How Passive, Turnkey Investors Should do Due Diligence

[Chris Clothier]

There is a difference and a different approach that passive and active investors should take when performing due diligence. After 23 years buying and selling real estate, 18 years owning and operating a passive, turnkey investment company with my family and having made every mistake an investor can make, I feel comfortable in voicing my opinions on this topic, some would say, rather forcefully. Passive investors must take a different approach to their investments than active investors.

First, so we are clear, I define a passive investor as one that truly takes no active role in identifying, renovating, marketing for sale or lease, or managing an investment property. By definition, most long-term buy and hold investors are going to be passive as few investors seek to flip houses or move in and out quickly in a passive way. So, for this forum post, I speak about passive investors as those that are looking to limit their role to oversight of the people or companies they are relying on for their success.

And, I am going to focus heavily on the turnkey niche, since it is one of the most popular topics here on the BiggerPockets forums and the word is so heavily used that in many ways it has lost its meaning. I prefer to use the marketing term “passive investment” but since turnkey is more popular, those operating in my niche are forced to keep using it. I define turnkey as:
- an investment where an investor is buying a property from a company or individual that owns the property.
- They have recently completed a full renovation. (In my opinion that means no deferred maintenance, but that is more about standards than definition)
- There is active management representation in place and that is provided by the same company doing the renovation. (Again, this is more about standards than definition)

Those three standards are how I define passive, turnkey investments. The company owns the property, they have completed a recent, full renovation, and the property is under management when you purchase the property. Anything short of those three standards, and in my opinion, it is not a turnkey property. Those are the three identifiable ‘heavy-lifting” areas.

So, how does the due diligence that a passive investor does on a turnkey property differ from an active investor?

This is the order in which passive investors must do their due diligence:
1. Identify the expectations. The exact results that you expect in order to call your investment a success.
2. Identify markets that you believe align with your expectations and have the highest probability of your success.
3. Identify existing companies or teams in those markets that give you highest probability of hitting your expectations.
4. Interview those companies and referrals of those companies to determine if what they offer and how they offer it give you the highest probability of hitting your expectations.
5. There is nothing wrong with going to visit a market at this point, but go with your eyes wide open. In most cases, you will have no idea what you are looking at or if you can trust what you are seeing. The biggest factor in visiting is to meet the company you are possibly going to do business with. If you have already built trust, then you are verifying if everything you have been told, if the very reason you think they give you the highest probability of success, matches with what you are seeing on the ground. The be very clear, you are doing your DUE DILIGENCE on the COMPANY! Are they all smoke and mirrors or do they actually match up with the story they told you on the phone. How big is the team? What systems are they using? Do you feel safe looking at the example houses? Are they trying to get you to sign on the dotted line right there on the spot for a house? Are they requiring you to put down a deposit to even come visit or get on a list to see houses? All of these questions should factor in to your due diligence on their professionalism and if you truly believe that houses you purchase from them and are managed by them will actually meet your expectations. It is easy to use paper returns and great marketing messages to be convincing, which is why looking people in the eye is your best way to do Due Diligence on a company.
6. Then and only then should you even consider a property.

You see, in my conversations recently, there are a lot of investors who want to do the same due diligence that active investors do, but they are making passive investments. Active investors are responsible for the purchase price of the property they are buying. They are responsible for the negotiation of that purchase price. They are responsible for understanding neighborhoods dynamics and knowing how certain renovations have certain effects on the mindset on residents. They are responsible for every facet of their investment and ultimately if that investment hits their expectations.

Passive, turnkey investors have zero input in each of those areas. They don’t pick the neighborhood that a turnkey company works in. They do not pick the renovations that a turnkey company does or how good they do them. They don’t decide the standards of how a turnkey company operates their management company. They get to pick the turnkey company they work with, and that about sums up the decisions they get to make outside of saying yes or no to a property.

A passive investors #1 job is to do their Due Diligence on the Turnkey companies! Now, don’t misread anything here. Every investor gets to decide when they say yes to an investment. You can still decide which neighborhoods you want to avoid or which types of homes, prices, rental prices you want to focus on from a turnkey company. You can still say to no to any properties that don’t fit your needs.But the fact of the matter is, no amount of due diligence a passive investor does on an individual property, can make up for a failure to do proper due diligence on a company. Bad companies with poor business standards and practices can ruin a fantastic investment property in a very short period of time. And unfortunately, history tells us that there are more poorly run companies than there are good.

Too often, in my opinion, passive investors are focusing on details that they have no control over. Those details are controlled by the company they are buying from. I’ve actually talked a lot of investors OUT OF doing business with my families’ company because I recognize in them the traits of active investors. Perhaps they start with one or two passive investments, but I know they really want to be active. They are asking the right questions and digging in and doing research that will have no effect on the success of their passive investments. In reality, investors who have the patience and stamina to put in the extra work it requires to be really good at active investing are never going to have their expectations met with a passive investment. They will always have questions and quite often have regrets because they believe they can do better. It literally takes two completely different mindsets and approaches depending on if your are going to be active or passive.

The biggest difference comes down to trust. An active investor has to be able to reach the conclusion that they have done the proper due diligence on the COMPANY they are working with, to trust that the investment they make will meet their expectations.

Lastly, I talk a lot about expectations because too often, especially here on BP, commentators judge other investors’ properties by their own expectations. In my opinion, and again after talking to many, many investors through the years, every investor has to set their own expectations. I have met many active investors who are able to let go of certain pieces of the process for passive investments and their expectations of those passive investments are very, very different than their active investments. They are a great example of how to approach these investments, because they are able to show how a total portfolio performs. They don’t expect low returns, but in a majority of the cases, they expect a lower return with much, much lower risk and a higher probability of a return of their investments. In order to hit those expectations, their due diligence focuses on the companies they work with, not on the property they own. If their due diligence is done right, the companies will make those properties perform to the investors expectations.

I wold love to hear other thoughts and even differing opinions. I’m open for discussing the best ways for passive and active investors to hit their expectation!