For investors in high cost of living areas, the best rental properties are often out of state. If you have a day job or are short on time, investing in a turnkey property can be a viable way to generate passive income.
The house has already been fully renovated and rehabbed. The roof, the HVAC and the water heater have all checked out. All you have to do is purchase it and start collecting rent each month. Easy, right?
Not so fast. Since turnkey companies make money from selling and managing properties, they have an incentive to push volume over quality.
We sought advice from seasoned investors and industry professionals to help first-time turnkey investors separate the good players from the bad.
Watch Out for Bad Actors
The problem is one of the misaligned incentives. Turnkey companies make money when they sell you their renovated properties, regardless of the quality and relative value. The turnkey business model means these companies have little skin in the game after the sale.
Alexander, an investor who purchased four turnkey properties in 10 months, says, “There are a lot of bad companies out there, and unfortunately it can be difficult to find a good one.”
Scammy turnkey companies that give the industry a bad name will use deceptive practices like only superficially renovating a property. They’ll just paint the house but not perform mechanical or electrical work. Some companies will even advertise a property with a photo of a neighboring house next.
“Don’t be too trusting,” says Justin, an investor from New York with turnkey properties also in the Midwest. “You have to be super skeptical and do your own due diligence before doing business with anyone.”
The thing about getting a freshly renovated rental is that you pay a premium for it. Most profitable strategies in real estate require sweat equity, literally. When you outsource the bulk of the labor, you’ll see lower returns since turnkey companies will charge a margin for their renovation work.
For busy professionals and investors who have a full-time job, this premium might well be worth it. However, you still want to make sure that you aren’t overpaying and that the renovation work on the property is as promised.
Great turnkey companies do exist, but they aren’t easy to find. You need to do your due diligence to ensure you end up with a cashflowing property at a fair value.
What Is a Turnkey Property?
Turnkey companies find and buy distressed properties, rehab them, and sell them off to investors looking for rental properties.
Types of Turnkey Companies
Turnkey companies come in many stripes. Some actually own properties and others simply market properties from other companies. You want to avoid the latter.
Marketers increase the price of the property so they can make a little bit of money, but have nothing to do with the actual rehab or property management— at the end of the day, they’re just liaisons or middlemen. They simply markup the price and skim the surplus from the original asking price.
In-House Property Managers
Some turnkey companies only rehab and sell, while others are also property managers. For a monthly fee, they take care of things like maintenance requests, screening new tenants and collecting rent.
Don’t Fall for Low Property Management Fees
The industry average for property management fees is 10%. If you go much lower than that, you’ll likely get what you paid for.
“Many people say that property management makes or breaks a deal,” says Jesse, “and it’s 100% true. Is it worth paying a premium for a really good property manager? It might be. There are a lot of really terrible property managers out there.”
Jesse had to evict his first tenant because he stopped paying his rent shortly after the lease began. He felt the tenant wasn’t properly vetted. He also noticed that there were errors on his bill for the first six months— things his property management company was charging him too much for but no one was catching but him.
He adds, “If I hadn’t brought these up, I just would have been shortchanged.”
A lot of turnkey companies rope you in with low property management fees, but experienced investors know that monthly fees are just one aspect that can affect their cash flow.
Joshua Roberts, a portfolio manager at St. Johns Properties in Jacksonville, Florida, says that many property management companies offer lower monthly fees just to draw in new customers.
“Low fees are enticing. But the heavy side of their fees is going to come from the backend of day-to-day work.”
These kinds of companies make their bread and butter from marking up maintenance orders and charging new tenant fees.
Joshua explains, “Their goal is to move someone in and out of that property every single year because a majority of what they’re going to make comes from the tenant placement fee and maintenance costs.”
Work with an Underwriter
Oftentimes turnkey companies claim they only accept cash offers because the properties sell so quickly. But reputable turnkey providers allow investors to use conventional financing.
One benefit of getting financing is, you’ll work with an underwriter whose job is to evaluate all of the risks associated with a property, the property’s value based on its location, and what expenses the property is likely to incur in the coming years. If you don’t have a solid underwriter, and also have an inept real estate agent, the results can be disastrous.
“I’ve seen a lot of investors make bad investments because they’re working with realtors who don’t have experience working with investment properties,” says Joshua.
Why? Because inexperienced real estate agents often project numbers that aren’t accurate. They know about the monthly fees, but they don’t understand the day-to-day fees associated with maintenance and finding tenants. It’s these fees that will eat away at your ROI if you’re not careful, which is why a good underwriter is a must.
Check out the Neighborhood
The biggest mistake most investors make is not visiting the actual turnkey property itself. Turnkey companies buy properties wherever they can get a good return on their investment. The houses are usually fixer-uppers in blue-collar neighborhoods, but not always.
Alexander frequently gets horror stories from his blog readers who were too trusting of their turnkey companies. He reiterates that the biggest mistake you can make is to buy a property unseen.
“A lot of these turnkey companies will sell properties in really bad neighborhoods. If you saw it you wouldn’t hesitate. You would not buy that property.”
On paper, class C properties in economically depressed areas tend to bring investors closer to the one percent. But they are more difficult to liquidate, unlikely to appreciate, and have higher vacancy and turnover rates.
Check crime statistics on Trulia and check metrics such as median household income on City Data for the neighborhood your property is located in. Ideally, select neighborhoods where the median household income is at least three times the rent you plan on charging. For example, if you plan on collecting $1000 in rent, check the median monthly income is at least $3,000/mo or $36,000 a year.
Account for All Costs
- Vacancy: There will be months where your property is not rented out and that you are not receiving cash flow. If a property management company reports a super low vacancy, that’s probably because they’re charging too little for rent.
- Maintenance: Just because the house was recently rehabbed doesn’t mean it won’t need any work for a while. Over the course of 30 years, you’ll definitely need to replace things like the roof, paint, siding, HVAC and water heater. You’ll also likely need to work on siding, windows, gutters and leaky pipes. One investor who owns 30 units across B- to B+ properties says his properties run at 25% expense ratio on average. Most investors set aside between $500-$800 a year for long term capex. Alexander sets aside 10% each month for future expenditures but also likes to have an emergency fund of at least $3,000 per property. Don’t make the mistake of deferring maintenance and not saving the proper reserves, only to be hit with a surprise when you try to sell the property.
- Utilities: Don’t forget to account for electricity, heating, water, sewerage, lawn mowing, and snow plowing.
- Turnover Costs: Lastly, there are turnover costs whenever a tenant leaves. You’ll need to paint, maybe get new appliances and replace the old carpeting. All of these costs are not typically factored into maintenance costs with your turnkey property management company.
Network With Other Investors
Sites like Biggerpockets are tremendous resources for both seasoned and novice investors. Reach out to an investor that knows the area you’re considering, but who don’t personally have any skin in the game.
Or engage a local buyer’s agent, someone to advise you on the comps and lend on-the-ground advice about the area. Real estate is hyper-local. Oftentimes, valuations change dramatically block by block. So engage as much local third-party expertise as you can.
Turnkey companies will often provide references from past customers, but Alexander suggests taking them with a grain of salt.
“They’re only going to give you the name of someone whom they know is going to give a good response. You need to find someone who is under their radar, but who’s used them. Through networking, you can start figuring out what a company’s real story is.”
Allow Everyone Time to Acclimate
Contracts usually only last a year or the length of the property lease. If you have multiple properties managed by the same company, then you’ll have a set end date. If you decide to cut ties early, you’ll have to pay a percentage of the profit they would have earned.
Know what the severance fees are because you may find it worth it to move on to a new property management company.
On the other hand, you also need to keep in mind that there’s going to be an acclimation period and you’re not going to make money right from the beginning:
“Any time you buy an investment property,” says Jesse, “there’s going to a seasoning period where you figure out how to work with your property manager and what your tenants are going to be like. I would expect a little bit of a rocky start until things normalize.”
In short, be vigilant but don’t walk away after the first hiccup. Mistakes are going to happen.