Real Estate 043: Turn-Key Properties, too good to be True?

What is a Turn-Key property?

There is no formal definition of "turn-key", and its meaning can differ from region to region, company to company. However, I can better explain this by sharing what I believe is a turn-key property and you can make  your own informed judgment.

To me, turn-key properties mean that they are generally older homes that have been restored and are considered "rent-ready" by you or the property management company. During the initial purchase of your turn-key property, you should receive a seller's disclosure and statement of work (SOW) from the seller informing you of the items that were replaced or serviced during the rehab.

Typically, if you have purchased a "turn-key" property from a legit provider, you should have received a property with little to no deferred maintenance (i.e. big ticket items that cost $1-5K or more such as roof, HVAC, hot water heater, furnace, etc. with useful life less than 5 years).

BENEFITS

As mentioned in my previous post, if you work with a TurnKey Company, you will eliminate 3 (acquisition, rehab, maintenance/management) of the 4 steps of the investment property process. These are very beneficial for people who do not have time to conduct the research, oversee the rehab, and manage their properties.

Acquisition: 
The TurnKey provider identifies the distressed property (REO, foreclosure, etc.) and purchases the property. They own the title. If they do not own the title, you are working with a middleman/marketer!

Rehab: 
The TurnKey provider will perform the rehab and replace CapEx items and make them "rent ready". Be very wary of "lip stick on a pig" where bad turnkeys will purchase a property, apply some paint, clean the floors, and sell them as "turnkey". These properties may look nice and show good returns on paper, but they will cause maintenance problems down the road and bleed you out slowly. Make sure you talk to other investors, ask for the Statement of Work (SOW) of what was replaced/seller disclosures, and ask about the warranties on the rehab (most places give 90 days, good turnkeys give up to 1 year).

The last thing you want is to buy a lipstick on a pig thinking you have great numbers and a beautiful property during year 1, only to find out that there are thousands of dollars worth of work needed in years 2-5 that will put you in the red.

Simple illustration (Bad Turnkey): if you have purchased a property for $100,000, downpayment and closing costs of $24,000 and rent is $1,100 (1.1% rent to value ratio), now take into account mortgage estimated $400, insurance $70, management $110, taxes $70, vacancy $88 and maintenance $88 for total expenses of $826. Your Gross rental income of $1,100 - total expenses $826 = $276 which is a 13.8% cash on cash - awesome, right? 

Not so fast. $276 a month will equate to $3,312/year, but a lipstick on a pig may result in replacement of the HVAC $5K, roof $5-10K, hot water heater $1.2K, furnace $3-5K. In addition to these major repairs, the $88 reserve/month for maintenance not be enough to cover  routine maintenance calls on plumbing, toilets, etc. if they were not properly reviewed/rehabbed from the beginning. Hope I didn't scare you as this is an extreme example and one to ensure that you do your due diligence before working with TurnKey providers.

Management/Maintenance: 
The Turnkey providers will typically charge 8-12% of the monthly rental income in fees as well as have other fees such as lease up fees (marketing/placing a new tenant), lease renewal fees, and other fees. In exchange for their fees, they provide services such as finding a tenant, periodic check up on your property, proper bookkeeping, and answering maintenance calls, to name a few. I feel that these services alone are well worth the fee. Its less headache for you and more time for you to enjoy doing things you love and spend time with loved ones.

Maintenance calls vary by property management company, as they may have an in-house handyman or outsourced contractor. They may charge only cost of the repair + markup, or cost + standard $40/hr (example). Typically, property managers will maintain a $500 reserve for each rental property and will approve repairs below this threshold, anything above this amount is communicated to you (owner) for approval of the repair.

DRAWBACKS

Now that we have covered some of the benefits of turn-key providers, let's dive into some of the cons of using a turn-key company.

1. You are paying market price: 
If you work with a turn-key provider, the fact is that you will be purchasing the property at market price (little to no equity). There is a saying that money is made in real estate when you buy (low) or sell (high). When you are buying at market value, you are technically going in knowing that your transaction costs alone will keep you from selling the property before 5 years at break even (exit plans are limited). You will need to hold the property for at least 10-15 years for you to break even (unless there is crazy market appreciation - this will not be true for linear markets in the midwest). However, not to fear, if you have analyzed the property carefully, it should cash flow, and that is what buy & hold investors, like myself care about.

You will notice that the appraisal of the property will come in at or slightly above purchase price. In situations where the appraisal comes in lower than the purchase price, I highly recommend you re-evaluate the deal to negotiate with the seller to reduce the price, or walk away/find another deal. There are simply too many deals for you to bring cash to the table to close, simply because the property is not appraising for the asking price.

2. Requires large capital: 
As mentioned in the previous post, there are many ways to obtain financing for your rental properties. The most common approach is conventional financing through a portfolio lender. Portfolio lenders are lenders who specialize in working with investors and offer conventional products such as the Freddie Mac/Fannie Mae loans. Portfolio lenders typically have rates 1% above the current interest rates that you may be able to obtain for your primary residence (i.e. 4.25% + 1% = 5.25%). However, these lenders are well versed in working with investors, turnkey companies, and market realtors and can provide guidance in financing your first 10 properties with Fannie Mae.

Note: your first 4 properties require 20% down payment, but properties 5-10 require 25% down payment. This is something you may want to think about when strategizing the purchase price of the first 4 homes. For example, if you buy low end homes at 50K for your first 4, its a 10K downpayment per home. However, if you planned to acquire homes in the 100-150K range, that could result in an additional 5-7.5K downpayment per property.

I believe that scaling your rental portfolio carefully and quickly is critical in your success. I like to use the Pareto principle/Law of Averages and assume that at any given time, 20% of my portfolio may losers and 80% may be winners. That is, 20% may have bad/trouble tenants, high turnover, maintenance, etc. However, if I am careful, the income from the other 8 (out of 10) should be more than enough to cover the issues found in the 2.

3. Lipstick on a pig: (sub-par rehab)

I hope this helps you understand the key pros and cons of using a turn-key company (I used one for my first rental). Some questions that you might want to ask yourself before choosing to go the turn-key route are:

  • Does it make financial sense (rent to value, cash flow) to invest in my local market

  • Do I have the right team and knowledge to do this on my own?

  • Am I willing to manage my own property in a local market?

  • How passive do I want to be (Note: Turn-Key does not mean its fully passive, however, a good turnkey company does mean you have the support of an experienced provider at your fingertips to provide guidance)

  • What are my exit strategies? (Sell on MLS, sell to an investor, re-sell to a turn-key, owner finance sell to a tenant)

Whatever you decide to do, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision.  Work with people who have vested interest in your success! 

Good Luck!

Real Estate 007: Rental Property Criteria

Now that you have identified a market, its important to start developing a criteria (again, a ship with no clear direction is sailing towards nowhere) and analyzing properties.

So how does an investor analyze properties? Below are some metrics that I use to evaluate rental properties. Remember to subscribe to my blog to receive updates as well as gain access to my free cash flow calculator and rental property criteria.

1. Cash on Cash (Used when financing a property)

To calculate the cash on cash return percentage, I take the net monthly income after all mortgage, insurance, property taxes, property management fees, vacancy and maintenance expenses are included, and annualize the amount. That amount is divided by your total cash invested into the property.

Below is a property analysis using real numbers of a sample investment in the midwest, USA.

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Net Cash flow of $174.13 * 12 months = $2,089.56 divided by total out of pocket cash $13,600 down payment + $3,400 estimated costing cost 5% = $17,000.00

  • Cash on Cash %: Net Annualized Cash Flow / Total Cash Invested

  • 12.29% (rounded): $2,089.56/$17,000.00

2. Cap Rate (Used when paying all cash)

The Cap Rate is used to make comparisons between similar rental properties. By taking the Net Annualized Cash flow / Purchase Price, you arrive at the Cap Rate of a rental property. This method is more meaningful when an investor pays for a property all cash thereby calculating their annual return on their lump sum of money. Please refer to the picture above that illustrates the Cap Rate calculation on this property

  • Cap Rate %: Net Annualized Cash Flow (no mortgage) / Purchase Price

  • 8.30% (rounded): $5,643.96/$68,000.00

3. Rent to Value Ratio

Another quick measure of relative costs of buying and renting across different markets is the rent to value ratio. As mentioned in my previous post of cyclical and linear markets, I have generally observed that cyclical markets tend to have a lower rent to value ratio, meaning you will make less by renting out of property relative to its purchase price, compared to linear markets with a higher rent to value ratio meaning its a better market for investors looking to cash flow on their investment properties. The rent to value ratio is calculated simply by taking the gross rent divided by the purchase price of the property

  • RTV %: Gross Monthly Rent / Purchase Price

  • 1.21% (rounded): $825/$68,000

4. Debt Coverage Ratio

The debt coverage ratio is not often used by all investors, but I like to use it to gauge the cash flow that is generated to pay my mortgage on the property. It is calculated by taking the Net Annualized Cash Flow / Total Debt Service owed to the lender. A debt coverage ratio of less than 1% means that the buyer will not be able to pay the current mortgage without using their own funds (i.e. negative cash flow). A ratio greater than 1% means that the buyer can use cash flow from the investment property to pay the mortgage.

  • Debt Coverage Ratio %: Net Annualized Cash Flow (no mortgage) / Annualized Mortgage Payment

  • 1.59% (rounded): $470.33 * 12 months / $296.20 * 12 months

So what do I look for when analyzing rental properties?

Great question. As I mentioned previously, I am a buy and hold investor primarily focusing on single family homes in strong working class (blue collar) neighborhoods for positive cash flow. Note that this criteria is quite fluid and used as a basis to narrow down my search from a pool of 50+ properties at any given time. Note: these are my "rules of thumb" as of writing date, and can change any time.

  • When Financing a property: Net monthly cash flow (after all expenses)> $200 per unit

    • Assumptions used: 5% closing costs, 8% vacancy reserves, 8% maintenance reserves

  • Neighborhood Rating: B- or above (Note that each investor may rate neighborhood's differently). For example, some investors rate A/B/C based on ratio of owners/renters, crime stats, schools, other statistics and demographics.

  • Property Type: Single Family 3 bedroom 1 bath (or more), ideally with a Garage in markets such as Kansas City, where there is heavy snow and hail. Note: Some markets (i.e. Memphis), it is common to have a carport instead of a garage. Further, 2 bedroom homes are more difficult to lease. 3 bedroom houses are most common, thereby increasing the tenant candidate pool.

  • Size of home: Ideally 1,000 - 1650 sq ft. Not too large, nor too small. Note: I do this on purposes as the extra sq ft. of ~800 (ex: 2,400 sq ft. homes) do not necessarily correlate to the same ratio of increased rent. Also, replacing a roof/flooring on a 2,400 sq ft. home is significantly higher than a 1,200 sq. ft. home.

  • Low Crime Areas

  • No HOA fees. The HOA fees are unpredictable and can kill your projected cash flow.

  • Cash on Cash: 12-15% or higher (Depends on market, type of property, location, etc.)

  • Rehab including updates to CapEx items 5 years life or less (Water Heater, HVAC, etc.) 10 years life or less (roof)Note: The amount of rehab (after reviewing scope of work) may result in a lower or higher maintenance reserve from base of 8%.

  • Rent to Value Ratio: At least 1% or higher, ideally 1.30% or higher

Please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!

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