Sam Zell always used the axiom that you should always buy deals with low risk/high reward, never buy deals with high risk/low reward and the ones that require thinking are those with high risk/high reward. So how do you approach those type of deals? That’s the focus of this Mobile Home Park Mastery podcast.
Episode 333: Strategies To Approach High Risk/High Reward Deals Transcript
The late Sam Zell was really the father of the modern Mobile Home Park industry. He was the largest owner of Mobile Home Parks through his REIT called ELS. But he also came up with a lot of the mantras and axioms that many park owners today follow religiously. And one of them was his old saying that "You should never buy a deal with high risk and low reward, and you should always buy a deal with low risk and high reward. And the ones you have to really ponder are those with high risk and high reward." This is Frank Rolfe, the Mobile Home Park Mastery Podcast. We're gonna talk about just that one item. How do you analyze? How do you come to grips with the reality of the high risk, high reward deal? And let's talk first about why Zell made that statement. And that's because in every deal you have these two very striking components.
You have the risk, the things that could hurt you, ruin you financially, destroy your deal, and then you have the reward, the reward of the good things, the profitability, the way you can enhance the property. So you have kind of these two very diametrically opposing items. And every deal has a certain level of one and a certain level of the other. A low risk, high reward deal, for example, will be one where you're buying it from a Mom and Pop, they've got the rent way under market, they've got a bunch of vacant park-owned homes, they've got water and sewer, which could be pushed back onto the residence since they use it. And at the same time, Mom and Pop are willing to sell or finance it with a very low amount down non-recourse debt. Well, that's a no-brainer deal. Assuming everything pans out, phase one comes back clean, permit is fine, then sure you're gonna do that because you have very little to lose and everything to gain.
And then you have your high risk, low reward deal. Well, that's one in which the risk is just terrible. Maybe you have a failing packaging plant or you don't have a good permit on it. So those are pretty strikingly scary things to deal with. And on the flip side, at the price Mom and Pop are asking, there's really no money in it. Yeah, you could raise the rents a little, but at the end of the day, you wouldn't be that happy with the profitability it can produce. But the high risk, high reward deals have stronger elements of both. You can't clearly put them into a box. They're not just, "Oh yeah, I would totally do this deal," or, "No, I would never do that deal." So how do we figure out how to put the high risk, high reward deal into a box?
Well, the first thing you have to do is you have to go to the end of the movie and find out what the true reward would be. Because in many Mobile Home Parks that you buy, let's say it's a high risk, high reward situation, it's a horribly hairy turnaround with lots of vacancy and lots of infrastructure issues to address and all this kinda stuff. Well, we gotta figure out what it's worth when we're done with all that. So you wanna model on that park. Let's say the park has got 70 lots, only 20 occupied, and the rent right now is 200 and the market's at 400. So you would say, "Okay, well if I got all 70 filled at 400 rent and I got the water sewer being paid by the residents, so at a 30% expense ratio, and I look at my net income and now I gotta cap it, well, what do I use for a cap rate?" Let's just say you used to be safe, a cap rate of seven or eight percent because we don't know where interest rates will be five years or so in the future.
And also, cap rates depend a lot on whether it's a large institutional property or a smaller kind of property. But you then come up with your projected net income at the end of the movie, after you get everything done, apply the cap rate and then compare that to what you're paying. Now, if the comparison shows you that through doing all these many steps of filling the lots and fixing things and raising the rent, I can make a million dollars over what I'm paying for it, then that's probably pretty attractive for many park buyers making a million dollars on a deal seems to be kind of the gold standard of making you want to do it. Or you may look at it as being a ratio of whatever your money in to what it would produce at the end. And you say, "Ah, well that would make five times my money. So yes. I'm a player for that. I'm gonna put in $100,000 and I can make back $500,000 if it all pans out."
But you can't make those decisions until you actually come to the end of the movie. Because to analyze the high risk versus high reward, although we know the high risk on the front end, we have to come up with the reward on the front end. So that's step number one, is we gotta identify what the reward is. And then we wanna look at three different cases 'cause... Now we've said, "Okay, well here's my best case. Here's if everything went perfect, here's where I would be." But life doesn't always go perfect. So how do I address that? Well, I look at my worst case. What's the worst case? Well, let's say I say, "Well, you know what? Let's assume I can only get the rate up to $250 and let's assume I can only fill 10 more lots, then where am I at?"
And when you look at that worst case, what you're trying to figure out is how punishing to you financially would it be? And the worst case scenario, are you having to write checks every month? Is cashflow negative? Can you service a mortgage? And if the answer is it's crushing, "Oh my gosh, my worst case scenario I'm losing $5,000 a month and I'll lose the property and ruin myself," well, then you shouldn't buy it. You don't wanna do any one deal that can sink you. The whole point of being a good deal maker is doing lots of deals and avoiding those one real bad deals that can ruin your career. So if you're negative, if your worst case scenario is some kind of horrible cash flow situation, well then let's not do that deal. Now, but what about the realistic case?
A realistic case lies typically between the worst case and the best case, kind of the midpoint. So you might say, "Well, the realistic case is I can get the rent up to $400, but I can't get up to 70 occupied. I'm gonna top out at 50." It's kind of like the middle. And then you look where that ends up and if that ends up is still in a happy place, it's not the massive reward you hoped for, but it's still a reasonably good reward, then you now know the options. So if you say, "Well my worst case I can survive and my realistic case I'm happy and my best case, I'm ecstatic," well then probably you should do the deal. And if the answer is, "I'll never survive my worst case, I'm not gonna be very happy with my realistic case, but I'd be okay with my best case," then you probably shouldn't do the deal.
You gotta look at it more than just when we say high risk, high reward, just don't focus just on the one high reward aspect. You gotta look at some other tranches of that. So the next thing you gotta do is you've gotta figure out on the risk side, what are the key drivers to this deal and how do I mitigate the risk? So on the deal we just described, we had several key drivers. One of them is we had to fill a whole lot of lots. And the other one is we had to nearly double the rent. So what would block me from that? Well, if you don't have rent control in your state and you kind of adopted don't exceed about $50 a year annual increase monthly, then we can model that, "Four years out, I can hit the rent. So on the mitigation side, on the rent, I'm feeling pretty good."
But what about on the home side? What about that? Because we all know the lenders are gonna require you to be a stabilized occupancy. That's what the dream is. You're probably starting this deal off with a seller note, let's say it's five years out. So I have five years to get up to stabilized occupancy, which on the 70 space park would be 80% or 56 lots. But let's assume I can't get there in five years, well then what do I do? Well, if you can't get there in five years, maybe we're gonna mitigate that by getting Mom and Pop to go longer. Maybe you make them carry the deal seven years or 10 years. Or you might say, "Okay, well to mitigate this, if I can't get Mobile Homes coming in, if I'm unable to have a credit source to bring in homes and resell 'em like Performance Equity Partners, PEP or something, then I'll bring in RVs, because my permit allows me to bring in RVs I'll bring in RVs."
But you gotta have a plan B, and a plan C, and a plan D to mitigate your risk. You can't just say to yourself, "This is a high risk deal." That doesn't mean anything. It has to be, "This is a deal with risk and these are the different permutations of risk, and then these are my plans to mitigate each of those." So once again, we've tried to help you make the decision based on not only understanding the reward side, that was the worst case, real case, best case, and numerically what the number is. We also have to understand the risk side "These are the risks, and here's how I plan to mitigate them." Now, the key item on a high risk, high reward deal that overshadows everything I've just said is you've gotta focus on liquidity and financing.
Because if you truly adhere to Sam Zell's axioms, why he was called The Grave Dancer is he never got involved in things he could not quickly sell or refinance. That's why he seemingly never got injured in all of the great recessions. And he was around for almost all of them. So Zell entered the real estate industry all the way back in the '70s, back in the era of Jimmy Carter and 10% inflation. And then Ronald Reagan taking interest rates to 18%. So he'd been through a lot of firestorms, a lot of battles, and he knew that at the end of the day, what really saves you is liquidity. And what creates liquidity is the ability to find a compelled buyer and/or finding plentiful financing. So on a deal that's high risk, high reward, what your key focuses needs to be, "How do I overcome the risk of liquidity? How do I overcome the risk of financing?"
Because any deal that you can't sell and you can't refinance has a horrible risk to it because now basically you're on the wrong side of everything. You only wanna get involved in deals that even though there's a lot to do, a lot of work out there, a lot of effort to do, that it does, at the end of the day, have liquidity. If you decided you don't wanna mess with this deal anymore, you can find a buyer. If you come to the end of your seller note, you can find a borrower.
Now, Sam Zell was a genius on real estate. No one can possibly argue that he's the only one to ever be number one in three different sectors of real estate, office, apartment, and Mobile Home Park. And if you've never read his book titled, "Am I Being Too Subtle" you're missing out. It's a fantastic resource for only about $30 on Amazon. And of all the formulas that Zell ever had in his book, probably the best one is his axiom on risk versus reward. And I suggest anyone looking at buying a Mobile Home Park should readily adopt it. And then dice and splice it in the manner we just discussed. This is Frank Rolfe from Mobile Home Park Mastery Podcast. Hope you enjoyed this, talk to you again soon.