Traditional accounting doesn't work well with appreciating assets.

I believe the shareholders' equity is likely worth more than what is stated on the books. To show you the difference, I have included depreciation (i.e. lower asset value) in the shareholder equity for my calculations. Then after, I add it back in.

Here are the charts for distribution, FFO/Unit, book value/Unit, and total units outstanding:

Note: I used FFO since AFFO wasn't calculated in the annual reports.

Leading us to the following average compounding growth rates:

16 year

5 year

3 year

Total Units Outstanding

8.5%

18.7%

23.1%

Distribution

1.3%

0.6%

1.0%

FFO

9.2%

22.1%

29.3%

FFO/unit

0.7%

2.9%

5.0%

Distribution/FFO

0.7%

-2.2%

-3.8%

Book value

13.1%

62.4%

82.3%

Book value/unit

4.2%

36.8%

48.1%

A couple things are apparent when analyzing these historics:

  • The distributions are very consistent over the past 16 years, never missing a payment
  • The book value took a huge hit from 2003 to 2010, becoming negative
  • After 2010, the book value made a huge comeback

Adjustments for Accounting

Now, accounting can be tricky. If you get confused or something doesn't make sense, you should always go back and look in the accounting notes to figure out what is going on. If you missed the depreciation the first time, these results should have at least confused you. Looking at the first chart, it doesn't make sense that book value was reducing year over year (2003-2010) while the cash flow was positive and the payout ratio was under 100%. Here is the book value with the depreciation added back in:

This is probably a closer representation of real shareholder value. The updated book value growth is as follows:

16 year

5 year

3 year

Book value

13.4%

31.1%

44.1%

Book value/unit

4.5%

10.5%

17.0%

Again, be very cautious of the book value and its growth. This business only realizes increases in asset values on its books when the property is disposed (sold). Therefore, book value does not necessarily represent the real or fair value of the assets held in this business.

Here is a close up of the distribution and the FFO/Unit:

FFO went negative in 2004 due to SUI significantly restructuring its debt. It took a $57 million hit restructuring fee, causing a negative income in 2004. If you ignore that, the FFO would have been consistent. In my opinion, this debt restructuring cost should have been amortized over a reasonable period (i.e. the life of the new debt). Overall, the FFO from the period has been consistently above the distribution. Let's look deeper into operations to get a sense of the overall business performance.

Operations

SUI is a complicated business. It makes money through rents, individual modular unit sales, and through the long-term acquisition and disposition of properties (i.e. long-term flipping). Note that FFO adds depreciation back into the net income and ignores other expenses related to buying and selling properties (assets). It's more of a measure for rental income profit. In a business of this size, capex is always occurring (even though capex is usually funded by long-term debt), modular units are always being bought and sold, and there is an annual churn of property acquisition and disposal. Therefore, we need to understand the profitability and success in each operational segment to get a better idea of the business performance.

The 2015 annual report reported performance in three segments: "Real Property Operations", "Home Sales", and "Rentals". The first segment is responsible for leasing land (exclusive of MH rentals). The second and third segments are responsible for selling and renting MHs (new and pre-owned), respectively.

Note that overall occupancy levels have been growing for the past three years (figures exclude the transient RV rental sites):

2013

2014

2015

Occupancy

90%

93%

95%

Occupied Rentals

9,726

10,973

10,685

Real Property Operations

From the 2015 annual report, here is a snapshot of the same site income from the real property operations (i.e. leasing land):

Overall, no issues. Note the years ended 2013 to 2014 showed good growth in real property NOI as well (7.7%).

Home Sales

Home sales include selling new modular units and buying and selling pre-owned units from existing owners. Here is a snapshot from the 2015 annual report:

Overall, SUI showed good profit and growth in the home sales segment. Note the years ended 2013 to 2014 showed good profit margins. However, NOI was down 8% in 2014.

Home Rentals

Home rentals includes the income and costs associated with renting modular units. Here is a snapshot from the 2015 annual report:

The home rental segment SUI has shown good profit and growth. 2013 to 2014 showed good growth and profit as well (20% year-over-year NOI increase).

Debt Performance

As of the 2015 annual statement, SUI holds a line of credit with the following covenants:

These debt levels are pretty reasonable. I expect SUI to maintain its debt levels under these thresholds for the long term. In addition, SUI states that an increase of 1.0% during the year ended December 31, 2015, would have increased the interest expense by approximately $2.2 million. Therefore, interest rates do not pose a significant risk in the short term and SUI should be able to absorb rate changes until management can adjust the rents to cover the costs.

Long-term real estate outlook (10-20 years)

In this real estate segment, I scanned a wide range of articles for the future outlook. Some claimed a wide decline in MH and RV park forecasts. Other more recent articles showed an increased demand for units from a growing base of low income and retired baby boomer segments. I'll leave it to you to speculate, but I would say that there is a reasonable chance this segment will exist in 10 to 20 years from now.

Business Summary

Overall, I found the business to be managed well and the historic financial performance and distribution payment was repeatable. The business also showed continuous improvements in its operations. The only downside was the inability to identify the market value of its assets, management's overuse of depreciation in the financial statements, and difficulty sifting through the annual reports, in general.

Valuation

To calculate a valuation, we need a book value growth rate and distribution forecast for the next 10 years. Based on the historic trends, I found it not safe to valuate this business using the short-term distribution and book value/unit growth rates. The historics forecasted the book value growing over 30% year over year as a result of its short-term success. Another way to look at it is, if you used the five-year or three-year historic book value growths, in 10 years, the book values would be $66B and $188B, respectively. The 16 historics yield a book value of $13.5B. I found this more likely.

In the following table, I calculated the present value of the cash flows using the 10-year US Treasury rate (2.5%), based on the 16-year historics:

Case 1: 16-year historic cash flows

PV of Dividends (2.5%)

Changes in BV

2017

$2.57

$2.38

2018

$2.61

$2.49

2019

$2.58

$2.61

2020

$2.55

$2.72

2021

$2.52

$2.85

2022

$2.49

$2.98

2023

$2.46

$3.11

2024

$2.43

$3.25

2025

$2.41

$3.40

2026

$2.38

$3.55

Total

$24.99

$29.34

Current BV

$52.71

PV Cash flows (2.5%)

$24.99

$64.10

Intrinsic Value

$89.09

If you paid $89.09 per unit for a Treasury bond (zero risk) with these cash flows and a face value at the current book value, you would get an annual return of 2.5%. At $78.38, the REIT is trading at a 12% discount to the risk-free rate based on 16-year historics. You should only pay $89.09 if you were 99.999% sure you would get these cash flows and were ok with a return of 2.5%.

Safety Factor

If you see this REIT as risky, you should apply a safety factor. Let's assume that, because of decreasing occupancy, the distribution drops to 90% of the current amount (i.e. to $2.34 per unit). Also, assume this persists for 10 years. In addition, assume the book value per unit decreases by 2% year over year for some reason. The new cash flows would look like:

Case 2: Disaster hits for 10 years

PV of Dividends (2.5%)

Changes in BV

2017

$2.28

-$1.05

2018

$2.23

-$1.03

2019

$2.17

-$1.01

2020

$2.12

-$0.99

2021

$2.07

-$0.97

2022

$2.02

-$0.95

2023

$1.97

-$0.93

2024

$1.92

-$0.92

2025

$1.87

-$0.90

2026

$1.83

-$0.88

Total

$20.48

-$9.64

Current BV

$52.71

PV Cash flows (2.5%)

$20.48

$27.22

Intrinsic Value

$47.70

If you were 99.999% sure this would occur (zero risk), the correct price to pay is $47.7 dollars per unit, yielding the annualized 10-year Treasury rate of return (2.5%).

Price

This is a tough REIT to valuate. You may be tempted to use a large growth rate to forecast the cash flows. I suggest reflecting on some advice from Buffett:

"When the [long-term] growth rate is higher than the discount rate, then [mathematically] the value is infinity. This is the St. Petersburg Parado. Some management think [the value of their company is infinite]. It gets very dangerous to assume high growth rates to infinity - that's where people get into a lot of trouble. The idea of projecting extremely high growth rates for a long period of time has cost investors an awful lot of money. Go look at top companies 50 years ago: how many have grown at 10% for a long time? And [those that have grown] 15% is very rarified. Charlie and I are rarely willing to project high growth rates. Maybe we're wrong sometimes and that costs us, but we like to be conservative." (Buffet FAQ)

Although I haven't mentioned it before, I calculate my intrinsic values before looking at the price (hard to do). This allows me to choose a scenario that I'm comfortable with and avoid the tendency to get swayed into justifying a price. If the price is not sufficiently discounted from the most likely scenario (25-50%), with some padding built into a disaster scenario, I won't buy. I don't want to get tempted into buying something without a margin of safety just because it has upside. I would buy SUI for around $50.

Strategy for Dealing with the Market

The market seems to be forecasting some growth for this REIT. If you are very confident this business will achieve good growth over the next 10 years, there is a reasonable margin of safety in the current price. However, should the business face some internal or external issues, there is little to no margin of safety. I do think this REIT is a very good business, just too expensive for my investing strategy.

It's useful to compare other REITs using this methodology. For example, BTB REIT is trading at a much larger discount to its historical growth rates, has potential upside, and a reasonable margin of safety.

Cheers,

Wayne

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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