Use Caution When Investing in “Turnkey” Rental Properties – Here’s WhyDoug Brien
February 2, 2018
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. A number of third-party “turnkey” providers have sprung up recently to meet increased demand. But is this really a wise investment strategy, or is it all just a cleverly marketed gimmick? Let’s take a look.
What are “Turnkey” Properties?
When we use the term “turnkey property” we are referring to the loosely defined investment strategy in which the investor buys, rehabs, and manages a property with the help of a third-party. The process of working with a third-party typically looks something like this:
- Finding a property. Based upon your personal investment goals, the company will help you identify 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 help evaluate which properties are likely to produce the greatest returns.
- Funding the investment. Unlike experienced investors, most turnkey buyers are unfamiliar with the various ways to finance rental properties (e.g. various loan products, 401K, 1031-exchange). The third-party turnkey provider will help you evaluate a range of financing alternatives depending on your individual circumstances and goals.
- Acquiring the property. Once you’ve identified the property you’d like to purchase, the third-party turnkey provider will assist you with all paperwork, home inspections, appraisals, loan documents, etc. They 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.
- Renovating the property. Depending on the situation, some turnkey properties will be in need of major renovations. Others will simply need minor repairs and maintenance to bring the property up to code. The turnkey provider will manage all repairs and renovations for you.
- Managing the property. The primary reason people buy turnkey properties is because someone else pledges to manage the property on a day-to-day basis. This includes finding tenants and responding to any tenant needs (e.g. fixing a leaky sink). It creates a stress-free investment opportunity. All that’s left for the buyer to do is deposit those rent checks!
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.
It is important 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 (an investor). Others specialize in helping you find cheap properties (as low as $20,000!) that need major renovations—and the turnkey 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 you commit to anything.
The Growing Popularity of Turnkey Properties
Turnkey properties have proven a great 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 nonetheless.
Guo 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, a 3-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 property in the Bay Area,” Guo says. “As long as the cash flow is coming and hitting my bank account, I basically don’t care about seeing them in person.”
Novice real estate investors, like Guo, are attracted to turnkey properties because they’re lower-cost and management is less time intensive. The average turnkey property sells for $50,000 and $150,000. Most are located in markets that were hit hard during the housing crisis. Florida, North Carolina, Tennessee, Georgia and Ohio have experienced an explosion of turnkey rental properties. In Florida, for instance, an estimated 12% of landlords are from out-of-state. 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 buying turnkey real estate is a no brainer! Not so fast. Turnkey 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 experience in real estate. They bank on the fact that most out-of-state buyers won’t want to come 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 on spending money to renovate the homes, but many turnkey providers sell people on the fact that the homes have already been renovated when that isn’t actually 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 professionally manage the properties they’re selling you.
Here are a few 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, 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 types of returns are they getting? If the company doesn’t own and manage its own rental properties, how will they know how to properly look after yours? 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 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 really 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 property? If you’re buying a turnkey 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, but there’s no guarantee that it will be rented at the price the turnkey operator has stated. Spend some time doing your own 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 providers are notorious for selling overpriced homes to out-of-state investors who are used to expensive real estate markets. A home that sells for $200,000 might seem like a bargain compared to where you live—but if local comps are selling for half that, then there’s a good chance you’re being duped by the turnkey company.
An Alternative Investment Strategy
Instead of buying real estate through a traditional turnkey operator, consider buying a cash flowing property through an online marketplace like Roofstock. Roofstock is a platform that aggregates market research, property data and other information about single family rental properties. Their thorough vetting process helps investors make better, more informed decisions. The Roofstock marketplace encourages 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 the Roofstock platform are fully leased, enabling the investor to start collecting cash flow from Day 1 after closing.
Turnkeys: To Buy or Not to Buy
Ultimately, the decision as to 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 all 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. But 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 in the event things don’t work out as initially planned.