When someone mentions “manufactured housing,” you probably don't think of clean, well-kept communities owned and operated by REITs. Instead, you likely envision rundown, trashy trailer parks — those widely disdained as “aluminum ghettos.”

“When folks are driving down the highway, there are plenty of terrible examples of manufactured homes to be seen, but it's important to note that there is a wide variation within the industry,” says Paul Adornato, a REIT analyst with BMO Capital Markets. “You can find very attractive, good-looking examples, as well as examples of those that are not well-maintained.”

It's likely that those high-quality communities are owned and operated by one of three publicly-traded REITs that specialize in manufactured housing (MH). The MH REIT sector, which consists of Equity LifeStyle Properties (NYSE: ELS); Sun Communities (NYSE: SUI) and UMH Properties (NYSE: UMH), is one of the smallest of the niche REIT sectors with a total market cap of $4.36 billion, according to SNL Financial.

Each of the three REITs operates in different geographic regions and/or focuses on different types of communities. Equity LifeStyle, for example, is primarily focused on age-restricted retiree-oriented properties in Florida, Arizona, California and the Northeast, while Sun Communities is more focused on high-quality, all-age communities in the Midwest. UMH's portfolio is concentrated primarily in the northeastern states of Pennsylvania and New Jersey and houses people whose income level necessitates affordable housing.

“Most institutional investors have gotten over the stigma surrounding the MH sector because these REITs have been in the public realm for a long time and have performed well,” Adornato says, adding that legendary REIT investor Sam Zell played a role in legitimizing the sector for institutional investors when he launched Equity LifeStyle in the 1990s. “But there is still some lingering bias against the sector from a retail investment standpoint.”

Indeed, financial advisors and investors who continue to disdain MH REITs in favor of other investments might be making a mistake. Green Street Advisors recently singled out manufactured housing as a sector that doesn't receive “enough respect.” A report from the firm stated: “Manufactured housing has delivered excellent performance at the property level, as NOI growth has been strong and cap-ex has been low. Not surprisingly, the sector has generally delivered superior total returns in the public market.”

Historically, MH REITs have generated income from leasing the site on which homes are located. They own the underlying land, utility connections, streets, lighting, driveways and common area amenities and are responsible for enforcement of community guidelines and maintenance. Homeowners are responsible for the maintenance of the home and leased site.

While MH REITs continue to generate the majority of their income from this model, they have been forced to expand into lending and MH rental. These new strategies have created additional risks for the sector, analysts agree.

Nonetheless, BMO Capital Markets has identified MH as one of the “favored sectors” from a fundamental perspective, according to Adornato. “The increased demand resulting from more reasonable underwriting on the single-family housing side has provided a nice uplift for manufactured housing, especially at the affordable level,” he says.

In fact, BMO Capital Markets estimates that both of the MH REITs in its coverage universe are trading at discounts. For example, the REIT universe is trading at a 19.2x adjusted funds from operations for 2013, while Sun Communities is trading at 12.9x its 2013 AFFO and Equity LifeStyle is trading at 16x 2013 AFFO.

“The stocks have done well over the last year, and we think there is very good upside still left on the table,” Adornato says.

For 17 million Americans, the American dream of homeownership has been achieved through a manufactured home, according to the Corporation for Enterprise Development. Fans of the sector say this type of housing offers a high quality and affordable entry into asset building for many families at a cost of less than half the average square foot cost of a site-built home thanks to the efficiencies of factory production.

Residents tend to stay in MH communities for long periods, primarily because of the cost involved in moving the home — as much as $10,000. Sun Communities, for example, reports the average resident remains in its communities for approximately 19 years, while the average home remains in its communities for approximately 37 years. This longevity contributes to stable and steady rent growth.

“Although manufactured housing is not necessarily an exciting space, it has some of the most stable returns in REIT land with same property NOI growth in the low single digit range in every year over the past 10 years,” says Taylor Schimkat, a REIT analyst with Keefe, Bruyette & Woods. “Other sectors can't say that because their businesses experience more NOI volatility. And even with all the challenges, the REITs have done very well. Investors view the sector as very defensive, although not high growth.”

Chattel Challenges

Although MH REITs have managed to achieve steady NOI and rental rate growth, the sector overall has experienced its fair share of challenges, and the REITs have not been unaffected. The biggest challenges — declining MH ownership and depressed occupancy rates — can be blamed on the availability of financing over the past 15 years.

The MH industry has been negatively impacted both by the availability of sub-prime lending for single-family homes and by the lack of MH-specific lending, known as chattel finance, which treats MH more like automobiles than homes.

The chattel lending industry went through its own crisis in the late 1990s, similar to the one that the single-family home lending industry experienced in the late 2000s. During the late 1990s, MH ownership increased significantly, but leveled out as chattel financing became less available and sub-prime mortgages allowed Americans to purchase site-built homes.

“During the period of irrational lending, people who would traditionally have purchased manufactured homes were given mortgages to buy site-built homes they couldn't afford,” Adornato says. MH REITs that focused on all-age groups or marketed their properties to income-sensitive Americans saw their community occupancies take a hit, he adds. “That period is over. And, if you think about manufactured home communities as a more affordable alternative to a stick-built home, the natural customer is returning now. We've seen increasing demand for the last three or four years, and we don't think it is going to stop anytime soon.”

The lack of chattel financing has compelled MH REITs to establish both rental and lending programs. All three REITs have rental programs where they acquire homes and rent them out to tenants.

Most of the homes are typically already on the REIT's property and are generally bank-owned after borrower distress. The rental program serves as a way to demonstrate the REIT's product and lifestyle to renters, while monitoring their payment history and working to convert qualified renters to owners.

“There is a lot of demand for rentals — the REITs can fill their rentals almost as fast as they put them in,” Schimkat says. “But it's far preferable for the companies to have the tenant on the site own the home — it's a much simpler business model. Expansion into rental programs adds some operational complexity to the business model and exposes REITs to real depreciation on the rental homes. With that said, it's the best alternative given the industry constraints.”

In addition, Sun Communities finances the sale of some rental homes to tenants on its own balance sheet and then sells them off to investors in the secondary market. Meanwhile, Equity LifeStyle has been adamant that it will not get into that business (although it does have some loans on its balance sheet from a large acquisition last year).

The inherent risk in this model is clear — Sun Communities today retains recourse on $95 million of MH loans. By retaining recourse, Sun Communities is on the hook for 90 percent of the outstanding balance for five years if the borrower defaults. So far, renters-turned-owners are no more likely than owners to default on their loans, but Schimkat believes it is not inconceivable to see new owners walk away in greater numbers as buyer incentives burn off.

Most industry experts contend that rental programs and their sister financing programs are necessary evils — without them, MH REITs would have a difficult time filling empty homes and managing occupancy. However, these same programs create additional risk for owners, and the jury is still out on the total returns associated with them.