Sun Communities (ticker: SUI) and Equity Lifestyle Properties (ticker: ELS) are REITs that manage Mobile Home (MH), RV Park, and Marina properties. The space has great tailwinds, stable growth which outstrips supply every year, high barriers to entry due to Not In My Backyard mentality (NIMBY), and are recession resistant businesses. I think Sun Communities outlook is bright.
These tailwinds set the stage for excellent compounding, demonstrated by the results of the asset class and the internal and external growth drivers.
However, we’ll also discuss if the outlook is bright enough to outweigh some of the issues I see with the company.
Sun Communities recently made a splash with the announcement that it was acquiring Safe Harbor, the largest marina operator.
I actually have looked at buying a marina privately and thought it was a great business. It’s not a “growth” business to a private operator, but the capital investment prevents competitors.
Try to even imagine building a new marina these days – it requires all the regulatory burdens (e.g. zoning, permits) but also dredging and making the marina accessible for boats. Not to mention, in some areas, you’re building on wetlands so environmental issues really come into play.
So this leads to a really sticky business (particularly in salt water where boats are larger and harder to move) because the boats often don’t have a great place to go, while demand is stable to moving up.
Even though (i) I thought Sun Communities was paying a lot for the $2.2BN Safe Harbor acquisition last year and (ii) it doesn’t have any real relation to its core business, I liked the transaction.
A few years ago, ELS expanded into marinas and I guess SUI also saw the merits. In addition to the marina benefits I mentioned above, it is still early days for a consolidation story.
So far in this brief post, I’ve only talked about marinas, but I should discuss the MH and RV space as well. Sun Communities has been rapidly consolidating the MH and RV space along with ELS.I think it will be just a matter of time before these two control the market plus a few mom & pops.
Readers may already know too well that in America, we have an entry-level home affordability problem.
Months supply of inventory is at all-time lows at around 2.3 months (6 months supply is considered “balanced”, and we’ve been well under that for 5 years). Months’ supply refers to the number of months it would take for the current inventory of homes on the market to sell given the current sales pace. Historically, six months of supply is associated with moderate price appreciation, and a lower level of months’ supply tends to push prices up more rapidly.
At the same time, millennials are finally getting married, having kids and have built up savings (I don’t really buy into the “flight to the suburbs” thing every headline is saying, as I previously wrote about). So the issue is that there just isn’t supply. If the average millennial is having trouble affording their first home, imagine the bottom quartile of America.
I think there will always be demand for mobile homes given affordability issues basically in any period of time, but at this point the story makes even more sense. As shown in the first two tables of this post, you can see some of SUI’s metrics for rent and NOI growth. Occupancy is also very strong. Even in 2008, occupancy and rent collection remained solid. Coming out of the GFC, they were firing on all cylinders (similar to Autozone’s cyclical dynamic).
Turning to the RV business, RV sales have seen a boon from COVID. SUI manages transitional and permanent properties and the transitional really took off in the 2H’20 has vacationers hopped in the RVs for the family trip instead of flying. I think we could see tailwinds for years to come here.
I do have concern that we may also have a glut of RVs in the near future once airline flying comes back. Fortunately for SUI and ELS, the number of RV shipments (or boat shipments on the marina side) doesn’t really matter. It matters if people are utilizing them and taking them on trips. We’ve seen sales take-off of this equipment, so it’s possible in 2-3 years the owners who no longer utilize them often just decide to rent them out.
It’s not all a great story though. While it should be clear by now that I like the fundamental story, I don’t like the capital structure and returns set-up. Let’s walk through two of the issues I see.
- FCF isn’t that great Ok so if you’re a REIT investor, you probably already know that cash flow on these names isn’t actually that great (despite being dividend stories).
- This is mostly because they consistently spend to acquire additional properties and that’s how they grow.
- In addition, because they are REITs, they basically have to pay out 90% of earnings as dividends. In exchange, they pay no federal income tax.
- The problem: they don’t build up cash. Therefore, they constantly rely on the capital markets to grow. I don’t think that’s a terrible issue, per se, but it does make the business more risky on the margin.
- Constantly issuing equity My last points above are really trying to drive at this issue. Because they don’t accumulate much cash and they don’t want to get too over their skis with debt, these companies issue a ton of equity.
- Share count for SUI is up from 58MM in 2015 to 110MM PF for the Safe Harbor acquisition. So essentially doubled in 5 years.
- Yes, Adj. Funds from Operations (AFFO) per share has grown at a 9% CAGR over that time period for SUI.
These two things matter to me mainly due to opportunity cost.
Home Depot generated $18BN of FCF in the LTM period. It then paid $6.3BN in dividends and bought back $3.8BN of stock. That means they have $10BN leftover to buyback more stock, do acquisitions, reduce debt, invest back in the business – whatever!
Now let’s look at Sun. LTM (9/30/2020 before the Safe Harbor marina acquisition), they generated $543MM of operating cash flow and spent $31MM on “recurring”, or maintenance, capex (which oftentimes is an understated metric and more of a “burning the furniture to keep the lights on” figure). So that is $512MM of FCF. They spent $853MM of acquisitions of real estate plus paid $303MM in dividends, so they had to fund that via $618MM of equity issuance plus debt increased by $108MM.
On one hand, Sun Communities is growing (and growing quickly). But on the other, they consistently need to tap the markets for this growth.
Maybe I’m being dumb and should think 10 years from now… then they’ll have the size where they can reduce this reliance. But I’m also buying a name that has to issue equity to fund growth.
I think I’d prefer to buying companies that generate so much cash flow and have healthy enough balance sheets that they don’t really need to rely of equity capital. I think names like this will compound much faster than those that do require equity capital.
Part of this is because volatile market DO happen. We saw it in 2020. We saw it in 2018. We saw it in 2016, and so on. I’d prefer to own companies that could take advantage of a market sell-off to act quickly.
I’m not just speaking of Sun Communities being able to buy back its own stock in these scenarios, but also move quickly to buy discounted assets. If the market was weak, then the currency Sun Communities uses to buy assets will also be weak and that will hurt returns.