This is the second installment in the two-part series entitled Is Turn-Key Real Estate Investing a Good Idea. In the previous article I covered the basics of what turn-key investing is, how it works, who the players are, and what everyone’s rationale is. In this article I want to focus more specifically on the pitfalls to you, the potential turn-key buyer – the kinds of things that may seem better than the reality may turn out to be…
I need to stress here that turn-key investing might very well be all you want it to be, and it may be the right approach for you. But, you should have all of the pertinent information upon which to base your decisions, which is where I come in with these articles.
As part of advertising of turn-key opportunities you will need to consider the income, expenses, and over-all logic. In this article, we will discuss these one at a time.
And with this, let’s dig in…
Advertised Income of a Turn-Key Rental
As you know, having read the part 1 article, when you buy turn-key there is already a paying tenant in the property. One question you must ask is – how long has this tenant been in the property and paying on time. In other words, it’s nice that there appears to be income on paper, but how seasoned is this income and can you trust it…?
Here’s what you need to understand. It is very easy to rent a unit. It is very difficult to rent a unit to such a tenants who is going to pay on time and stay for a while. With this in mind, turn-key has some moral hazard built into it. On the one hand, the turn-key operator is interested in collecting the profit on the sale as quickly as possible. On the other hand, he is anxious to begin collecting that property management fee from you as soon as possible.
These two elements in the turn-key operator’s mentality introduce moral hazard. The turn-key retailer knows that the house cannot be sold to you as turn-key until and unless there’s a paying tenant present. For this reason, the turn-key operator will often do what he must to achieve a paying tenant in the property…
Unfortunately, in the Mid-West there are not so many qualified tenants. We are not hitting them out of the ball-park economically, which is, by the way, why the houses are so much cheaper here. This is also why it is hard to find a responsible tenant. If moral hazard is present whereby someone is more eager to have a tenant than to have a “good and reliable” tenant, then you are relying strictly on the moral fiber of the turn-key retailer.
Some of them are great. But, most…how lucky are you feeling?
Tenant Quality vs Rental Income
When I buy a building, you can be sure I’ve studied the market and know the rents of my competitors. The thing you need to understand is that a house with market rent of $750 can indeed be rented for $800 or even more. The trade-off is quality of tenant.
There are a lot of potential tenants out there whom I will not rent to based on my qualifying standards. They have to live somewhere, though. So – they offer to pay more just so someone will let them in.
The turn-key moral hazard in this case is that the purchase price to you is substantiated upon capitalization of the NOI. This means that if higher rents are shown, a higher asking price could be rationalized. But, if the higer rents are achieved via poorer qualified tenant, then you get hit on both sides – you pay too much for the house, and you potentially incur expenses which you wouldn’t have with a better qualified tenant at lower rent. The only way to guard against this is to know the market…
The Expenses of a Turn-Key Rental
This is the example we discussed in the previous article, which I think is close to reality now days:
Let’s just take Ohio, since this is where I am and what I know. And let’s say the turn-key retailer purchases a house for $20,000. He then markets to you that $12,000 of repairs have been completes and the house is now rented for $800/month. The marketing materials indicate that value of the house after these repairs is now $55,000, and the asking price is $45,000 – meaning you will instantly gain $10,000 in equity. Finally, the management fee will be 10% of gross.
The advertized expenses most of the time, include these items:
- Property taxes
- Fire Insurance
Let’s just say that property taxes are $100/month, Insurance is $50, Vacancy is 10% or $80, Maintenance is 5% of gross or $40 (because the maintenance is done in house, you are sold on the notion that your maintenance costs will be very low), and Management is $80. Thus, total expenses are $350/month.
At rent of $800/month and expenses of $350/month, the NOI would seem to be $450/month. The marketing brochure multiplies this by 12 to arrive at $5,400. Finally, the marketing brochure advises you that at the suggested purchase price of $45,000 the NOI of $5,400 constitutes a 12% Capitalization Rate.
Before we get into the expenses relative to the cash flow, which are the Operating Costs, let’s talk about the $12,000 rehab.
Remember, you are dealing with a 60-100 year old house with wiring, foundation, plumbing, HVAC, and likely windows, siding, and other mechanicals of an old house. Guys – I can’t even spit on the sidewalk for $12,000. What in the world can you buy for a house like this on a budget of $12,000..?!
Perhaps there’s a new furnace and water heater. Perhaps there are new appliances, paint, and flooring, and a few fixtures. But that’s it. This was an old house, and it’s still an old house, and what does this mean for your expenses of ownership?
Stuff is gonna break and you’ll have to pay to have it fixed – that’s what this means. The notion of 5% R&M budget is absurd. And then there are these:
- CapEx, when big things like furnace or appliances need replaced.
- Loss to Lease (LTL), when you decide that keeping a paying tenant in the property is better than raising rents and risking losing them.
- Bad Debt, for when your house is vacant for a month because the tenant ran off in the middle of the night without telling you, or because you have to evict, which takes 45 days and requires paying an attorney.
- Concessions, when you need to come off of your rent a bit to attract someone who is not going to stiff you or trash your property.
- And more…
All and all, when you add these up, they could easily shave 15% off of the suggested proforma. What would that do to your assumptions of returns and the price calculation? Let’s see
Pro Forma NOI: $450/month
Economic Losses 15% of Gross: $120/month
Your NOI: $330/month or $3,960
Value at 12% Cap: $33,000
You see – if you paid $45,000 for this asset which seemed to make sense both relative to cash flow and equity position, you’d be over-paying by a minimum of $12,000 – this will kill you!
Economic Logic and Turn-Key Rentals
I think I touched on this previously, but let us be completely blunt for a sec. You must realize that prices of everything in a free market society are driven by demand. Therefore, logic should tell you that if something is cheap, it is quite likely because the marketplace doesn’t think it’s worth any more.
With this being said, when you are takiing your money out of California, Vancouver, or New York and bringing it to the Mid-West to buy dilapidated housing in a place which is loosing jobs and population, what are you really doing…think about it?!
I am here in Lima Ohio, and I buy in Ohio – sure. But, I am HERE! I can manage my own, and I can cherry-pick what I buy – you can’t! Think about that…
Finally, if you are sophisticated enough to underwrite to the IRR, you’ll know that you absolutely must have appreciation in the mix. If you don’t, the cash flow adjusted to NPV will not satisfy – period. Well, the TK seller takes the forced appreciation off the table – you pay that to him. And organic appreciation on a $50,000 PIG in Mid-West is unlikely.
Think on this…
Does this mean that you should not buy turn-key? Not necessarily. If it were underwritten correctly accounting for all of the economic losses that are as sure to happen as I will some day drop dead (hopefully not any time soon), the sure – consider it. If all of these economic losses are accounted for, this is an indication that you are dealing with a pro.
But, if not – how lucky do you feel?
Hopefully this helps some of you. A lot more could be said, but I am done. Feel free to leave your comments and questions below.