Disadvantages of investing in Turnkey

20 Replies

Hi everyone,

I am considering the possibility of investing with a Turnkey provider. Just wanted to hear about your perspectives with regards to disadvantages of investing in Turnkeys?

What were your experiences like? and what turnkey provider might you recommend?

@William Wong

Some people see disadvantages differently.  Some people will say you are paying top market dollar and in many cases you are but you are also paying for the service that is being provided for you with that price.  

Being far from your property might be a disadvantage.

Good luck

No or very little appreciation. Only exit strategy is selling to another investor (often at a loss) after transaction costs. Very little control so you are at the mercy of a property manager who makes money by doing repairs and turning over units while viewing you as a deep pocketed investor (aka a flesh covered ATM machine) from CA or NY or wherever. What could go wrong with that set up? Relying on the local knowledge of people that have a profit motive. Your boots on the ground can't be the guy trying to sell you something. I know my local market almost street by street, so when a wholesaler emails out a very thin deal using comps from a mile and a half away in a much better area I know it's BS. I saw what looked like a great deal last week and couldn't figure out why it was still available after 60+ days. When I drive by I discover it backs up to a methadone clinic and a liquor store. There were 6 hits on the Megan's law website from the apartment complex on the same street. There were dope zombies walking through the neighborhood. Three blocks over the area is really improving and prices are skyrocketing and if you entered from a different direction you never would have seen the issues. Those deals that look good on paper often get pushed to investors from the Bay Area that don't know any better. I can only imagine the lines that are blurred when some turnkey company is sitting on a "challenged property" and some chump from 1500 miles away thinks the pro forma looks great.

I invested in a turn key for my first two deals out of state. The pro's were that even though I was paying top of the market in the area it was handled professionally and it was a lower cost of entry. It was a great entry into real estate. Now that I got my feet wet, it's giving me confidence to know do the research on my own to find properties and pay a lower cost. Turn keys could be good properties if you are looking for longer term versus short term exit strategy.

Originally posted by @Joe B.:
No or very little appreciation.

Only exit strategy is selling to another investor (often at a loss) after transaction costs.

Joe, I'm not understanding why you feel this is a disadvantage of a turn key. This is a function of the class of property, not the method of acquisition. Not all turn key properties are in the hood. We sell a  lot of A and B class turn key properties in owner occupied neighborhoods with appreciation potential.

Niha--turnkeys don't always cost more than doing it yourself for the following reasons. At the end of the day, there's not usually a big cost savings if any especially for the risk you take on

Turn key properties do not always cost more than when you do it yourself for the following reasons:

  • Most turn key companies can buy properties for substantially less than an individual buyer through auctions, tax sales etc and are paying cash. The worst way to buy is to finance an MLS listed property.
  • Turn key companies get volume discounts on materials and supplies
  • Turn key companies have more leverage with contractors and have cheaper construction costs
  • There are no construction cost overruns when you buy a turn key. Renovation projects rarely go as planned and quite often cost more than originally expected.
  • There are no holding costs (taxes, insurance, utilities, mortgage) incurred while the rehab is being done and the property is being marketed for a tenant with a turn key.
  • You don't lose 1 month of rent for lease up with a turn key property.
  • Lost cash flow opportunity while you put a team together and find a property, especially when you keep losing out on MLS deals because you're financing.
  • Lastly, you don't recognize equity until you sell which means you need to look at the present value of that future equity. Whatever you might save up front is going to be worth less in future dollars that it is today. The longer you hold the property, the less that savings becomes. For instance, if you are able to save $10,000 by doing it yourself and hold the property for 20 years, at 3% annual inflation, that $10,000 will only be worth about $5500 in todays dollars. Not  big gain for the amount of risk you take on.

Personally turn key is not for me. We have a portfolio of over 150 rental and we are in process of buying another 125 before the market turns but for folk from states where numbers are just really crazy it may a good alternative. 

Here in Chicago we have turn key providers. The model is very different than the model we invest with. We want a huge amount of equity when we buy. We don't want any cash stuck after refi we also won't go into C or D areas at all. For rental I like solid B areas. 

When you go to the market you buy a packet of chicken you bring it home and cook any meal you want with it or if you go to a restaurant for the same chicken breast you will pay a lot more. It's the same chicken. The prep and cooking is done either by you or someone else. If some one else is going to serve you and manage the entire meal and the process then you have to expect to pay for it. 

There are a lot of turn key companies. I think they fill a great niche in the market not my cup of tea but I don't think I can say anything good or bad about them. I do question the investment from the individual investors perspective. 

I think from the model I have looked at they are investing for cash flow.

I invest for 

1. Equity

2. Cash Flow

3. To pay off the properties with in 7 years with Zero in

4. Appreciation. (It will happen already has in our market but I don't count on it because I can't control it)

The biggest issue here is time. If you are going to do it yourself it will eat up a lot of your time. As long as you are committed to that part of it and are willing to take on the headaches it can be pretty profitable. 

I invested in what I thought was a turnkey and paid top dollar. Well, needless to say, it needed a new roof (missed during inspection) so it wasn't really turnkey. 

Learning experience but the disadvantage is paying top dollar and it takes longer to make your money back after you count all of the closing costs, etc.

I talk with a lot of turnkey buyers, and I find that a vast majority of them have good experiences and buy tk again and again.  I have come to understand that the person you buy from can make or break your experience, and the few bad tk companies have overshadowed the reputation of the good ones. 

I personally have not bought tk properties, but like @Andrew Holmes said about eating chicken... I just do things close to home because my market and markets close to be are good for investing and being full time REI I have the time a capability to do so.

Like Brie said, it really does come down to the turnkey provider you use.  It is very difficult to find a good one and one of the biggest due diligence steps you can take before you ever even start is finding a good provider.

Then after that, you need to crazy due diligence on the property you are thinking about buying.  Dont ever take what the turnkey provider gives you as the main source.  Find out for yourself.

There are many things you can do to make sure you have a good experience, you just have to do them.  

This is a good thread. To me, the major downsides are:

  • Diligence risk -- It's often said that "There's no diligence you can't do" on a remote property, which is technically true. But it's inarguably harder to vet a neighborhood & property from far away. My experience so far has also been that turnkey operators have preferred lenders and inspectors. I'm sure this helps deals close smoothly, but I (and many buyers) would probably prefer to work with independent folks of our choosing. 
  • Liquidity risk -- Properties purchased at or above retail will be difficult to unload except at a loss. (Obviously, turnkey buyers should not be buying expecting to have to sell, but the limited exit strategies are a drawback.)
  • Potentially misaligned incentives -- As already noted, property managers that make money on repairs & turnover can eat away at an investor's returns. Of course, you want to buy from turnkey sellers that also own an in-house PM operation, but you need to do a lot of diligence to understand how they run PM.

I still see many upsides, especially for those with demanding day jobs who want real estate in their portfolios but don't want to be active. The keys are diligence, realistic expectations, and contingency plans.

I have always bought turnkeys for myself, and now I work in and around turnkey world, so I've seen quite a bit about them-- both good and bad. 

I'd say the only major downfall to the turnkeys is really just your inability to force appreciation on them. I agree with everything @Mike D'Arrigo says about the price of turnkeys, but past that as the downside is that when you buy the turnkey it is already in tip-top shape (if you've bought through the right people) and therefore there's nothing you can really do to force appreciation on it. One way to get it, though, is to buy at the most infant stage of a growing market (not to be confused with the beginning stages of an unproven market). I did that when Atlanta was hot and I saw quite a bit of appreciation on my properties in just a couple years. The markets aren't really like that now since the real estate economy in general has improved a lot, but it's still an option. 

Truly I would say that's the only downside that covers both good and bad turnkey companies. The only downsides past that are if you are working with a less-than-stellar turnkey company. Then you may have issues of rehab quality and property management quality, etc. But assuming you are working with a good turnkey crew, you should be in good hands.

The main reason, I think, a lot of people are against turnkeys in addition to the no forced appreciation issue, is the idea of having to trust other people with their investments. I totally get it...it's definitely not for everybody. The good news is though that there is literally nothing about a turnkey that you can't check up on and verify, and while it may seem like you don't have control of your property once you buy it because a property manager is handling it, you do in fact have control. That property manager essentially works for you, just as any other employee. If they don't take care of your property correctly, fire them and hire a new one. You definitely do have control over your own investment.

And my last thing, in response to a comment I saw up above... if you work with good turnkey providers, you will have the opportunity to buy properties in primarily owner-occupied areas. When you do that, you most definitely are not forced to only sell to investors later. MFRs, yes, but not necessarily SFRs.

Originally posted by @Curt Davis :

@William Wong

Some people see disadvantages differently.  Some people will say you are paying top market dollar and in many cases you are but you are also paying for the service that is being provided for you with that price.  

Being far from your property might be a disadvantage.

Good luck

Curt has provided some really good insight with his comment above.

 I see a lot of threads about this topic and lots of people seem to forget this fact. Of course you are going to have to pay more than someone doing the work themselves. You are buying a service and that service is going to cost some money. There is sweat equity and there is paying for a service. You can't have your cake and eat it to.

(Disclosure: I am a provider of property management & turnkeyesque offerings)

Here is how I look at it. I've been a property manager myself in my local market and have bought turnkey out-of-state. If you're awesome at property management or can build an awesome property management team, then doing everything yourself makes a lot of sense. In my case, I suck at property management and so turnkey has been better for me.

I also rehab lots of properties in my area and excel in this sort of thing. However, I know that local boots on the ground often save money than I could rehab out-of-state myself. Why deal with all the hassle in a market that you have no connections and no boots on the ground?

In other words, why manage your own investments out-of-state; you don't have advantage that you have in a local market. The only reason to invest out of state is if your area has high cap rate compression. 

I've heard it said many times on the BP podcast that you can find cash flow 2 hours from anywhere. However, from my experience, I don't know anyone I trust two hours from where I live. I trust the turnkey out-of-state providers more than what I've found locally (here in Seattle) and so I've went that route. In fact, I was so nervous to go out of state in 2010 to purchase from turnkey providers in Phoenix that I only bought 5 properties. I am kicking myself for not buying more out-of-state at that time. 

Thank you all for your feedback on this. This is very helpful.

Since so much depends on the turnkey provider, does anyone have any references of good turnkey companies to look at?

I am currently taking a look at Elite Invest and Memphis Invest. I would be open to other options.

@William Wong

Yes, check us out for sure!!!!!

http://www.biggerpockets.com/users/WilliamW16, definitely check out Curt Davis.  He is first class.

I would also highly recommend Terry Kerr at Mid South Home Buyers and Stephen Akindona (http://www.biggerpockets.com/users/sakindona) at Discount Property Warehouse in Memphis.  We work closely with both of them on a regular basis.

Thanks,

@James Wise  

Not sure I agree with your take on what @Curt Davis said. At least in some markets I have looked at or bought in the bigger guys/girls got pricing that was much better than I could get if I did it on my own. 

Rather, I would say the difference is not necessarily the markup on the rehab (though a lot of people do that) but the type of deals you see. Assuming you make X margin on each property (though I know James does more JV stuff too which is different) that means its volume and by nature each deal can't be a crazy deal so the really crazy deals that a local might wait for is tougher for the out of state guy/girl to get least that is who I view it.

Originally posted by @Charles Worth :

@James Wise  

Not sure I agree with your take on what @Curt Davis said. At least in some markets I have looked at or bought in the bigger guys/girls got pricing that was much better than I could get if I did it on my own. 

Rather, I would say the difference is not necessarily the markup on the rehab (though a lot of people do that) but the type of deals you see. Assuming you make X margin on each property (though I know James does more JV stuff too which is different) that means its volume and by nature each deal can't be a crazy deal so the really crazy deals that a local might wait for is tougher for the out of state guy/girl to get least that is who I view it.

 Basically what I am trying to say is investors should not expect to buy a property with an inordinate amount of equity in it from across the country. You should expect to pay for it what it is worth or slightly below and there is nothing wrong with that. The margin between what it is worth and what it can be picked up for by intense marketing and networking is what has created the entire business. One should not expect that margin to be given away. If it was there would be no Turnkey business.

The turnkey business model has a fatal flaw that can only be overcome in a market that experiences significant appreciation. In its absence, turnkey investing will be disappointing in the long run. 

I assert that turnkey investing will not work in Chicago. I wrote a post on this in another thread. I don't know how to post a link to it, so I cut and pasted it here in the hope that someone will take me up on my challenge.

Here’s an analogy that may be helpful in illustrating the fundamental problem of a turnkey rental strategy. Take a 2012 Honda Accord ES in pristine condition, low mileage, loaded with every available option: premium wheels, top of the line infotainment/GPS system, sunroof, etc. Its worth 14k. Another ES in fair condition, with high mileage and no options, is worth 11k. While the cars are very different, the differential in price is only 27%. The value of a car is primarily determined by the year, make and model. Condition and equipment are relatively minor factors. The same is true for real estate. Upgrading the mechanicals, finishing a basement, installing granite countertops, there are dozens of ways to spend thousands of dollars improving a house. While it may have a measurable impact, the primary determinant of a house's value is location. Turnkey operators are buying cheap houses and over improving them. A $5000 set of mag wheels on a $10,000 car doesn’t make the car worth $15,000. Neither does putting 30k in improvements in a 40k house make it worth 70k.

An investor using a competent turnkey operator, should not have a horror story in the immediate future. That would only occur if the operator seriously miscalculated rental demand or did shoddy construction. Good operators buy (cheap but) decent houses, fix them up in tip top shape, with the bling to attract tenants who will pay a premium for that new house smell. Any aging components should have be replaced so the investor shouldn't have major cap ex for the first 5-7 years. In the short run things look good, but shortcomings in the underlaying fundamentals can’t be avoided. The investor is likely to experience disappointment in the long term. The first surprise may occur in a couple of years, when the first tenant moves out and the investor needs to spend 2k to get the property back into ready to rent condition (the cost of painting, re-carpeting, fixing dinged up kitchen cabinet doors, etc. adds up). The property may take a bit longer to rent out this time, since its not as fresh as it was. As the years go on, the investor is unable to raise the rent because the rental market is so competitive, rent levels are flat. Unfortunately, the same can’t be said with expenses. A couple of cap ex events occur in year 10 that eat up the equivalent of several years’ worth of profit. But the biggest disappointment comes 15 years down the road, when the investor sells and realize at closing that the proceeds are just enough to cover their loan balance.

Under the best case scenario, the pro forma ROI that turnkey providers quote may be hit the first year or two. I'd love to hear from anyone who's achieved their expected 10 year IRR. The only way to win big with turnkey rentals is with significant appreciation. I don't know about other areas, but that is not likely to happen in Chicago in the neighborhoods where the turnkey operators work. Here's an article that provides one explanation of why. Without getting into the sociology, I'll summarize: people don't always behave in an economically efficient manner.

http://danielkayhertz.com/2014/12/05/chicagos-grow...

Turnkey operators price their properties based on the income approach (which is typically used on commercial and 5+ unit multifamily properties). But the prevailing model for valuing 1-4 units is based on the comp approach. The problem arises when there is a large discrepancy between the two models. If I own a 6 flat and increase the rents by 50/mo per unit, I’ve increased the value of my building; if I appeal my tax bill and win a reduction, I’ve increased the value of my building. If I do the same actions with my rental house, the value is unchanged. The value of my house is roughly the same as the surrounding houses. My house is not inherently more valuable because its rented out and my neighbor’s house is not worth less because he lives in it. While the ludicrousness of this is obvious on houses, the flawed logic is a little less apparent with 2-4 flats. This is probably why Chicago turnkey operators are focusing on them. I don’t know how they are getting the banks to make loans at these inflated valuations, but I’m guessing they couldn’t get them to play this game with SFHs.

I’ll preface this by saying I’m just a landlord. Unless you’re looking to rent a 2 BR in the South Deering neighborhood, I’ve got nothing to sell anyone. I don’t personally know any turnkey operators in Chicago and have no vendetta against them. I’m just sharing my opinion.

Chicago is segregated and my comments do not apply to the north side, South Loop, Hyde Park, Kenwood, or gentrified areas. The areas of Chicago that have high rents relative to home prices are on the southside, "west side", and southern suburbs. That’s where the turnkey operators work, that’s also where my properties are. For the purposes of this discussion, these areas I'm referring to when I say Chicago.

Chicago turnkey properties are overpriced by a lot, like 90-100k too much. Every example I’ve seen on their websites is priced at least twice what the property is worth as a rental. I’m not talking about appraised value, as a buy and hold investor, that’s not necessarily relevant. Value for me is measured by lost opportunity cost (ie. what else can I get for my money).

There is no financial justification for paying 70k+ per unit for 2-4 flats in the neighborhoods where these turnkey properties are located. I won't refer to a specific example because it wouldn’t be fair to pick on one operator when they’re all doing the same thing, but if someone wants to post the specifics about their particular deal, I’ll be happy to respond with specific comparisons.

So let’s say an operator is selling a duplex for 170k that is rented out for 2200/mo, located in a marginal (with regard to the type of tenant it will attract) neighborhood.

Alternative 1: That same amount of money could be used to buy and fix up a couple of brick bungalows in Chatham or Pill Hill, two of the most desirable neighborhoods in Chicago. They'll rent for a combined 2700, to a higher quality tenant (resulting in less turnover, less management, higher ROI). While the properties may still not experience future appreciation (refer to the article in link above) there is appreciation baked in, achieved by buying it undervalued. In this example, a cost basis of ~65% of current market value. Overall, this strategy is less work, less risk, and earns a higher return than the stereotypical turnkey duplex.

Alternative 2: For those willing to assume more work and risk, in exchange for a higher ROI. The 170k could be used to buy 4 houses in neighborhoods similar to where the turnkey property is located. This would bring in 5000/mo rent. Many of the issues would be the same, but compared to equivalent multifamilies, detached houses are able to attract the best of the applicant pool and command higher rents.

Alternative 3: If asset appreciation is more important than interim cash flow, there are areas where gentrification is most likely to occur. These areas are obvious, and that anticipation is reflected in the prices. In the short run, the property bought for 170k might look and operate a lot like the turnkey duplex. But over the course of ownership, the IRR may be vastly superior because of exit strategies like a condo conversion 10 years down the road.

No matter what the investment goal is, turnkey properties aren't a good way to get there. I’m throwing down the gauntlet to any turnkey advocate. Please challenge me on any of this as it pertains to Chicago. I’d love to hear your case. If you provide the details of a deal we can analyze it here for all to see.

@John Lowe

John, I'm not necessarily an "advocate" of turnkeys, but I am actively evaluating one of the larger turnkey operators in Chicago and considering an investment there. And I've been reading some of the same Daniel Kay Hertz material that you linked.

The provider I'm considering focuses purely on single-family homes in the south suburbs. I've vetted around 30 of their properties and found 3-4 that I would consider buying. Though their focus is on SFRs, I think a majority of their inventory likely resembles what you've described (e.g. product priced based on the 1% rule in neighborhoods unlikely to appreciate.)

That said, the handful of homes I've found do appear to me to have potential.

These are homes in neighborhoods with average or above-average schools, 80-85%+ owner occupancy, very low crime, and trailing 5-year average appreciation of 2.5-5%. 

The homes are priced at 5-10% below the median home value in their broader neighborhood and appear to be selling close to fair market value based on my comps analysis.

I wouldn't have tons of equity going in, I'd pay considerably more for this "quality" than if I just bought from their core inventory, and my returns on paper (using all of my diligence and conservative assumptions) look way lower than the pro formas.

But given that I do plan to hold for 15-20 years minimum and don't intend to get much more hands-on than periodic market tours and some spreadsheet jockeying, I think there may still be a fit here.

Good morning @Keith Anderson ...depending on which south burb you may be right. Some have much slower growth than others. Usually, the further south and further west you go, the more opportunity you have for that growth with a buy and hold.  Unfortunately most of the news reports the bad about Chicago and doesn't note the rebuilding taking place and how it is reshaping Chicago. There is a current shift in that the city is rebuilding many areas in order to attract suburbanites to return to city to live, especially if they work downtown or near downtown.

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