By Mark Simpson
In some markets for manufactured home communities, sale prices and the corresponding capitalization rates seem logical and justified. But, in other markets, prices and rates test the imagination. Capitalization rates can and do become irrational, which brings about the need for a “Rational Capitalization Rate” as a type of barometer for measuring market pressure.
A Rational Capitalization Rate is a rate of return that makes sense financially. Financial common sense is quantified by the relative risk of loss. At the most basic level of financial truths, the risk involved with the debt piece of a deal is less than the risk involved with the equity position.
For a debt-based asset like real estate, the market-based terms of debt should form the foundation of establishing the lower limit of returns for the equity position. In other words, the equity position is riskier than the debt position, and the equity investors should demand a correspondingly higher return. It becomes subjective when the spread between the debt return and the equity return is considered. If an investor is going to be in the first equity position with no cushion and the possibility of 100 percent loss, is it logical that he/she would require a return of only 1 basis point more than the debt return? Probably not. For our purposes, we will assume that the minimum rational spread between the debt and equity returns is 100 basis points.
For this first calculation, the transaction market is assumed to be hot with relatively low-cost debt abundantly available, similar to the period after COVID and before the Federal Reserve rate hikes of 450 basis points during 2022 and 2023. The following figures are intended to reflect the debt terms available for a good-quality “Mom & Pop” manufactured home community during that period.
Interest Rate: 4 percent
Amortization Period: 25 years
Max. Loan-to-Value (LTV): 80 percent
The Mortgage Capitalization Rate is calculated by dividing the debt service by the initial principal balance. This figure of 6.33 percent reflects the maximum return for the debt and therefore helps to establish a minimum for the Rational Equity Investor.
The Equity Capitalization Rate is calculated by dividing the cash flow after debt service by the initial equity investment. If the Rational Equity Investor decides that he/she needs at least 100 basis points more than the debt investor to make the investment acceptable, then the rate of 7.33 percent could be used as the minimum acceptable.
Next, the data is inserted into a weighted average capitalization rate using the Band of Investment technique, which is a widely accepted appraisal formula. The calculation indicates that if the investor is rational, then the minimum cap rate to consider in this particular market is 6.5 percent.
During the period after COVID and before the Fed rate hikes, there was so much activity that some brokers stopped the practice of estimating appropriate cap rates and asking prices. Instead, the asking price was “to be determined by the market.” Stealing a term from a great bubble creator, the manufactured home market exhibited “irrational exuberance.” So, during this furious period, high sale prices coincided with irrationally exuberant capitalization rates.
For this example, which was assumed to take place during a hot market period with low interest rates, many listings were receiving multiple bidders, and the comparable sales transactions supported an average cap rate of 5 percent. This cap rate reflects the actions of market participants.
Previously, the rational cap rate based on the relationship between debt and equity was estimated to be 6.5 percent. Immediately above, the exuberant cap rate of 5 percent was found from sales data in a market. A manufactured home community generating $100,000 in stable net operating income would be valued as follows:
Scenario NOI OAR Value
Exuberant Market Value $100,000÷ 5 percent = $2 million
Rational Market Value $100,000 ÷ 6.5 percent = $1,538,462
Irrational Value = $461,538
The difference between the values is $461,538, or 23 percent, which represents the component of Irrational Value. This Irrational component of value would be most at risk when the buying fever normalizes.
Conversely, the period following the Financial Collapse of 2008 was a buyer’s market with extensive inventories of bank-owned and distressed manufactured home communities. Further, the current market reflects severely reduced sales activity and relatively high interest rates in a frozen market. The following figures are intended to reflect the debt terms available for a good-quality “Mom & Pop” manufactured home community during a cold market.
Interest Rate: 6.5 percent
Amortization Period: 25 years
Max. Loan-to-Value (LTV): 70 percent
The same calculations were applied again, including the Band of Investment technique, to estimate that the minimum cap rate that a rational investor in this cold market would consider is 8.4 percent.
The point is that the manufactured home community sector is subject to human emotions and actions. Companies eager to grow will make aggressive buying decisions. And when the market turns chilly, prices will reset.
Investors may learn a great deal about a particular market by comparing the market-based, Conventional Cap Rate with the debt-based Rational Cap Rate. An optimistic market with the Conventional Cap Rate substantially below the Rational Cap Rate should serve as a warning signal that prices may be in bubble territory. Finally, investors also may learn a great deal about a particular property by comparing an Asking Cap Rate with the debt-based Rational Cap Rate. If the Asking Cap Rate is substantially lower than the Rational Cap Rate, the seller may be reminiscing of days past when market conditions were different.
Mark D. Simpson holds the MAI designation from the Appraisal Institute and earned an MBA in Finance from the State University of New York at Albany. He has practiced commercial real estate appraisal throughout the U.S. since 1989 and has owned and managed a variety of investment properties, including manufactured housing, for well over 20 years. He can be reached at marksimpson@brighthouse.com.
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