Parks & Preferred Returns
Passive MHP Investors (limited partners) and operators (general partners) view preferred returns slightly differently.
Investor (LP) viewpoint:
“I give you hard-earned cash, you give me a respectable return above bonds before you take any profits from the deal. It is the backbone of the limited partner & general partner relationship and should be respected.”
MHP Operator (GP) viewpoint:
“I hate preferred returns".
Okay, it’s not that bad.
There are plenty of mobile home park GPs that have solved the preferred return (aka “pref”) puzzle.
But there are a lot that struggle to structure deals and business plans around a market (usually 6%-8%) preferred return.
Here are the major issues:
Many retail investors confuse preferred returns as “promised” - or “guaranteed” cash flow yields and are disappointed with distributions below the preferred return. This is a communication error. But…it’s good to remember that nothing is ever promised in investing.
Partly because of the above, GP’s get overly fixated on hitting the pref and distribute too much cash. Returning capital to investors is often not the best use of that capital.
Older mobile home parks are not cash cows, many are assets with GIANT deferred maintenance “balances” that will need to be paid at some point. The infrastructure will fail sooner or later.
The preferred return often incentivizes the operator to sell the property too soon, optimizing for IRR (total return) vs. equity multiple (total hard cash).
As the saying goes, investors can’t eat IRR.
Don’t get me wrong, I’m not advocating for eliminating preferred returns.
A preferred returns ensures:
investors are properly incentivized & rewarded for taking investment risk.
the GP feels the preferred return clock ticking and hustles to put capital to work and grow cash flow.
This is all well and good provided both parties have the same expectations and the GP aligns the business model with the overall structure of the deal (preferred return + profit splits).
Problems arise when the business plan and the asset don’t line up with investor expectations or deal structure.
This is most commonly seen via investments in older 2-3 star parks in tertiary markets that need a lot of love. Too many inexperienced MHP operators buy these parks assuming they can improve operations on a shoestring capital budget and still distribute a hefty 8% current yield.
This is where MHP dreams go to die.
Unexpected capital expenses, excessive repairs or a spike in collections puts the entire deal at risk given the lack of working capital.
And trust me, there will be capital expenses….
Day 1 cash cow business plans don’t work well with old parks unless you get lucky on:
the tenant base
park infrastructure
city inspections
park owned homes
and capital markets (on exit).
Buying a park like this and not reinvesting cash into improvements is usually a “greater fool” business model. In other words, it requires that someone pays you a higher price than you paid for the park.
Yet, that same deal under a three year capital improvement plan - where you reinvest everything back into the park - might have worked beautifully.
In other words, it wasn’t the wrong park. It was the wrong investor base.
What might have fixed this?
Extremely clear communication and cash flow expectations in all investor communications prior to purchase. Put it upfront and in bold, don’t bury it on page 30 of a presentation deck. Investors will miss and forget. If you have a major turnaround park it should be made abundantly clear that the preferred return does not equal expected cash flow yield.
By partnering with a family office or private equity firm with deep pockets that is total return driven (vs. high cash flow driven).
These parks tend to work really well for high-octane private equity style investing. This strategy is IRR driven and the investor doesn’t care about current yield as long as they get paid a great return upon sale.
A private equity structure will still have a hefty preferred return, but that pref is usually accounted and paid for out of sale proceeds. Whatever is left over after the accrued pref is paid goes to the GP + LP based on their negotiated profit splits.
Ideally, the money that could have been distributed was reinvested back into the park at a much higher return on those incremental dollars than 6-8%.
Obviously fixing up vacant homes, infilling new homes or adding new pads would be a better use of capital as it should increase the park value $40k - $100K+ depending on park quality & market.
It’s hard to watch an unpaid preferred return accumulate, but investing cash flow and spending money to increase NOI on a value-add park (vs. stabilized) is often best path for a GP to maximize total dollars to the partnership.
Happy Trails,
MHP WEEKLY