What Kind of Property Should a Turnkey Investor Be Offering?

Question

In another thread about a turnkey investment, I was encouraged to post this question to get feedback from other investors:

Do you think a turnkey company should be offering D Class properties to their clients?

I know what I feel is the answer, but I would be curious as to people's thoughts about their opinion, as well as why or why not.

Sharon Tzib · Answer

Thanks to everyone who has answered so far. I thought since I asked the question, it was time for me to give my answer to the question:

“Do you think a turnkey company should be offering D Class properties to their clients?”

First, I will say that I think 99.9% of all problems stem from a lack of setting expectations up front and poor communication. So the first thing that I believe any turnkey company needs to do is to verify what does turnkey mean to the investor client.

Prior to this post and a couple others on the forum lately, in my mind, turnkey meant:

1.Completely rehabbed property so that only minimal or routine maintenance would be required for many years to come.

2.Accessibility to a professional and high qualified team, most importantly, but not limited to, property management.

3.At the close of escrow, management has placed a well-qualified and screened tenant into home at a previously agreed to market rent so that the home is cash flowing from Day 1.

4.MAYBE turnkey offers financing options in house as well, for ease of transaction.

5.As an investor, one can remain virtually passive by receiving monthly reports from the PM and receiving cash flow checks.

Overall, my impression of turnkey was an investment that allowed an investor to remain very, very passive. I have since learned, however, that turnkey can mean different things to different people, so again, it is incumbent upon the operator to make sure every client that “walks through their door” is thoroughly vetted to discover their definition.

Next, I would like to discuss the turnkey company itself. Normally, an investor’s first interaction with a turnkey company will be via their website. Let’s face it, most buyers of real estate, whether they are looking for a personal residence, or an income property, will begin their research online. So, I believe it is also very important for a turnkey company to accurately represent the kind of investments it has available, the type of investor the investment best suits, and what the investor can and cannot expect.

This leads me to the investor themselves. I personally believe that investors who are considering turnkey want to be passive because they do not have the time or interest in educating themselves on specific markets, assembling a team, or dealing with a rehab or tenants. Furthermore, if they can’t find good deals in their backyard, they may have no choice but to invest remotely, therefore, a turnkey company can prove very convenient by organizing everything they need under one roof.

While I won’t say this applies to all turnkey investors, I do think that by and large, the majority of them would call themselves unsophisticated. Not because they are stupid, but simply because as stated above, they don’t have the time or desire to spend getting educated, or since the market isn’t in their backyard, they’d rather find an operator who has a proven track record in a market that they can purchase from.

A lot has been made of the fact that every buyer needs to do their due diligence. Of course they should. But unfortunately, by nature of their unsophistication, many investors do not know exactly what kind of due diligence they should be doing. So again, I think it is incumbent upon the operator to steer them through this process. Unfortunately, not all will do that.

Also because of this unsophistication, I do not feel it is fair or prudent to be offering D Class property to them. First of all, D Class property in no way offers what most turnkey investors are looking for. In order for any property to cash flow sustainably, it must be in an area desirable to a large amount of tenants so that vacancies are at a minimum; the units themselves must be in excellent condition so that again, they are desirable to tenants; repairs and capex should be minimal in the beginning of the investment; and tenants must be good quality whereby they pay on a timely basis and take good care of the unit.

To be best of my knowledge, D class properties do not meet any of these criteria. In fact, they seem to be the polar opposite of what most turnkey investors are seeking.

However, I keep hearing if an investor asks for it, then turnkey operators will provide it. Personally, for reasons stated above, I do not think the majority of turnkey investors even know what a D class property is. Even after it has been explained to them, I don’t think they have the experience to fully digest what an investment like that would be like, every day, for the entire time they own it. The lure of great returns may be why they buy it, but really, in the end, are the returns that great? And are the turnkey operators seriously saying the best they can do to give great returns is offer up D Class property? It seems to me there is some room for improvement here.

If an investor insists on investing in this asset class, then as a turnkey operator, I would insist they get on a plane and come visit the area, so they can see with their own two eyes what they are getting into. I would also make darn sure that the property manager assigned to them was exceedingly experienced in this asset class. And lastly, I would be concerned about over-improving a property like this.

Sorry for the long explanation – the writer in me got carried away – but these are my thoughts. Feedback?

Mike D'Arrigo · Answer

This is a great question. In my opinion, a turn-key property is one that has been fully renovate, rented and under property management so that it is cash flowing from the start. The level of rehab is key. I don't believe it should have any deferred maintenance. For instance, if the mechanicals or roof have only a few years of useful life, they should be replaced. The problem is there are as many definitions of turn key as there are investors, so if someone is thinking of going the turn-key route, they really need to understand what that means. A lot  of times, a home on that has a renter is referred to as turn-key but no renovation has been done on it for years. I recommend asking for a scope of work on the renovation to see what was really done and when.

Although I would never touch a D class property and wouldn't recommend one, I don't see property class a factor in whether it's a turn-key. Property class usually refers to location, age, rent etc.

Just my 2 cents.

Chris Clothier · Answer

Sharon - thanks for taking this question over to the forums.  I thought it would bog down on the other post and possibly even take away from that posters' original thread.

Unfortunately, I think that Turnkey companies are going to offer whatever investors are willing to buy.  It involves so many different questions about responsibility for all parties involved.  The investor has the responsibility of making a good and informed decision and the TK company has the responsibility of offering a good product that will perform.  And too often, on both sides of that equation, neither side lives up!

I think it will be extremely difficult for any investor to see any real upside to investing in 'D' labeled properties in a turnkey situation.  Even investing in them passively where they hire out the services will be difficult.  That level of property just comes with so many issues and each of them negatively effects the cash flow and value of the property, which are the reasons for buying TK in the first place.  Cash flow and added value.  Those are hard enough to obtain on D properties without TK involved much less with it.

So I am leaning toward it being a bad idea, but also realize that as long as investors ask for it, TK companies will provide it.

Marco Santarelli · Answer

As a general rule, I think turnkey providers and promoters should offer the best quality properties they can.  I break this down into four areas:

MARKET:  The market (metro area) should be healthy, and preferably growing.  No depressed markets should be considered.  This is the "top-down approach" I refer to in my 10 Rules of Successful Real Estate Investing.  Ideally you want to pick markets that have good job growth, a good employment base, positive in-migration, a healthy housing market, and be somewhat diverse in its industrial sector profile.

NEIGHBORHOOD:  Neighborhoods vary greatly within every market, but it would be wise to stick to bread-and-butter housing within the market you choose.  That places you near the middle of the bell-curve in terms of the socio-economic mobility within that market. Often you'll find these in the 'B' grade neighborhoods and I find most turnkey providers focus on those areas.

If an investor prefers a more "premium" location with a better quality tenant then an 'A' grade neighborhood should be their main focus.  If they want higher cap rates/cash-flows then they may want to consider some of the "lower" grade areas within the market, typically a 'C' grade neighborhood.  Regardless of what they chose, it's very important to have great property management working for you.

I find most turnkey providers offer properties in 'B' grade neighborhoods, but they range from 'A' thru 'D'.  Our company has always focused on 80% 'A' and 'B' grade neighborhoods, with the other 20% on 'C' grade neighborhoods. Occasionally we have a 'D' in areas undergoing gentrification or a high degree of rehab activity.

PROPERTY: The property itself should be safe, clean, functional  and in very good condition.  I recommend investing in either  new-construction properties with 10-year builder's warranties, and/or  fully renovated residential properties with comprehensive renovation work (mechanical, interiors, etc.).  We prefer to focus on properties with a more extensive Scope-of-Work to help defer early maintenance and provide more desirable property to tenants.

MANAGEMENT:  Most turnkey providers don't do the property management.  They refer or outsource it to a local management company.  You could argue that one scenario is better than the other, but I've seen this work both ways.  You just need to look into the management company and do your due diligence.

Shaun Reilly · Answer

@Sharon Tzib

That was a great analysis.  Hopefully anyone getting into turnkey investments that are on BP see this thread.

Gerald K. · Answer

@Sharon Tzib

Well done! Simply eloquent. A very sensible conclusion.

David C. · Answer

From what I've read by the others on the other thread, there seems to be agreement that Class D properties have too much hassle to be considered: turn-key or a passive investment.  For that reason, I don't think they should be offered as 'turn key'.

Now - if a turn-key-operator sees to much potential profit and has too many aggressive investors, then it might be very hard to turn away the business, in that case - I just think the marketing, promises and guarantees needs to match reality for these class D properties.  They should not describe them as 'turn key' or 'passive'.

Riley F. · Answer

@Sharon Tzib

Thanks for starting this thread, as I've been following the other with a lot of interest. I think that it's fine for a turnkey operator to offer a Class D property to an investor as long is there is full disclosure and that the investor understands what they are purchasing.

It's an issue of definition, but to me, a turnkey property is a property that is move in ready. Presumably the buyer is less sophisticated than an investor that goes through the entire process on their own, but nonetheless, the old adage "caveat emptor" applies. You are purchasing a property with an expected set of future cash flows, and an assessment of the probability that you can expect the receipt of those cash flows.

Look at it this way - the US 10 Year is yielding around 2.8% right now, which is your assumed risk free rate of return. Real estate markets may not be perfectly efficient, but in general the are approximately efficient, though some idiosyncratic risk applies from property to property. If you are expecting a return of 30% (a combination of yield and mortgage amortization), you should be expecting commensurate risk, pure and simple. The risks that you are assuming include, but are not limited to, idiosyncratic risk (buying a single property, it will not behave in the same way as the market overall), liquidity risk, business risk (read uncertainty of future cash flows), and local market specific risks. Markets are very good at pricing risk, even inefficient markets. How many of us have seen a home go onto the MLS and be purchased day 1, while others sit for more than a year? In short, if it seems to good to be true, it probably is.

Presumably we are all adults and are capable of evaluating our own financial decisions. I think entering into a purchase lightheartedly is a very bad idea. I am sure the investor in the other thread thought he did sufficient DD, and hopefully he gets out of this mess with his shirt. That having been said, unless Marco willingly made misrepresentations, I don't think he did anything wrong. If it was risk free it be yielding closer to 3%.

Perhaps Marco and other turnkey operators and marketers can avoid these fiascoes by being VERY upfront with investors about investing in D areas, or removing them altogether from their websites.

Tim Soto · Answer

To me, a turn key property is a property that's move-in ready, whether it's in an "A" or "D" location. And in some cases, as an investment property, that even includes the tenant.

But if we're taking about a "D" property, doesn't that mean the property has some deferred maintenance? To me, for a "D" property to be considered turn-key would mean that it has a tenant, but the property needs work.

As with every investment property being purchased, every buyer must do their due diligence.

Marco Santarelli · Answer

David -- this is a valid argument, and it lends itself well to the lack of a definition on what "turnkey" really means.  Like I said earlier, ask 10 investors and you'll get 10 different answer.

BTW -- I assume you meant a 'D' area, and not a 'D' property.

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