Use Caution When Investing in “Turnkey” Rental Properties – Here’s Why
Bay Area real estate values continue to climb, and, as a result, many investors are finding themselves priced out of the market.
Some don't want to give up on real estate investment altogether, so they've turned to an alternative strategy: buying turnkey rental properties in undervalued markets to generate passive income.
Many third-party turnkey investing providers have sprung up recently to meet increased demand.
But is turnkey property investment a wise investment strategy, or is it all just a cleverly marketed gimmick?
What are Turnkey Rental Properties?
When we use the term turnkey rental property, we're talking about a loosely defined investment strategy in which the investor buys and manages the property with the help of a third-party turnkey property management company.
What is the Process of Working with Turnkey Third-Party Management?
The process of working with a third-party typically looks something like this:
1. Finding a Property
Based upon your personal investment goals, the turnkey real estate company will help you identify a good investment and build a portfolio of properties that meet your needs. Most claim to have a pre-vetted database of properties for you to consider. Some also have proprietary software to evaluate which properties are likely to produce the most significant returns.
2. Funding the Investment
Unlike experienced investors, most turnkey rental buyers are unfamiliar with the various ways to finance rental properties. The third-party turnkey property provider will help you evaluate a range of financing alternatives depending on your circumstances and goals.
3. Acquiring the Property
Once you've identified the turnkey real estate investment property you'd like to purchase, the third-party turnkey rental company will assist you with all paperwork, home inspections, appraisals, loan documents, etc. The turnkey seller will provide end-to-end service, much like a real estate agent would, but they are specialized in working with long-distance buyers who want to take a hands-off approach. The typical turnkey investor hopes to be a passive investor who can sit back and let the turnkey real estate provider take care of all the work while the rental income flows in.
4. Renovating the Property
Depending on the situation, some turnkey properties will need major renovations. Others will need minor repairs and maintenance to bring the property up to code. The turnkey provider will manage all repairs and renovations for the investment property owner.
5. Managing the Property
The primary reason people buy turnkey properties is that a property management team will be managing the property on a day-to-day basis, including finding tenants and responding to any tenant needs. It creates a stress-free investment opportunity. All that's left for the buyer to do is deposit those rent checks!
How Much are Turnkey Management Fees?
Generally speaking, most turnkey firms will charge around a 3% fee for property acquisition, another 10% for construction management, and then anywhere from 7% to 10% for ongoing property management.
Who are the Best Turnkey Real Estate Companies?
This question is difficult, if not impossible, to answer.
It is essential to know that there are hundreds of turnkey firms across the U.S., and no two are exactly alike. Some will buy, rehab, rent, and THEN sell a property to you.
Others specialize in helping you find cheap properties that need major renovations-and the turnkey rental property company will take on all of those renovations for you.
The range of services can vary greatly, so always be sure to research turnkey providers well before committing to anything.
The Growing Popularity of Turnkey Properties
Turnkey properties have proven to be an excellent fit for people like Yang Guo, a 30-year-old data scientist who lives and works for a tech company in San Francisco. Even though he earns a good salary, he's been priced out of the Bay Area.
Guo wanted to add real estate to his investment portfolio. He ultimately purchased two properties: a small home in the suburbs of Birmingham, Alabama, and another in the suburbs of Columbia, South Carolina. He used HomeUnion, a third-party turnkey provider based in Irvine, CA.
HomeUnion helped Guo purchase the two properties for a total of $60,000, quite the bargain compared to the Bay Area, where the median home price is over $675,000.
HomeUnion, an 8-year-old startup company, handled all renovations and now manages the property for Guo. He's never actually seen the properties and hasn't met the tenants-but he collects a rent check each month, all from 2,000 miles away.
"There's too much risk with buying a property in the Bay Area," Guo says. "As long as the cash flow is coming and hitting my bank account, I don't care about seeing them in person."
What are Turnkey Rental Property Benefits?
Novice real estate investors, like Guo, are attracted to turnkey properties because they're lower-cost and management is less time-consuming.
The average turnkey property sells for $50,000 and $150,000. Most are found in a rental market that was hit hard during the housing crisis. For example, Florida, North Carolina, Tennessee, Georgia, and Ohio have experienced an explosion of turnkey rental properties. Florida and Georgia are also two of the top landlord friendly states.
Turnkey investors tend to come from high-priced markets and want to buy in states with low home prices and relatively strong rents. Yet, long-distance buyers tend to lack local market knowledge. "You see these people coming from California and what I like to call 'yuppie-ing up a place,' but they don't realize it's not in the best area because they didn't do their homework," says Tony Kazanas, a Cleveland area real estate agent.
There are all sorts of miscellaneous things novice real estate investors don't consider, like local vacancy rates and the need to obtain hurricane or other specialty insurance.
Turnkey companies fill the gap by providing local market expertise.
The Dangers of Turnkey Properties
Based upon our initial overview, it might seem like turnkey real estate investing is a no brainer!
Not so fast.
Turnkey investment providers often target uneducated buyers and sell the promise of a stress-free, cash flow generating investment opportunity. Unfortunately, too many buyers forget to do their due diligence. They fall for a compelling pitch and slick marketing materials, only to regret the investment down the road. See, there has been an explosion of turnkey providers since the downturn. Many of these companies are run by people in their early 20s who have little real estate experience.
They bank on the fact that most out-of-state buyers won't want to come to see the properties they're selling, which often haven't been upgraded to "turnkey" standards. Some are pitching portfolios of "turnkey" properties that look to be straight out of the foreclosure process, where upgrades haven't even begun.
This isn't a red flag for someone who intends to spend money to renovate the homes, but many turnkey providers sell people because the houses have already been renovated when that isn't the case.
As it turns out, many of these turnkey providers are expert internet marketers- not expert real estate professionals. Many don't even know how to manage the properties professionally they're selling you.
What are warning signs that a turnkey company may not be legitimate?
- Inexperienced operators. Find out how long the company has been in business, where they've invested in real estate, and how many buyers they've worked with. Don't be shy about calling references. If you're going to be getting into business with someone, do your due diligence first.
- Lack of direct investments. Has the company invested in its own portfolio of rental properties? If so, what type of returns are they getting? If the company doesn't own and manages its own rental properties, how will they know how to look after yours properly? This is a major red flag!
- Weak support structure. Is the person who's selling you on the investment the same person responsible for property acquisition, rehab, tenanting, and maintenance? If so, that's an indication that there's a weak support structure in place. Legitimate turnkey rentals firms typically have a deep bench with professionals of varying expertise. If someone promises you that they can do it alone, how much individual attention will your properties be getting?
- Shoddy renovations. Before going into business with a turnkey company, take the time to tour a few of the other properties they manage. What condition is the property in, and have renovations been done on the property? If you're buying a turnkey investment property that the company says has already been thoroughly renovated, spend the money on an inspection to be sure. Otherwise, you could get stuck with costly repairs down the road.
- Rental guarantees. Experienced real estate investors know there is no such thing as a "rental guarantee" - a property may be more or less likely to rent quickly. Still, there’s no guarantee that it will be rented at the price the turnkey operator has stated. Spend some time doing market research to understand what market rents are in the area you're looking to purchase.
- Overpriced properties. Similarly, spend some time researching the local market. Turnkey properties providers are notorious for selling overpriced homes to out-of-state investors who are used to expensive real estate markets. A house that sells for $200,000 might seem like a bargain compared to where you live. If local competition is selling for half that, then there's a good chance the turnkey company is duping you.
What are Alternative Investment Strategies?
Instead of buying real estate through a traditional turnkey operator, consider buying a cash flowing property through an online marketplace like Roofstock.
Roofstock and Investimate are platforms that aggregate market research, property data, and other information about single-family rental properties. Their thorough vetting process helps investors make better, more informed decisions.
These marketplaces encourage investors to treat their real estate investments more like stock portfolios, focusing on asset allocation rather than trying to buy, fix, and lease vacant apartments the way a turnkey operator might.
All properties on these platforms are fully leased, enabling the investor to collect cash flow from Day 1 after closing.
Passive Real Estate Investment Strategies
Buying and Holding Properties
Not to be confused with flipping, rehabbing entails fixing a place up just enough that you can rent it. If your first investment leads you to want more properties, you can quickly scale your investment portfolio.
BURL stands for "buying utility; renting luxury." This would entail scaling your investment portfolio to include several properties that reliably generate passive income so that you can invest in a luxury property. You might never be able to 100% pay the loan off on the luxury property, but the amount it appreciates and the rental increases may make it all worthwhile.
A live-in flip is between house flipping (fixing up a house and selling it quickly) and buying and holding. You make your property your principal residence for two years while you renovate it, and then you make it a rental property for at least three years.
Then you sell your property using what's known as a Section 121 Exclusion to write off upwards of $250,000 (if single) or $500,000 (if married filing jointly). And since it's an exclusion, it means it isn't necessary to pay taxes on or reinvest those funds. This strategy is often bundled with a 1031 Exchange, which allows you to use the profits from the same of your investment property to purchase a property of equal or greater value without paying capital gains taxes or depreciation recapture.
Rental Debt Snowball and All Cash Rental Plans
Snowballing is when you pool all your money to either pay off your rental property mortgages one by one, or you use your money to buy properties without any mortgage at all.
Turnkey Properties: To Buy or Not to Buy
Ultimately, deciding whether or not you should invest in turnkey rental properties is a personal one. Your experience in the real estate industry, knowledge of local markets, and investment objectives should influence your decision. Turnkey rentals can be a great way to diversify your portfolio, especially if you've been priced out of the local market.
But be cautious about who you invest your money with - always, always do your due diligence before committing to a specific turnkey provider.
No investment is foolproof.
And keep in mind that rental property is highly illiquid.
Turnkey properties are often easier to buy than they are to sell, so be sure to prepare your exit strategy if things don't work out as initially planned.
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