I know there's enormous appeal to collecting a distribution each month from an income property, so I understand if the title of this article seems counterintuitive, counterproductive, and maybe even like bad advice.
But hear me out.
Without a doubt, there is something satisfying about “mailbox money.” It’s a true passive income. However, when you really look at the underlying economics of re-investing capital proceeds back into the property that generates it, it becomes readily clear that not only does it provide a better property with happier tenants, but it also confers a significantly greater economic return for investors.
With that in mind, here are my top 6 reasons why it’s better to invest case back into your mobile home parks:
1. Cash flow extracts value from a property
When you take money out of the property bank account, the tangible result is that you have less funds available to make capital improvements. But there’s also psychological effect at play, because a recurring low balance will hinder long-term, capital growth thinking. For example, if I only have an average account balance of $5,000 in a property account, the idea of installing a $40,000 trash compactor is simply out of the question. It also precludes pre-emptive maintenance, which can ultimately hurt your property.
It’s hard to justify a $15,000 seal coating every 3 years for road surfaces, so a low account balance means this will likely get skipped—until an insurance inspector requires a complete re-pave in order to continue your policy. Suddenly, opting for the short-term cash extraction has left you with a $75,000 re-paving bill.
2. Investing cash back into property allows for better rent growth
Re-investment into a property improves the property in multiple ways: Upgrading the curb appeal with landscaping will encourage pride of ownership from your tenants. This in turn can lead to better home exteriors, as well as fewer complaints about rent increases since they see active improvements. In addition, making select investments into expense reduction can have an even greater impact on property value than rent increases.
3. It controls and reduces expenses
Like paving maintenance, numerous other preventative capital investments will not only save money on an operating basis but also delay or even eliminate the need for an expensive (and likely emergency) capital repair. And even though all these items can be budgeted for, it becomes much harder to justify a preventative item (i.e., “The road looks fine to me. Why do I need to seal coat?”) when the account balance is perpetually low. Furthermore, nearly all of these investments directly contribute to higher property values, either by reducing expenses or enhancing property quality, which translates into higher rents without causing tenant relationship issues.
4. It makes lenders happy
There is nothing worse than having a lender walk a property after you’ve made every payment on time for 5 years, only to hear “You know, I don’t think we'll be able to keep this loan. You’ll need to refinance with another bank.”
Keeping a loan with the same bank offers multiple advantages and losing your current lender often muddies the refinance waters with others. And an almost sure-fire way to lose your current lender is for them to see an active decline in the property quality (Remember, your loan officer doesn’t visit every year even if he says he does.)
One way to make your lender happy, however, is to actively invest in items that reduce operating expenses. As they see these line items decreasing, it not only increases net operating income but also serves as a hedge against ever-present increases in operating expenses, such as taxes.
5. It makes tenants happy
While I am unable to place an exact number to this, it’s anecdotally undeniable that tenants who see active property management are much more likely to cause fewer problems, invest into their homes, and better understand increasing rents. As any property manager will tell you, it's hard to put a price on the value of a park with no headaches.
6. It helps your taxes
I wouldn’t be advocating for this management strategy were there not a very real means of achieving some form of cash flow from your park property. In this case, the distribution comes in the form of periodic, tax-free cash via proceeds from a refinance, rather than more regular, but fully taxable, distributions. Not only will you get more cash flow from your property using this methodology, but it will be in a much more tax advantaged form
Case Study
For a simple example, let's review a simple 5-year projection as follows:
- Bridge Mobile Park is an average quality, 30-unit mobile home park that has gross rents of $180,000/yr, expenses of $63,000, an NOI of $117,000 and an annual loan payment of $82,500, yielding an annual cash flow $34,500. The loan term is 5 years, after which point the property will need to be refinanced.
- In scenario A, rent growth is 5% annually, leading to an annual gross income of $218,000. The owner elected to distribute 85% of cash flow, leading to limited repairs on an as-needed basis. Expenses increased 6% during the same period, leading to an annual expense bill of $79,500 and a net income of $139,000. This owner also received $193,000 in distributions during the 5-year period. Assuming a 6.00% capitalization rate, the property value at year 5 is $2,320,000
- In scenario B, the owner invests ALL proceeds back into the property, contributing to a 6% annual growth rate. Additionally, by investing in utility repairs and upgrades (i.e., water line repairs, trash compactor, advanced metering) this owner only saw a 3% increase in expenses during the same time period. The gross rents for this owner are $236,000, annual expenses are $71,000 leading to an NOI of $165,000. Higher asset quality leads to a slightly lower capitalization rate of 5.50%, and a stabilized property value of $3,000,000.
Obviously, several variables can be modified in these examples, but the effect remains the same; investment into a property rather than distributing cash yields a significantly greater value for both tenants, operators, and investors.
[1] Obviously I am not a tax professional and cannot provide tax advice; please consult your accountant or other tax consultant to determine the tax status of any investment