Out of state investing- SCAM! False promise land of cash flow.

[Joe Kim]

BEFORE I say anything.  I want to be clear I am totally bullish on real estate investing.  But I want to warn people that it is not what you think it is.  And share my own journey over the last 3 years.

Ok.  Out of state investing is NOT a scam.  

But all the hype and promises are rarely realized.

First some background.  I started buying buy/hold rentals out of state (I live in California- no surprise right?) in late 2013 in texas via a "turnkey provider".

I completely bought into the cash flow is the key to REI (real estate investing) philosophy especially since California properties are overpriced and cannot cash flow. Buying for appreciation is gambling. Sound familiar?

So I got to 10 conventional mortgages this year when I bought my 9th rental property(10 doors). That equaled a total of 10 doors/units (I have 8 SFR, 1 duplex, and primary home).

I also bought into the whole diversification model and bought in 6 different metro areas in 5 states!

Before I unleash my tirade on why out of state investing SUCKS.   Let me say this.  I made a lot of money doing REI over the last 3 years.  I love REI.  I will continue to invest in real estate until I die. 

Also, I want to thank my buddy DK who introduced me to REI.

That being said, let me outline what the promise of "out of state" "turnkey" "passive" "cash flow" investing has been for me.    Only "out of state" is true...rest of the it -turnkey, passive, cash flow---all a pipe dream of sorts and/or significantly lower ROI than promised with a lot of headaches.

#1 Turnkey.   I went to recent SF summit in Oakland(by J. Martin) this past weekend.   Chris Clothier of Memphis Invest and Australian Dingo (Ohio) spoke about what REAL turnkey is all about.   Let me tell you I've yet to experienced TRUE turnkey that these two guys were talking about. (Unfortunately, I have not yet invested with two of these reputable companies (Memphis Invest and Ohio Cash Flow) but I have dealt with 3 different turnkey providers in 3 different states.

This is what turnkey investing should look like:

**Release control: IDEALLY: The turnkey provider does 99% of all the work. The investor only has to put up the cash or financing for the property. EVERYTHING else is done by the provider. The list of properties- nearly every one of them should be HIGH quality, good cash flow, FULLY rehabbed to new or nearly new condition (with no real Capex expected for at least 5-10 years!)

REALITY CHECK: I'm constantly checking up on the turnkey provider due to current or prior bad experiences of poor rehab, poor property management, unexpected Capex within 1-2 years of purchase, costly maintenance nearly every month, terrible cash flow. How can I release control when problems keep coming up?

#2 Passive.   Communication should be prompt and timely.   Lease renewals should be given notice to the owner.   Any major problems like lease NON-renewal, eviction, etc.  should be communicated quickly with a plan of action that is executed after owner's consent.  

REALITY CHECK:  I felt bipolar about being "passive".  I would be passive as much as possible and then a string of problems make me sensitive to all that is happening.  4 evictions in 3 years is pretty high and in some cases clearly due to poor tenant selection.  That makes me want to be part of tenant screening/selection - that's not passive.    Being "passive" and poor property management just kills your cash flow.  For me, if I'm going to spend the time fixing problems or dealing with issues, I should just self-manage -then my time is well spent.   Spending time deal with property management rarely ever resulted in big savings, rather just more stress.   Poor communication made things worse.   I could give examples, but this post is getting too long.

#3 Cash flow: Promise land of cash flow will let you quit your job and retire early. Good luck. If you could buy 20, 30, 100+ SFRs(for higher income earners) to replace your income. Jason Hartman says routinely in his podcasts, "Even if you get HALF of the promised ROI, it's good." Well, I would say, HALF is the MAXIMUM you will get with most of these turnkey providers. Let's say predicted cash flow is $300, then $150 is likely your maximum cash flow when calculated over at least 2 year period. Because within the first 2 years of buying these properties I had roofs, HVAC, electrical panels ($2000), moldy bathrooms ($3000), rotting tree removal ($1100), make ready whenever there is turnover (as much as $1500) ,toilets ($600), etc...so many capex or maintenance costs it has wiped more than a year's worth cash flow easily in some properties.

REALITY CHECK: Cash flow sucks.   Unless the property is rehabbed to NEW or "like-new" conditions and high quality long term tenants are chosen (for that class of property), capex/maintenance and turnover costs will eat away a LARGE portion of your cash flow.

Now you may think, this guy is an idiot who did not buy the right properties from the right turnkey providers.   I think making $500,000 to $600,000 in equity appreciation in my 9 properties in the last 3 years with properties in high cash flow areas like texas, Indianapolis, chicago etc... is pretty awesome and makes up for the poor cash flow.  Certainly, I made a lot of mistakes and got some LUCKY breaks (market timing) in the my first 6 properties but I think I'm doing it better now in the last 3 properties I bought.   This post is too long.   in the next post, I will highlight what I learned and how I applied what I learned to the last 3 properties I bought in 2016.

[Michael Gansberg]

@Joe Kim, I'm so glad you wrote this post. As a seasoned investor, I first read about these turnkey(turkey?) companies from BP, and I smelled a scam. I reasoned this way- I've been doing this for 13 years, I currently own and operate a bunch of MF properties, I consider myself and my management damn good at what we do(though that may be my ego talking,) and I still put time into operations. 

So I thought- how do they do it? They've replaced me and my job, which is basically to interface with management, and they've also taken over management, and the owner is in theory at the top of the food chain, so the Turkey Companies have extra layers and still there's room for cash flow to the owner? Hmmm...my NYC Scam Alert was in high gear when I heard this. After all- if this was really "passive" investing, then I wanted a piece! 

So I did my research, and the scam was immediately evident. My research suggests that most Turkey companies buy some junky foreclosure for pennies in a B-(or worse) neighborhood, do a poor quality rehab project(because hey, after all, it only has to look good to the out-of-state buyer, who'll likely never know that the drywall is from China and is spewing fumes, along with the cheap laminate which offgases enough formaldehyde to start your own chemical factory...) and THEN the Turkey co. says, wow- all I have to do is price this over retail and promise easy returns, and some out of state buyer will fall for it. Hey, I can tell the buyer they're paying more than retail because they won't have to do any management! And then when those returns fail to materialize? Hah! I'll just point them toward the fine print, nobody is gonna sue for a shortfall of $4k or $5k per year...would they?

In this whole scenario, the Turkey co. is strongly incentivized to do poor quality work, as the less they spend on the house, the greater the profit when they sell. They are strongly incentivized to charge high management fees and have high tenant turnover, because hey...what recourse does the hapless buyer have, it's just mo' money in the pocket of the Turkey provider, after all(in other words- caveat emptor, mater frotteurs! No, don't even try to disentangle that.) Think about it- the tenant moves out...oh no, the rugs need to be replaced! $2k in labor, $20 in materials at the "Leftover Garbage" shed. That toilet is leaky! $150 in plumbing labor, $5 in materials for a stainless steel line.

And then, just when the buyer realizes that the pain is too much, and he'd probably be better off investing in almost any other way...the buyer finally realizes how much of a mistake it was to pay more than retail, solely for the pleasure of having a dishonest entity mismanage their assets. I mean- how much can the buyer really recover when they paid say- 20% or 30% more than a properly rehabbed house? Anyone who buys from them will likely do their due diligence, and will discover just how much lipstick has been shmeared all over that pig. And that pro forma? Oh my god, stop, I'm about to die laughing. 

I have to admit, I've come to a turning point in my life. The old me would have left it at the above, offering no solutions, but solely pointing out the egregiously flawed model that exists in the hopefully-soon-to-be-dead Turnkey space.  Are there any legit Turnkey providers? I'll never know, as I'd never enter into a business relationship where someone else's success was my downfall. If you're really interested in passive investing, and you want to own real estate directly, the closest one can get is triple net, single tenant properties. Period, end of sentence. If you have tons of experience, even multifamily can approach "passive" investing, but after thirteen years and a ton of experience, I'm not there yet.

MG