The Ugly Truth About Turnkey Real Estate
As many of you know, I'm a big proponent of buying properties remotely. They may be harder to manage, but it's much easier to find a property that cashflows when you're not limited to a 25-mile radius around your home. There are, however, a lot of headaches when it comes to buying a remote property, especially if it's your first rental.
First you have to find a good area to buy in, with high cashflow and appreciation potential. Then you have to find a patient real estate agent to find a property that fits your buy box. It's no secret that many agents don't like working with investors. We're too picky compared to the average home buyer. Investing is not like House Hunters, where you buy the 3rd house you're shown. Investors look at dozens of properties and often lowball their offers. Many real estate agents don't have the patience for that.
Once the property is under agreement, you need to find a lender to finance it on favorable terms. Lenders too can be difficult to work with. Many lenders require a high downpayment on multi-family houses and limit the number of properties you can own. Just like with the agent, it takes a while to find an investor-friendly lender. And the headaches don't stop there. Once you have the property under agreement, you need to schedule inspection and appraisal without being physically there.
Finally, after you buy the property, it will often be in rough shape (otherwise you probably overpaid for it). This means that you need to find a contractor to make it rent-ready (this is the first R of BRRR strategy). But finding a reputable contractor remotely who won't rip you off is yet another pain point that makes remote investing cumbersome. Finally, after all is said and done, you need to find a competent property manager to screen the tenants and handle the day-to-day. This entire process can be daunting to a rookie investor. Enter the turnkey operator.
How Turnkey Operators Work
Turnkey operator is a company that handles all of the above headaches and allows busy professionals with little knowledge of real estate to scale their rental portfolio passively. A typical turnkey operator will buy entire city blocks of like-kind properties, rehab them to a consistent standard, put a tenant in-place and assemble a property management company of their own. They may even give a rent guarantee for the first year (as insurance against non-paying tenant). After all, the operator benefits from economies of scale and passes those savings down to you.
The turnkey operator may even invite you on-site to showcase the quality of their renovations as you walk through one of the finished properties. They may even connect you with their lender who will automatically pre-approve you for the purchase with much less scrutiny than your typical bank. This seems great on paper, where's the catch? The problem with turnkey operators, as with property managers, comes from incentive alignment.
How Turnkey Operators Make Money
Turnkey operators make money on the spread between their total invested cost and the sale price. Here are the basics:
- Acquisition at a Low Cost: They purchase distressed or undervalued properties, often in bulk, at prices below market value.
- Cost-Efficient Renovations: Leveraging economies of scale, they renovate these properties at a lower cost per unit than an individual investor could achieve.
- Selling at Market Value: Once the properties are rehabbed to a consistent standard, they sell them to investors at the after-repair value (ARV), pocketing the difference between the purchase plus rehab costs and the selling price.
- Additional Revenue Streams: Many turnkey operators also offer property management services. They earn ongoing income through management fees, tenant placement fees, and sometimes even maintenance markups.
- Financing Kickbacks: By connecting investors with preferred lenders, they might receive referral fees or kickbacks, adding another layer to their revenue model.
The first question that comes to mind is how are these operators able to acquire so many properties at a discount close to each other quickly in a relatively inelastic real estate market? The answer is that not only the properties themselves are distressed, but so are the areas they invest in. Turnkey operators often focus on D-class areas for their acquisition. Popular choices include West Philadelphia, Southside Chicago, and Gary, Indiana. These are areas that are declining in population, have high levels of poverty, property crime and attract low-quality, high-maintenance tenants.
I've already warned about the dangers of investing into D-class areas remotely, but this is different, right? The turnkey operator already pre-screened a tenant and put their own property management company in place. The property will cashflow from day 1 and property management company will absorb the headaches. Not quite.
As I already mentioned in my article on property managers, the PM collects their fee regardless of performance - often charging you even more in PM fees during the eviction process than when everything goes well. The only thing that keeps property managers honest is their reputation. But reputation only matters when the customer shops around, not when the turnkey operator picks a PM for you.
Not only does the turnkey operator pick the PM, they may even form a new legal entity solely for the purpose of managing these properties - an entity that has no prior experience in property management and is not legally or publicly connected to the operator. In other words, the turnkey operator doesn't care if the PM sucks or goes out of business in a year.
In fact, the turnkey operator won't care about this area at all after a year. They pick a distressed market with high inventory of distressed properties, swoop in and snag those properties at a discount. They then negotiate a discount with a local GC, lender, and a PM for the business they bring and move on to a new market each year. They have no skin in the game and don't keep any properties for themselves.
Turnkey operator doesn't need the market to do well long-term, they only need to sell the buyer on the investment in their pitch deck. They collect positive testimonials from happy buyers at the time of the sale who are impressed by the new renovations and receiving that first monthly rent payment. These buyers don't yet realize what lies ahead, that many of these tenants will stop paying rent after a few months, and they won't be able to find a new tenant due to high crime and vacancy rates. Not a big deal for the operator, they will issue you a $6000 check to reimburse you. They can afford it, because their spread was $50k+ on each property. The buyer overpaid.
But how is that possible? An independent lender underwrote the property and there were no issues with the appraised value. Even if you were to go with the lender recommended by the turnkey operator, Dodd-Frank Act prohibits the lender from picking the appraiser. The appraiser has to be an independent third party.
But the appraiser uses what's called comparable sales (comps) for determining property value. This means finding 3-5 like-kind properties (w/ similar size, condition, and renovations) sold within 1-mile radius in the last few months. And who controls these comparable sales? The operator, of course! The hardest part is making the first 3 sales, which will serve as comps for the rest. After that, the properties will have no problem appraising because the vacant housing stock without renovations is not considered like-kind. A much closer comp sale is available from the same turnkey operator.
To make the initial three sales go smoother, the turnkey operator may even offer seller-financing to the first few buyers at great terms, similar to what developers do on new construction. The newly-done renovations look sharp. The buyer (often coming from a wealthier area where housing is much more expensive) is deceived by the cheap price and focuses on scrutinizing the build quality rather than researching the area. Their only understanding of the market is based on the turnkey operator's pitch deck.
As the age-old adage goes, the most important factor in real estate is location, the second is also location, and so is the third. Unfortunately, turnkey properties have neither of those three. Turnkey operators often put location last on the list of their considerations. It's a model designed for quick turnover rather than benefitting the investor long-term.