There are four methods of measurement regarding mobile home park performance: 1) cap rate 2) coverage 3) cash-on-cash and 4) cash flow. But what is each one and how do you derive it? And what is acceptable? That’s the focus of this Mobile Home Park Mastery podcast.
Episode 246: The Four C’s of Performance Transcript
There are many things that come in fours. The Four Horsemen of the Apocalypse. Four balls and you're out. Even four letter words. But with mobile home parks, it all boils down to four units of measure, which we call The Four C's. This is Frank Rolfe, the Mobile Home Park Mastery Podcast. We're gonna talk about what these Four C's are, and how those help you evaluate any mobile home park property. The first C you need to worry about is what is called the cap rate. Now, what is a cap rate? A cap rate is nothing more than a fraction. It's the net income of the property over the total cost of the property. Let's model one. You have a mobile home park, it makes $50,000 a year of net income, and it costs half a million dollars. You divide 50,000 by 500,000, and what you end up with is 0.1, which means it is a 10% cap rate. Now, is that good or is that bad? Well, depends. If you're buying a mobile home park, 10% would be considered good, but if you're selling the mobile home park in today's market, not so good. You see, the higher the cap rate, the better the deal is for the buyer, and the lower the cap rate, the better the deal is for the seller.
Now, what is the appropriate cap rate? That's something that people have debated for decades. In our opinion, you wanna have a spread between the cap rate and the interest rate, typically three points. If you can establish a three-point spread using leverage of 70% to 80% loan-to-value, that will get you the magical 20% cash-on-cash yield that most buyers are looking for, but you have to be able to evaluate any mobile home park based on the cap rate. Is there a trick to it? Well, sure there is. Number one, what is the true net income of the property? What is the true revenue-less expenses of the property? But then additionally, what is the true going-in number as far as total cost of the property? 'Cause it's not just what you're paying for it. It's what you're paying for it plus whatever additional capital that it needs. But getting a cap rate is a very, very initial building block to figuring out whether that deal is going to work for you economically or not.
Then the next C is the coverage ratio. Now, what does that mean? Well, when you go to get a bank loan on a mobile home park, and recall from just a second ago, I talked about a 70% to 80% loan-to-value, because we all put debt on every mobile home park. No one buys mobile home parks for cash. Rarely do they do that. So then when the bank gets involved, they're gonna wanna feel safe about the loan that they make, and the way they feel safe is they wanna know how much the net income of the property can cover the mortgage with a little extra left to spare. Most banks like to see a coverage ration of 1.2, which means they want the park to have the ability to cover 120% of the mortgage payment and not just 100%. Why not 100%? Well, you'll wanna have a little held back for a rainy day. What if your collections aren't up to par? What if you lose a resident? Banks like to have the feeling that they will definitely get paid.
Now, some banks even stress test loans. They may apply an additional strategy to it. They may say, "Well, what happens with this mobile home park, let's say, if the net income declines by 10%, or even the revenue by 10%?" And I see nothing wrong with that. You definitely want a bank to be conservative because the bank helps you stay out of trouble too. But one thing that all banks will look at; I've never had a bank that didn't, is to look at that coverage ratio, which means it's not enough that the mobile home park be able just to barely cover the mortgage. It has to cover the mortgage with a little extra to spare. And again, that typical number is a 1.2 to a 1.25. The next C is the cash-on-cash return. Now, here's what a cash-on-cash return is. You buy the mobile home park and you put X dollars down. It might be 20% of the price, might be 30% of the price, or it might be less. So this unit of measure is how much you get back on the money you put down. Let's say, for example, that you are buying a mobile home park, putting $100,000 down, and the mobile home park can create $20,000 a year, which comes back to you from that 100,000. That would be a 20% cash-on-cash yield.
Frank Rolfe: Is that good? Yes, that's excellent. Can you name another investment that yields 20%? Because I can't. You could say, "Well, I'll put my money in a CD." Well, that's 2%, so that means the mobile home park is doing roughly 10 times as much as that CD does. And even though the stock market's done pretty well over the last few years, thanks to that big plummet but then recovery from COVID, now that the market has cooled off enormously, it's not quite as impressive as it used to be. In fact, if you look over the last rolling 12 months in the stock market, well, you would have lost money. So that 20% is infinitely better than what you would have made in stocks. But the bottom line to it all is the cash-on-cash return is very, very vital because that's showing the kind of return you're getting from your own money.
Now, how do you figure out the cash-on-cash return? Well, the one thing you need to know about a cash-on-cash return is that the principal portion of your mortgage actually flows to you ultimately. That's where a lot of people get confused in doing the cash-on-cash. Let's assume that you buy a mobile home park and you've got a mortgage payment of $5,000 a month, and of that $5,000 a month, additionally, $3,500 of it is interest, if 1,500 a month of it is principal. That principal, although the bank is not giving it to you, that principal is ultimately going to go to you. When it comes up for renewal, when you sell the property, the amount that you have as far as principal on that loan is therefore being diminished by $1,500 a month, or $18,000 a year. Some banks like to call this concept enforced savings, which is really fairly true. If you have an interest only note, then there would be no principal in that note, right? But if you have a principal and interest note, then you always will have some form of principal.
Now, as you're probably aware, over time on a straight note, the principal portion goes up every month while the interest portion declines, and you'd have to take that into consideration when you do your actual calculations, 'cause the number is always going to be changing slightly. But on a broad brush analysis or a cash-on-cash return is simply stating how much money you're getting back from your down payment, not only in the form of cash, but also that accrues to you from that principal pay down on the note. Now that C, however, leads to the next C, the final C, which is cash flow. Cash flow is very, very different than cash-on-cash return, because cash-on-cash return can include that phantom gain you're making every month and you're paid on a principal. It has to be allocated somewhere. We can't skip it altogether. So the cash-on-cash return has really given you the most fair idea of how much money you're making for the amount that you put down, but cash flow is equally important. But the cash flow is... It tells you what you have left over after you've made the mortgage payment. It's possible that you could have a cash-on-cash which would appear positive, and still have a negative cash flow. So you have to know how much money at the end of each month, assuming you hit all of your targets, how much is left over for you to actually go in your pocket.
A healthy deal would have not only a very attractive cash-on-cash return, but also a healthy amount of cash flow. Now, you can calculate how much cash flow you'll have from any mobile home park if you look not only beyond the mortgage, but what you will do to the park after purchase. Many buyers today are by mobile parks at prices where you can cover the mortgage in total and positively cash flow, but your big money comes from those other things that you do to enhance the cash flow, which are things such as raising rents. That's the big one. Filling vacant lots and homes, sub-metering water/sewer, and cutting any other costs, such as water leaks or a manager who's been paid too much. That's the best way to actually create significant cash flow. I get asked all the time, "How can you make $100,000 with one mobile home park?" The answer is simple: Buy a mobile home park that has at least 80 lots occupied in a market in which you can increase the rents over the next, let's say, two to five years by $100 a month, and bingo, you've got $100,000 of cash flow coming to you each year after the payment of the note and all other costs.
One thing that if you start looking at these numbers that you will see, probably the most interesting part is the impact of the way you structure your financing, because the way you structure the financing, despite the cap rate, and in light of the coverage can still really, really influence your cash-on-cash return and your cash flow. If you have a seller who will do seller financing, and you can work out a deal which is zero down, and we've done 12 of those deals with seller financing, then you have the ability to have actually an infinite cash-on-cash return because you have no money in it. So there are tricks you can do to stylize those numbers and change them dramatically, but that's not the norm. Your typical deal out there is gonna require some degree of amount down on it. It might be 10%, 20%, 30%, but that's typically what we're all starting on the sheet of paper with in calculating that cash-on-cash number. And again, the cash flow is another number that can be heavily manipulated by what you do after the purchase of the property. All these numbers are very, very fluid. You need to fully understand each of them on every property to have an idea of what you are really buying. But if you can master those four Cs, you can then also master how your performance will be and how well you will meet your budgets and expectations.
This is Frank Rolfe from Mobile Home Park Mastery podcast. Hope you enjoyed this. Talk to you again soon.