Sun Communities: A ‘Buy” For The First Time In Almost A Year (NYSE:SUI)

Dear subscribers,

I’ve been looking at Resi REITs, or residential REITs for a number of months now, allocating capital to all of the attractive ones as they’ve become cheap. My latest buys, including what I’ve communicated through articles, have been purchases of Mid-America (MAA) and Camden (CPT), two I didn’t really believe would get a substantial upside in the first place, at least not quickly.

However, this market keeps delivering solid opportunities, and I keep taking advantage of those opportunities.

The latest opportunity that I consider good enough to act on is Sun Communities Inc (NYSE:SUI) – one of the higher-quality residential REITs out there.

Let’s look at what makes SUI such a great long-term potential holding now that it’s actually trading below 17.5x P/FFO.

Sun Communities – Upside from Sunbelt.

It’s no secret that we at iREIT on Alpha like our REITs, and our Sunbelt. We’ve been investing in the companies since the market turned. This doesn’t just include the residential sector, but also things like office properties, where we’ve seen incredibly impressive short-term returns as we’ve seen some recovery over the past month and more.

But the point here is value and opportunity. Remember, I want 15% annually or more. If I can see my way to that sort of conservative return, I’m on board, and I’ll show you exactly how I see that return as likely to materialize.

So, Sun Communities.

The REIT is a proven outperformed of the market. It’s platform has resilience backed by data, with strong same-property NOI growth even during troubled times. Unlike other residential REITs, this one has a very attractive overall operational rental mix.

Namely, this.

So, as you can see, both RV and Marinas actually together make up for more of the rental revenue than the typical manufactured housing.

What’s more, the company also has international diversification going for it. It has UK operations – at least some. And the mix isn’t as illogical as you might first consider it to be. The reason is that Manufactured housing, RV and Marinas share the common characteristics of having outsized demand, but very high entry barriers and relatively low demand. New supply to the market is extremely rare.

And unlike some other REITs in the segment, the company’s income isn’t just rentals – the company makes money from a service segment, with retail, dining, and entertainment, as well as from home sales. While these two segments together account for only 14% of annual NOI, it’s still worth mentioning as the company does have an overall more “interesting” mix going for it than other companies here.

The company has declined significantly in terms of valuation. This decline was justified.

Why was it justified?

Because despite yielding less than 2.5%, and growing at single-digit rates, the company still traded well above 20x P/FFO up until late 2021, commanding share prices of over $200/share. The company is BBB rated – but not A or BBB+ – there are, as such, resi REITs with higher ratings, and its leverage isn’t stand-out as some sort of sector leader either.

So a correction for SUI was without a doubt, as I see it, on the table and justified.

But things have gone too far in relation to how the company has been performing and how it expects to perform. There’s also the overall fundamental safety of its operations to consider – which is high.

The latest set of results we have for the company is the 1Q23/2Q23 period. The company reported above the high end of its guidance range, in terms of core FFO, total growth of 6.7% YoY on a total same property NOI. Given the macro context, this is absolutely massive. The company also updated its 2023 guidance, now expecting even better numbers for the 2023 period, at a same-property NOI of 5-6%, which means that the company would offset close to most of all the inflation.

As of May 31, this has improved even more. Transient RV revenue is up 7.6% CAGR since 2019, despite a decreasing transient site count, and the company managed more than 1,100 home sales in the UK, which is up since 1Q23 on a sequential basis.

Therefore, it’s fair to say that the overall issues and troubles in real estate are not affecting SUI as heavily as they are impacting other companies.

Here is a broad overview of what the company does, in its various segments.

Overall, I would say the primary argument for investing in SUI derives from the compelling supply-demand fundamentals. Its mix of various end markets, even if MH is the largest by far, is appealing. MH is even considered to be relatively tight, given a company-wide portfolio occupancy of 96.0% as of 2Q23. That’s with 55,000 applications in 2022 alone to live in a Sun Community.

Sun has a market advantage here because its single-family rentals cost on average 50% less per square foot than others found in multi-family rentals. So the typical customer that I’m talking about when I review AvalonBay (AVB), or Essex (ESS), aren’t typically the people that rent an SUI home. That’s not to say at all that these REITs properties are aimed at low-income- they’re just far more price/performance-compelling than others. And this is duplicated with its UK portfolio.

I don’t need to spell out for you the growth rates we’ve seen on the RV side of things – 8% CAGR is enough said here, and the marina segment is by far the single most exciting sub-segment I’ve seen for a REIT in a very long time.

With over 12M registered boats within the US and an estimated supply of only 0.9-1M leasable wet slips and dry racks, this is one of the largest imbalances I’ve seen. It’s also very unlikely that any sort of sinking capacity is coming to market – waterfront capacities are being redeveloped, and not to marinas. So the REIT is sitting on a veritable gold mine here for its Marina subsegment.

This compelling set of fundamentals has resulted in the sort of massive disconnect in normalized FFO growth that we want to see – namely outperformance. Other multifamily REITs have averaged FFO growth on a core basis at less than 6% per year, or 30% since 2018.

Sun communities have averaged almost twice that. Its Core FFO is up 9.8% CAGR, or 60% since 2018. The disconnect started in conjunction with COVID but has continued since then. Like any REIT, the company can deliver contractual rent increases, solid occupancy gains based on overall tight markets, expansion, and renos in many of its sites. SUI has invested over $280M since 2020, with internal rate of return targets of 10-14%.

For RVs, the trend is converting transient RV sites to to annual sites for better forecastability and resident appeal. 50% of the transient sites are candidates for such conversions.

As I said, the company’s underlying business trends and segments have meant that the company outperforms not only in growth but on stability.

And this is worth a premium – no doubt about that. I would, and do even accept lower rates of dividends due to this.

On the fundamental side, SUI isn’t as “ironclad” as some of its peers. 31% of its NOI is encumbered, and over 15% of its credit is actually still at a variable rate. This means that, unlike some peers with BBB+, the company’s credit comes “only” to BBB. It’s good enough, but usually below what I would be looking for.

The reason I’d want to own SUI is because of its relatively unique mix and its overall price points for its alternatives. This makes it a very attractive sunbelt potential, and a great REIT at a good price.

And yes, I believe that the price is actually good here.

Let me show you why.

Sun Communities – An upside exists

While you do need to accept a valuation premium for investing in this business, I don’t believe the market is asking you to take any massive leaps of faith at this valuation.

The company’s 10-year average P/FFO level is around 24x. This reflects the company’s premium portfolio base, as well as a high single-digit FFO growth rate of almost 9%. For the type of REIT, this is, this is overall very solid.

But the company is not trading anywhere close to 24x here. It’s actually at 17.2x. While this isn’t 15x, which would be low, the company hasn’t been at 15x in over 10 years. 17.2x actually is fairly close to a record low on a 10-year basis.

From then on out, it’s all about how you estimate the company’s future prospects and what valuation it should be at. Now, assuming you say that 15x P/FFO is all you’re willing to pay, then yes. Your upside wouldn’t be that great. 3.3% per year with a total 8% RoR until 2025. But 15x P/FFO is completely unrealistic both based on assets and where the company has been historically.

So what is a likely valuation level here that could be considered fair, while also taking into account the high likelihood of a lower growth rate compared to the historical one?

I would say around 20x P/FFO.

I believe this encapsulates both the company’s quality, while also allowing for the fact outlook is looking far lower than the 10-year average of almost 9% in FFO growth.

A 20x P/FFO on a forward basis implies an upside of over 15% per year, which as I’ve said in the initial part of the article, is my target for a company like this.

S&P Global targets are in alignment with my expectations here. The 13 analysts following the REIT give us a target range of $140/share on the low side to $177/share on the high side. Out of 13 analysts, 12 are at “BUY” or equal positive rating.

Again, there is a lot to like here. And as I see it, there are really no worrying or massively negative company-specific signs to worry about on the US side of things. What I would look at is rent increases, occupancy, and leasing trends apart from the company’s pipeline for developments, to make sure that projects continue to meet the company’s return goals. The one thing I might look at is some of the unorthodox sections of the company, such as UK home sales. The last quarter saw a downtick in sales profits as well as volumes – and its a question of when we’ll see the bottom. But because this is a relatively small portion, the impact is small.

The reason for that? Same reason as most of Europe. Overall inflation/CPI has really gone down far slower than in the USA. We’re down to numbers below 3.5% in the US. In Sweden, as an example, going by local KPI, the rate of inflation is still 9.3%, down from 9.7%.

So the USA is ahead of the curve, the consequence is that things are not yet recovered, or recovering as fast even in the UK, Germany, France, or other areas here.

That notwithstanding, this company is a “BUY” here, as I see it.

Thesis

• Sun Communities is one of the more interesting residential REITs out there due to its significant stake in Marinas and RV parks. The company has not only good performance, it outperforms most of its comps. While its fundamentals aren’t as ironclad as its peers, it’s still a very safe bet, as I see it.
• This makes it, despite a sub-3% yield, one of the better investments in the space at this time. Consider also that SUI is actually undervalued here (as I see it) for the first time in over a year, and can be bought at what I view as a conservative upside while meeting my overall minimum return targets of 15% per year.
• For that reason, it’s a “BUY”. My PT is $170/share long-term, and I see a significant upside here.

Remember, I’m all about:

1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

This means that the company fulfills every single one of my criteria, making it relatively clear why I view it as a “BUY” here.