What's your offers cap premium or return premium on private utility parks?

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Obviously without city utilities there is risk of the utilities malfunctioning which may require a large capital expenditure. We can have a fixed monthly reserve for trying to predict when the utility will fail. For me though, I think it’s very uncertain when a septic leach line will fail so a higher overall return for the risk makes sense. That’s just my logic, and I don’t want to convince you. I’d rather hear your opinions.

Do you want a cap percentage point or two or three higher for it having a septic, treatment plant, well or lagoon or how do you evaluate this?

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Your logic is good.

The reserve for each of those will be different based on a number of factors - such as 1) utility age; 2) replacement cost; 3) regulatory risk; 4) maintenance records / serviceability; and 5) costs associated with any ability to mitigate risk via insurance or other contingency plans (e.g. if you have one well a water trucking company to fill a large water tank).

I prefer septic and a well since they are “fairly predictable” and easy to know what you’re getting into using proper diligence. Compared to the cost to perform an emergency replacement of a 45 year old packing plant servicing 100+ units?

Lots of assumptions and estimating to bake into your pro forma, but those feed into your acceptable return uplift dictating a reasonable purchase price. Other people put their finger in the air, add 5%, and call it good. It just depends on your risk tolerance and level of diligence.

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I agree with your 5 points exactly. It sounds like you try to quantify risk through a reserve instead of thinking about another point of two higher cap rate than what you would be happy with a park with city utilities.

Like maybe you estimate 10 years left on the overall septic and think x dollars times 10 years would buy a new system or fix the problem. Then maybe add more money to the reserve because the city may have higher septic regulations or higher sewer tap rates.

I haven’t done outside research on packaging plants besides what I know from mhp courses. I’ve looked into septic a fair amount, and from what I understand the most likely reason to replace a system (I bet you realize) is due to leach field failure because of underlying “biomat” growth blocking soil absorption. Fields supposedly average about 15 years, but of course some may last 40-50 years, and replacing one is like 5-15k. That ends up being about $55 a month per lot over 15 years. I hope somehow I overlooked something that makes the expense look better.

A well doesn’t scare me. Do you find septics affordable to maintain given their lifecycle?

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You have to apply a capitalization rate to the park to normalize ROI with another park that has city utilities. If you say “I’m keeping reserves” - well, you’ve just upped your costs because now you have a significant OCC (opportunity cost of capital) if you have $200K for example sitting liquid waiting for your leech field to fail. Sure, you could keep that $200K invested in the markets but then it isn’t actually a reserve - it’s simply capital at work in a different investment.

Having said that I have a park on well and septic (mound system) bought last year - because the location was so insanely good I could not turn down the deal, and the mound system was only 12 months old with all receipts, engineering plans, etc. It was high quality done by a reputable firm. We did our diligence. I got a good cap rate on it and would buy more all day long if I could find them (I need to start looking again). To me the location and the significantly under-market rents compensated for the well and septic.

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Thanks for the info Ivan_ilych.

I see two viable strategies:

  1. Trying to estimate realistic reserves as additional expenses that would increase operating costs in an evaluation pro forma. Those additional expenses would lower NOI which leads to wanting a lower price in order to be at a comparable cap rate with a park with city utilities. I think @jhutson made a very good point (if I understood him) that there are other risks like future regulation and uncertainty of real maintenance costs which also leads to an additionally lower offering price.

  2. The other approach is more about trying an educated guess at how much additional capital returns or how much of a higher cap (10% vs 12% for example) makes the risk worth the deal, independent of scrutinizing cap ex disasters.

Your strategy makes a lot of sense though. It seems to be more aligned with 1 if I understand you correctly.

Did you see how much the septic system cost and for how many lots was it? Also do you know if the system is a master linked system or one per home?

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Sorry I should’ve been explicitly clear - “opportunity cost of capital” is not a cost as defined by accounting - it’s simply a theoretical mental concept used in finance and economics. I’ll show you below how to correctly factor it into your decision whether to buy the park - in a precise mathematical, standardized way that all accountants and finance folks would understand if you showed it to them in a print-out.

Opportunity cost of capital simply means "my money could be earning $5 in dividends as a share of Coca Cola stock instead of in this mobile home park. Therefore my “opportunity cost” of not owning the Coke stock is $5.

You absolutely cannot count capital reserves as operating costs in a pro forma - that would make a nonsensical pro forma. It’s gibberish. Definitions matter or other folk won’t understand what you’re saying. Keeping reserves (cash in a bank account or gold bars under your mattress) for a rainy day capital expenditure like replacing a leech field has nothing to do with your NOI and will not affect it one bit. Net Operating Income has a very specific definition: All revenue minus all operating expenses. The salary you pay to the secretary who accepts rent in the park office is an operating expense. The electric bill for the sewer pump is an operating expense. Interest on your loan is NOT an operating expense. Depreciation and Amortization are NOT operating expenses. Loan principal paydown is NOT an operating expense.

Reserves are nothing more than capital (money) sitting in a pile for safe keeping.

So why did I tell you to consider “opportunity cost”? Was it to confuse you? No. Your leech field rainy day gold pile comes into play in the equations that help you determine your overall return-on-investment through time. Read on:

The place in your investment analysis to consider what other places on planet earth your $200K for leech field reserves (opportunity cost) is NOT in the accounting pro forma but rather in the time-value-of-money metrics you should always be calculating when making investment decisions:

1 net present value
2 internal rate of return
3 modified internal rate of return (I prefer over simple IRR because you select your realistic reinvestment rate of cash flow - vs IRR which assumes you always have access to returns as good as that killer park deal you bought in year zero)

IRR and MIRR allow you to compare very different investments with very different cash flows and different times and make them become an apples-to-apples comparison (in theory - nothing is perfect but they help). Each formula requires you, the investor, to decide what return on your money you require to invest in this world. I don’t have the time or energy to explain them right now but these is finance-101-first-day-of-class stuff. Not insulting you but you need to know those metrics and how to use them if you are to make intelligent investment comparisons and decisions.

The accounting cash flow statement tells you how much moolah came in or out of your bank account at any given time.

So to calculate your IRR over say a 10 year period (and compare it with - whatevs man - rolling it into a Dogs of the Dow strategy or putting it on Bitcoin speculation) you do this:

Open a spreadsheet, any spreadsheet (google is free) and type in a column of numbers. At the top is your initial investment - your down payment plus those leech field reserves you mentioned! You see the IRR just sums up the in and out cash flows during each time period (year), “discounts” them back to the present (dollar tomorrow ain’t worth as much as a dollar today), works a math formula that assumes each time your park spits cash flow at you that you can find another investment just as juicy - nd then it rolls up those lumpy in and out cash flows through time to give you an approximation of a yearly return you can use to compare to any other investment held the same time period.

You could compare to a tech stock for example that you could have bought instead of your park at the same time. The tech stock may pay zero dividends but grow in value. If you buy it all on day 1, you do not see your money (investment) again for a decade in this example. In year 10 you sell your Fubarbook shares for 5 trillion dollars per share. So you can compare this to your park return - you just do another IRR calculation that has 8 blank years in it because you got no dividends. Doesn’t matter. Investment “out” in year 1 and total sales (minus taxes) in year 10.

Voila! You have two different IRR’s to compare - Fubarbook stock vs Mobile Home Park - and you know what investment to buy. In reality you don’t because of course you can’t predict if Fubarbook will even exist in a decade or if it will be Twerker Inc. that is the dominant social media platform.

IRR and MIRR are more useful tools to compare two parks for example - you still have to do guesswork on your yearly cash flows but it’s closer.

AS YOU CAN SEE - THE LEECH FIELD RESERVES “DISAPPEAR” ON DAY ZERO IN THIS ANALYSIS (INVESTMENTS AND RESERVES AND ANY ONGOING CAPITAL CONTRIBUTIONS ARE GIVEN A NEGATIVE SIGN - CASH FLOW AND SALES PROCEEDS ARE A POSITIVE SIGN). The capital reserve for your leech field will pull down your IRR in the calculations because the sums of the positive cash flows through time will be a smaller overall return on investment - so THIS is where you factor it iun to compare this park vs another park that has city utilities. In year 10 when you sell the park if your sewer didn’t go bad you give yourself back the reserves as a positive cash flow number in the spreadsheet. If leech field went tits up sometime in that decade you do not ever see the $200K again. It’s your thought experiment - build two IRR’s and see how much that reserve affects it.

Plenty of tutorials online about this calculation - there’s a standard Excel fomula for it that works in Google Docs spreadsheet as well. You must input an “r” - your “required rate of return” - and again that is something YOU invent. It’s personal - how much return do YOU require to make this investment - factoring in loss of liquidity during the holding period, risk of loss, etc. That “r” is effectively your “opportunity cost of capital” that I mentioned way at the beginning.

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Sometimes I forget that a few of these ideas are 2nd nature to me only because many years ago I took a minor in economics and one semester of corporate finance - they were beaten into my brain during lectures and long boring problem sets. And they are really the conceptual foundation of all investing and finance (time value of money). “Resources are limited” is the foundation of economics. Most folks didn’t get to take those classes so here is the super-fast version of one semester of lectures on TVOM - the most important concept in all of investing (except for “don’t lose money”)).

If you do nothing else ever again in your entire investing life please take the time to watch this quickie series of 5 10 minute vids in Khan Academy: the Present Value series. Everything else always boils down to these core concepts - mobile home parks, TSLA stock, municipal bonds - everything. Be sure to watch all 5!

1 - Time Value of Money
2 - Introduction to Present Value
3 - Present Value 2
4 - Present Value 3
5 - Discounted Cash Flows

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Finally btw - Investopedia has great quick summaries of arcane sounding (but really simple in reality) finance terms. “What is X” and then “Breaking down X”

For example: What is Net Operating Income?

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A pro forma is an estimation tool, not an IRS submission. I can put whatever I want there to determine a park’s profitability the way I run it, and an offer price I believe is fair based on those numbers - and calculate a return using that as a baseline. How those translate to GAAP or IFRS standards was never the intent.

Reserves are also an “expense” item in the MHU Due Diligence manual, so it’s not like this is some obscure approach banks have never seen.

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By golly you’re right - we’ll put 'em wherever we like. I forgot what forum I’m in. :Ivan wanders off to find his saw and start cutting out the soft spot in the particle board floor of his next remodel home.

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“…I think @jhutson made a very good point (if I understood him) that there are other risks like future regulation and uncertainty of real maintenance costs which also leads to an additionally lower offering price.”

Yep there’s all kinds of risk - and to be clear the valuation formulas do not factor those in. If you want to try to really factor in risk (kind of a futile idea because by definition it is uncertainty) you’d build out several different IRR calculations for different scenarios:

1- You never use the reserves. You get them all back in year 10.
2 - Leech field needs minor repair in year 5 but you get most of the reserve back in yr 10 at park sale.
3 - Government says “no park for you!” and Donald Trump shuts down all mobile home parks with leech fields to build hotels on instead.

Then you assign a weighting to each of the above 3 outcomes with the total adding to 100%. For example you decide there’s a one in four chance you don’t use the reserves. So the “expected value” of scenario 1 is 0.25 * the IRR of scenario 1. You decide you have a 50% shot at scenario 2. And 25% chance of scenario 3 (you get your reserves back but park value goes to zero 'cause Trump and Bannon seize it during the night and refuse to pay you).

So your “expected value” is 0.25 * scenario 1 IRR + 0.5 * scenario 2 IRR + 0.25 * scenario 3 IRR = IRR you expect after assigning probabilities to all possible outcomes of having a leech field.

Once again - of course - you are left at the end fibbing 'cause nobody knows risk - by definition it is in the future and we live in the present. But - you do the best you can.

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Aside from what I’ve learned in mhp classes, I haven’t done any outside research on packaging plants. I’ve done some research on septic systems, and from what I’ve learned, the most common reason for system replacement (as you probably already know) is leach field failure due to underlying “biomat” growth impeding soil absorption. Fields are meant to last 15 years on average, but some may survive 40-50 years, and replacing one costs around $5-15,000. Over the course of 15 years, this works out to around $55 per month each lot EduHelpHub . I’m hoping I missed something that makes the cost appear lower.