By Merrie S. Frankel

Although it remains a small sub-sector of the commercial real estate industry, the manufactured housing market offers investors some interesting opportunities despite facing serious challenges. Manufactured housing (MH) REITs possess sound credit fundamentals, but are being challenged by lax underwriting standards by finance companies that have caused a lingering oversupply of MH units, as well as higher delinquencies and an increased rate of repossessions.

The oversupply problems were caused by easy credit terms to both borrowers and sellers of manufactured housing units in the mid-1990s, which lead to over-production. In addition, credit problems with some residents due to lax underwriting have created tightened credit requirements and occupancy challenges for communities.

However, the publicly traded real estate companies in this sector have mitigated these difficulties by maintaining higher credit standards for new residents, and have not experienced unusual levels of repossessions, primarily because their parks comprise more well-maintained units and retirement communities than private parks. Also helping REITs remedy the negative market forces over the next few years will be the aging U.S. population and the continued need for quality affordable housing. The improving product image and quality of manufactured housing, and better affordability compared to site-built housing, should also help drive demand. Strict zoning also controls MH community supply.

Today's Market

Manufactured homes have come a long way since their inception in the early 1900s. Modern factory-built homes are designed according to strict codes, and commonly sport modern design elements like skylights, fireplaces, vaulted ceilings, pitched roofs and wrap-around decks making them more attractive to a broader range of occupants. The MH sector comprises homes that are built off-site (usually at a factory) and trucked to the lot where they are installed, versus "stick-built" dwellings, which are constructed directly at the site. Approximately 21 million people, or roughly 7.6 percent of the U.S. population, live full-time in the 8.9 million manufactured homes in this country, according to figures from the Manufactured Housing Institute.

While first-time homeowners and retirees form the traditional core group of manufactured housing owners, new trends are emerging. According to the Manufactured Housing Institute, the sector is seeing more interest from younger empty nesters, Baby Boomers and their children (Generation X), single-parent households, and people with more substantial disposable incomes who are looking for vacation or second homes. Manufactured home communities fall into two broad categories—senior communities for adults aged 55 and older (about 10 percent of the communities fall in this category), and "all-age" or "family" communities (accounting for the majority, 90 percent, of all communities) that accept residents without age restriction.

Manufactured Housing Sector
# of REITs	5
Market Cap.	$2,389,568*
Industry Market Cap.	$155,317,898*
% of Industry	1.5%
Average Dividend Yield	6.4%
YTD Total Return	1.5%
1-year Total Return	16.1%
3-year Total Return	13.1%
5-year Total Return	10.1%
Weighted Daily Volume (shares)	58,556,603
Weighted FFO Growth (2001–2002)	-1.1%
*These figures represented in thousands. Data as of Feb. 28, 2002. Source: NAREIT

Key Credit Drivers

There are several major credit drivers impacting manufactured housing communities. Among the primary factors affecting the sector are stable cash flows, long development and lease-up periods, operational management, industry consolidation and previous financing activities.

• Stable Cash Flows Are a Plus

Cash flow stability is a key distinguishing feature of MH community REITs, and is exemplified by zoning that tends to make developing new communities slow and difficult. Because of this, sharp shifts in supply are uncommon—a contrast to many other property types. Furthermore, there is reduced turnover as residents tend to stay put, especially older individuals. In addition, if a resident fails to make the rent payment on the pad (the plot of land the home is situated on), the community owner can seize the unit. In most cases, pad rent represents a small portion of a resident's housing costs. Given the value of most units compared to pad rent, it is uneconomical for the resident (or for the resident's finance company) to skip payment.

Because of these factors, internal growth tends to be the driver for MH community revenue. Operating margins are a healthy 60 percent to 70 percent. Break-even occupancy levels are approximately 40 percent unlevered, reflecting low operating costs. Community owners' recurring capital expenditures average just $150 to $200 per site, per year in older communities, and $60 to $100 for newer communities. By contrast, apartment building owners incur annual capital expenditures of $400 to $600 per unit. Some MH community REITs are generating ancillary income through fee-based programs for residents that provide cable, trash, security and senior citizen programs.

• Long Road to Stability

The flip side of tough zoning is that developing new communities or divisions is a slow, arduous process, which typically takes up to five years. This process ties up capital in non-earning assets and elevates risk. Zoning permits are often delayed due to local residents who voice concern for the communities being built in their neighborhood. In addition, once a community has been built, stabilization takes several years.

Furthermore, repositioning a community (for example, to accommodate new, larger units), such as moving roads or enlarging pads, is slow and laborious, and boosts vacancies for several years; moving residents either within or outside of the community does not happen quickly or cheaply. Thus, stabilizing communities is slow, but once stabilized, they tend to stay that way for reasonably long periods.

• Operational Management Is Vital

More so than most other property types, MH communities are operating businesses that demand significant, effective, hands-on, day-to-day effort to keep them running properly. Many MH communities are, in reality, small towns, with the community manager living on site, and being a de facto mayor who is responsible for such items as roads, community centers, security, water, power and sewage. Management's level of interaction with residents is also high, and the right type of manager needs to be recruited and trained. Experienced managers are often moved from one community to another.

• Consolidation?

A great majority of MH communities are smaller and privately owned, and large, private or public MH community owners are rare. The five publicly traded manufactured housing companies are American Land Lease, Inc., Chateau Communities, Inc., Manufactured Home Communities, Inc., Sun Communities, Inc. and United Mobile Homes, Inc. While this creates opportunities for sector consolidation, any activity will be slow, because identifying sizable portfolios is difficult and the private owners are often content with owning their businesses as is. Thus, achieving sector, or even regional, leadership and building a brand will be a lengthy process.

• Special Financing Issues

The financing of manufactured homes in the mid-to-late 1990s was strongly affected by volume-driven relaxed underwriting, which caused an elevation in unit sales (initially), followed by heightened repossessions and delinquencies. We think the effects of the overproduction and credit challenges will continue to resolve themselves. However, several lenders have since exited the business, leaving only a handful, which creates risk. Nevertheless, the Federal Housing Administration's manufactured housing loan programs are enjoying renewed prominence, and at least 30 percent to 40 percent of MH REITs' residents pay all cash for their units, thus limiting the REITs' exposure to this credit crunch.

Key Data on Major Manufactured Housing REITs (as of 4Q '01)
Company	Ticker	Total # of Properties	# of Sites (incl. RV sites)	# of States	Assets
Chateau Communities, Inc.	CPJ	214	71,659	37	$1.6 billion
Manufactured Home Communities, Inc.	MHC	148	50,761	23	$1.1 billion
Sun Communities, Inc.	SUI	116	44,885	15	$1.0 billion
American Land Lease, Inc.	ANL	30	5,984	1	$217 million
United Mobile Homes, Inc.*	UMH	24	5,759	5	$74 million
*Data as of Sept. 1, 2001 Source: Moody's Investors Service

Looking Ahead

Based on steps already being taken, the future looks promising for the manufactured housing sector. Reduced production and shipments of new manufactured housing units have alleviated some of the inventory glut. Tighter underwriting credit standards have improved credit performance, which should bring the manufactured housing sector back into equilibrium within the next two years, thus improving the performance of manufactured housing REITs as well.

Future demand will be driven by the improving product image and quality of manufactured homes and the greater affordability compared to site-built housing, as well as the aging Baby Boomer population's housing needs. Community supply should be held in check by high barriers to entry, strict zoning and long lease-up periods. Over the next few years these positive attributes should prevail over the sector's excess inventories, repossessions and financing challenges.

Merrie S. Frankel is vice president/senior credit officer for Moody's Investors Service.