Turnkey sellers - why are expenses ignored?

[David Beard]

It seems that turnkey sellers are sprouting like mushrooms, not unexpected giving all the distressed inventory being snapped up.

Current practice by the largest turnkey sellers strikes me as questionable. Here are actual properties for sale on the sites of two of nation's largest turnkey companies, who enjoy preeminent reputations in the industry.

Company 1:
Sale Price: $109,900
Down Payment: $21,980
Closing Cost: $5,500
Total Investment: $27,480
Monthly Rent: $1,125
Monthly PITI: $725.68
Monthly Management: $90.00
Monthly Cash Flow: $309.32
ROI: 14%
Price Per Sq Ft: $73.00

Company 2:
Purchase Price= $89,150
Monthly Rent= $825
Taxes/Insurance -$135
Management Fee -$35
Monthly Expenses -$170
Monthly Income x12= $7,860
Yearly ROI= 8.82%

OK, if you've on BP longer than 30 seconds, you'd quickly see that there is no vacancy, maint/repairs, or capital reserves. Really?? How do they ignore these items, you ask? Well, in most cases they offer a Year 1 guaranty of net operating income, and teh possibility of purchasing a maint. plan for later years (though the cost of this plan is not included, and at any rate it's not going to replace your roof or your old furnace).

Plus, they point out that the properties are nicely rehabbed, in solid neighborhoods with high rental demand, tenants are rigorously screened, and to cap it off, the buyer may well sell the property at a big gain well before these repairs and capital expenses start hitting (remember, you presumably "captured" a boatload of equity when you purchased), at which time you can roll into another property.

At any rate, if you hold the property, the assumption is that Years 2-30 will experience none of these expenses.

Yes, these other items (vacancy, maint/repairs, capital reserve, evictions, etc.) are assumptions, but they are nonetheless highly predictable over time. We all know this, it's common sense.

So the question is: why do they do it? Does using higher expense assumptions depress the yield assumption to the point where no one will buy? Perhaps, especially if you're selling at relatively low gross yields anyway. But still, the net yield (assuming a more realistic 45-50% expenses/vacancy/capital) is considerably better than most alternatives.

Maybe it's this: they like you to lever up so that you can use your capital to buy multiple properties (meaning multiple sales and higher prop mgmt and maintenance residuals from tending to all these properties). However, this levering wouldn't make any economic sense for you if the true net return (cap rate) barely exceeded the borrowing rate. So it's vital that net returns be portrayed as materially higher than the borrowing rate.

It's usually the smaller, newer companies that are at least acknowledging these expenses, though they often understate them (vacancies at 5%, maint/repairs/capital at 5% is common).

I'd love to hear insights from others on this. It would seem to be in everyone's best interest in the industry to have reasonable standards for illustrating expected performance on rental real estate. No one wants, gulp, heavy handed government regulations to address all the disgruntled future investors/constituents...