Sam Zell has only been gone for a short while yet it appears that many buyers and sellers have already lost track of the art of imputing risk – the necessary element of factoring risk into buying and selling decisions. In this Mobile Home Park Mastery podcast we’re going to review the Zell formula on approaching the subject of risk and what some of the issues are when you don’t adhere to those principals.
Episode 319: The Lost Art Of Imputing Risk Transcript
Sam Zell passed away in May of this year. And with Zell went, the legend of his almost maniacal view and focus on risk. This is Frank Rolfe, Mobile Home Park Mastery Podcast. We're gonna talk about imputing risk in deals and how people are starting to lose sight of that. It's only been since May, when Zell left the building, and we lost Zell as a force to constantly remind us of the importance of risk versus reward. And it's something we all need to think about constantly, because we all need to refresh our course on it from time to time to make sure we're making good decisions. Now, Zell's theory on risk versus reward was, if a deal has low risk and high reward, you should always buy it, if it has high risk and low reward, you should never buy it, and if it has a high risk and high reward, only then do you really have to think about it.
And one problem you have is that many of today's buyers and sellers have lost track of what some of the real risks are to the industry, the things we don't talk about a whole lot. So when they look at a deal, buying that deal, they say to themselves, "Okay, for me to get from point A to point B, let's see, I've got to fill X number of lots, I got to raise the rent up to this certain level, I've got to cut these various costs, and if I can do those things, I'll hit my budget." And yeah, they're completely correct. They look at each of those steps, they say, "What would stop me from successfully completing that step?" And they then think of that as being the risk to the deal. And then going back to Zell's axiom, they say, "Okay, well, I understand the risk, I understand the reward, now, I'm ready to make a decision." But the problem is, there are some risks that people don't always think about, but you have to think about when you're trying to figure out what the true risk of the deal is and whether you should go forward or not.
So let's go over what some of those things are. Let's start off with insurance risk. If you're looking into mobile home park in California or Florida or Louisiana, you need to impute into that deal, the inherent risk you may not be able to get insurance and/or you may be facing extremely high insurance premiums. We all know about California's woes, they had constant issues with predominantly fires at this point, but you also have earthquakes, and recently they've had almost everything bad go on there weather-wise, and then you've got Florida. Florida just cannot get a break, all they get is every year some kind of terrible hurricane issue, flooding, and it's become so bad the many insurance companies have just pulled up stakes and left. They don't want to ensure things in Florida anymore because they're uncertain that they'll make a profit in doing so. And now even Louisiana is being lumped into that, because they've had progressively worse and more frequent storms.
So if you're looking into mobile home park in those three states, you really need to get a handle on insurance and make sure that you've budgeted accordingly for higher premiums and make sure you can obtain insurance itself. Then, and somewhat tied to that, is flooding a risk. Now, if a mobile home park is in floodplain and many of them are, that's not the end of the movie. I've seen mobile home parks in floodplain, we've had some where actually none of the actual lots are in the floodplain. Just the green space down at the bottom, where the basketball court is. So when you're looking at a park that has floodplain, you can't rank them all the same. Instead, what you need to know is how many lots are in the floodplain, whether that water is a flood way or a flow way, or simply what they call still pooling water, and where the BFE is, which stand for Base Floodplain Elevation, in other words, how high the water goes above the ground, because if it reaches the bottom, the floor of the mobile home, the mobile homes would be ruined.
But it's not enough just to say, "Oh yeah, well, there's some floodplain," and then just cast it aside, disregard it as though it's no big deal. It's a huge deal. Look at all the recent flooding events that we have had. Now the Corps of Engineers isn't helping much because they recently revealed, after there were some terrible floods in states like Vermont, that in fact, they've only really mapped out about a third of America, and most of those maps are greatly out of date. So if you really wanna know your flooding issues, you'll have to go a little further yourself. You'll need to talk to the city and the neighbors to see if there's been any evidence of past flooding.
Next, blue states versus red states. Now, I think we all instinctively know that, but America is basically breaking to two very distinct, different political ideologies. You have the red states, which are landlord friendly and the blue states which are tenant friendly. And while that's not that big a deal at this point, you do have to make sure that the state that you are looking at buying into you, is not going to go to the worst of all types of tenant rights, and that is rent control. Now, there are very few states in the United States that have ever enacted rent control, roughly about five out of 50. It's not usually popular, but there are still some states that you have to look at very carefully. States such as Washington, for example, which you will think would probably go into rent control being the fact that California and Oregon have already done so. And there's some also in the Northeast, you have to look at it very closely because they are so extremely anti-business, that it's very possible at some point they will tip over the top of the fence and fall into rent control zone. So you've gotta also impute that risk in, when you're looking at deals as what's going on in the political ideology of that state.
Another risk that people have to think about is the insanely high cost of new mobile homes, which then begs the questions, will your customers in the future be able to afford them? If you're looking at a mobile home park, which has a lot of lots to fill in an area that is not very economically robust, people's earnings are not high enough, if their down payment and credit scores are not appropriate, they can't get approved on the mortgages on homes that cost sometimes as much as $80,000 or more on a single wide. You've got to impute that risk.
Then you've got property tax issues in states like Florida and Texas. States which do not have personal income tax, but pay all the bills simply off property tax. What's gonna happen as far as those tax rates? What will occur as property start going up in value, how quickly will the tax assessor raise those values? Then you have failing private sewer systems. If you've got a packaging plant, which is a private sewage disposal facility, and the packaging plant is 70 years old, it has never had any maintenance done at all, no one's ever even bothered to look at the thing, you can't buy that unless you really, really understand what you're buying into. A packaging plant is a very expensive asset, it can cost up to a million dollars or even more. How many years of useful life does it still have?
Then you have the issue of liquidity and lending. If you buy a park that has lots and lots of vacancy, because most lenders want parks to have 80% occupancy, that's called stabilized occupancy, and that's the trigger where they think the park is safe to make a loan on. And some banks will go all the way down into the 60 percentile. But when you're buying a park that's, let's say it's 30% or 40% occupancy, what are you gonna do if your loan comes up before you hit 80%? What do you do if you have a mom and pop loan and you can't get to 80% before it comes due. Can you get a new loan? That's another risk you have to think about.
And then you have the issue on a park that has lots and lots of park-owned homes and you wanna convert those tenant-owned homes. Are you making the correct assumptions on how many people will run off? We have found typically about 25% of everyone in a park-owned home rental will run off when you try and convert those into tenant owned homes, when you try and get them to buy their own home or even give them away. And when someone runs off, you'll now have to rehab that home. Do you have the correct amount of money allocated for that rehab?
Then you got even the generic tax law changes that may be coming down the road. Because as we all know, America is broke, we don't bring in nearly enough money to pay the bills, running negatively and terribly. And we're looking at, I think the estimate of the deficit in the US will hit by the year 2030, they estimated around $50 trillion, an unbelievable sum. So how will the government make it up? Well, they'll probably try to enact changes to the tax system. You probably saw that Biden himself, in fact, was hoping to undo capital gains and reduce it back to ordinary income rates. So if you're a seller particularly, that's another risk you have to think about. If you don't sell your park today, but you'd like to sell it years in the future, what the tax rates be? Will you still have capital gains tax to jump on to?
The bottom line to it all is that Sam Zell knew exactly what he was talking about. I highly recommend you read his book, 'Am I Being Too Subtle?' Probably one of the best books ever written on Real Estate regarding the subject of risk. Because everyone, every buyer, every seller really needs to follow his metric of risk versus reward, and that includes all risks, not just the simple ones, the basic ones, the ones we all know, 'cause you also have to delve into the more esoteric. Because at the end of the day, how we understand and measure around risk has everything to do with how good a mobile home park buyer and operator you will be. This is Frank Rolfe, Mobile Home Park Mastery Podcast. Hope you enjoyed this. Talk to you again soon.