Flagship Communities REIT owns and operates a portfolio of manufactured home communities (MHCs) in the Midwest. The business model is centered on renting plots of land to owner-occupiers of manufactured housing. The MHC provides utility connections, community infrastructure, recreational facilities, and other amenities. The MHC also solves a challenge facing many owners of manufactured homes - zoning codes restrict them from placing a manufactured home in most residential neighborhoods. Flagship owns 75 communities with ~14,000 individual lots. Despite having all operations in the US, the units are listed on the Toronto Stock Exchange, where they trade in both US$ and C$.
The attractive of this business is that from the tenant’s perspective, switching costs are prohibitively high.
Here’s an example. In Evansville, Indiana, one of Flagship’s major markets, the median household income was $36,300 in 2016. Call it $45,000 currently. MHC tenants tend to be lower income, so assume a typical household in an Evansville MHC earns $40,000. Manufactured homes are a depreciating asset. A 10-year old manufactured home may be worth $70,000, assuming it was purchased for $100,000 new. Relocating the home to another MHC in the Evansville area may cost $4,000 - $15,000, depending on the type of manufactured home and level of service. The price only goes up if the relocation is further. From the perspective the the tenant, relocating the home is unaffordable. A tenant decision to move will almost certainly result in the sale of the manufactured home, which, from the perspective of the MHC operator, keeps the asset on site.
Impossibly high switching costs support the MHC’s pricing power. Since 2015, Flagship’s CAGR of average lot rent has been 4.2%. Average rent has increased annually, ranging from a high of 6.7% in 2023 to a low of 0.6% in 2019. CPI during this period has averaged 2.9%.
Barriers to entry exist. In theory, any developer with access to financing can construct a greenfield MHC. While this does happen, and doing so adds supply and reduces incumbents’ bargaining power, in practice limited new supply has come online. Industry publication MH Insider estimates that just 315 new MHCs were developed from 2002 to 2019, compared to 2,600 in the prior 15 years. Flagship management has stated that it is unaware of any new MHC development in its operating region since 2005. The public has a distaste for ‘trailer parks’ and competing land use favors commercial or site-built residential communities.
Flagship units trade at 0.7x tangible book value and yield 3.3%, using 2023 figures (and assuming Class B unit conversion). Flagship carries its investment properties at estimated fair value, whereas major peers use cost less accumulated depreciation, so the P/TB multiple can not be compared directly to peers.
As always, there are a few issues of which to be mindful.
To what extent does it face increased financing costs in a higher rate environment?
Overall gearing is not excessive. Net debt is 82% of unitholders’ equity. Following refinancing in early 2024 there are no material debt maturities until 2029 or after. The debt is a mix of fixed and variable rates, and frustratingly, it does not disclose the precise mix. Its cost of debt has crept higher to 4.1% in 2023 from 3.8% in 2022 and 3.4% in 2021. This will likely continue to move higher, though the long maturities will insulate it from a major shock.
What to make of the Class B units?
Class B units are issued by the REIT’s subsidiary Flagship Operating LLC, which directly owns most individual MHCs. The Class B unitholder may redeem them for cash or units (on a 1-for-1 basis) as determined by the REIT. On the balance sheet Class B units are presented within liabilities as they are considered ‘puttable instruments’. They are carried at estimated fair value, which is based on the market price of the units. Holders receive distributions proportionately to those made by the REIT to holders of the units.
The REIT often issues Class B units to selling parties in asset acquisitions. Counterparties may be able to defer taxes through this structure.
As of 2023, there were 5.6 m Class B units outstanding compared to 15.5 m units. Overall, we should expect Flagship to continue to issue Class B units as it pursues inorganic growth, and that outstanding Class B units should be included in per-share data.
Is Flagship overpaying for acquisitions?
The MHC industry is fragmented. There are some big operators like Sun Communities and Equity LifeStyle Properties but local mom-and-pop operators dominate (estimated 80% share). Flagship’s strategy has been to acquire assets from smaller operators, in particular within its core operation region.
From late 2020 until 2023 Flagship acquired assets is ~17 transactions. Flagship does not disclose P&L metrics relating to these transactions, just the consideration, # of lots, and occupancy. There is no clear trend in terms of per lot price - this has swung from$18,000 to $96,000.
If Flagship is overpaying for acquisitions, the ratio of revenue to investment properties, excluding FV gains, should be declining. No sign of this - excluding FV gains, the gross rental yield of the portfolio has increased to 9.9% from 8.5% in 2021.
Can it achieve cost economies of scale?
One rationale for operating in 7 contiguous states (Arkansas, Illinois, Indiana, Kentucky, Missouri, Ohio, and Tennessee) is that Flagship can generate economies of scale. For example, having properties located with a few hours’ drive allows it to employ its own maintenance and repair staff and utilize regional managers. This is a theme to watch.
What to make of related party transactions?
Flagship’s CEO and CIO are majority owners of Empower, a business involved in the MHC industry. Flagship and Empower have multiple agreements in pace to govern this relationship. Most importantly, Flagship will present to Empower opportunities to acquire MHCs that do not meet its investment criteria. Empower may sell its MHCs to Flagship (at a discount to appraised value). If Flagship achieves a gross book value of $1.5 b, it will have a one-time right to purchase all assets owned by Empower. In addition, Flagship will provide some asset and property management services for a fee.
In general, related party transactions need to be monitored closely to ensure public shareholders are not disadvantaged. So has this occurred in the case of Flagship’s relationship with Empower?
To date, transactions with Empower have been immaterial and there is no clear sign that Flagship public shareholders have been harmed. The major transactions have been:
Flagship has lent money to Empower (via a Notes Receivable). The amount is small at $2.5 m. The note is due in 2031 and until then, Empower only makes interest payments. Interest is set at ‘Prime’ (unclear in reference to which bank) and appears variable in line with Prime. The effective yield of the note was 8.3% in 2023.
In 2023 Flagship acquired two MHCs from Empower for a combined consideration of $10.5 m.
There are some other small transactions relating to payroll and repair & maintenance.
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