The turnkey business model has a fatal flaw that can only be overcome in a market that experiences significant appreciation. In its absence, turnkey investing will be disappointing in the long run.
I assert that turnkey investing will not work in Chicago. I wrote a post on this in another thread. I don't know how to post a link to it, so I cut and pasted it here in the hope that someone will take me up on my challenge.
Here’s an analogy that may be helpful in illustrating the fundamental problem of a turnkey rental strategy. Take a 2012 Honda Accord ES in pristine condition, low mileage, loaded with every available option: premium wheels, top of the line infotainment/GPS system, sunroof, etc. Its worth 14k. Another ES in fair condition, with high mileage and no options, is worth 11k. While the cars are very different, the differential in price is only 27%. The value of a car is primarily determined by the year, make and model. Condition and equipment are relatively minor factors. The same is true for real estate. Upgrading the mechanicals, finishing a basement, installing granite countertops, there are dozens of ways to spend thousands of dollars improving a house. While it may have a measurable impact, the primary determinant of a house's value is location. Turnkey operators are buying cheap houses and over improving them. A $5000 set of mag wheels on a $10,000 car doesn’t make the car worth $15,000. Neither does putting 30k in improvements in a 40k house make it worth 70k.
An investor using a competent turnkey operator, should not have a horror story in the immediate future. That would only occur if the operator seriously miscalculated rental demand or did shoddy construction. Good operators buy (cheap but) decent houses, fix them up in tip top shape, with the bling to attract tenants who will pay a premium for that new house smell. Any aging components should have be replaced so the investor shouldn't have major cap ex for the first 5-7 years. In the short run things look good, but shortcomings in the underlaying fundamentals can’t be avoided. The investor is likely to experience disappointment in the long term. The first surprise may occur in a couple of years, when the first tenant moves out and the investor needs to spend 2k to get the property back into ready to rent condition (the cost of painting, re-carpeting, fixing dinged up kitchen cabinet doors, etc. adds up). The property may take a bit longer to rent out this time, since its not as fresh as it was. As the years go on, the investor is unable to raise the rent because the rental market is so competitive, rent levels are flat. Unfortunately, the same can’t be said with expenses. A couple of cap ex events occur in year 10 that eat up the equivalent of several years’ worth of profit. But the biggest disappointment comes 15 years down the road, when the investor sells and realize at closing that the proceeds are just enough to cover their loan balance.
Under the best case scenario, the pro forma ROI that turnkey providers quote may be hit the first year or two. I'd love to hear from anyone who's achieved their expected 10 year IRR. The only way to win big with turnkey rentals is with significant appreciation. I don't know about other areas, but that is not likely to happen in Chicago in the neighborhoods where the turnkey operators work. Here's an article that provides one explanation of why. Without getting into the sociology, I'll summarize: people don't always behave in an economically efficient manner.
http://danielkayhertz.com/2014/12/05/chicagos-grow...
Turnkey operators price their properties based on the income approach (which is typically used on commercial and 5+ unit multifamily properties). But the prevailing model for valuing 1-4 units is based on the comp approach. The problem arises when there is a large discrepancy between the two models. If I own a 6 flat and increase the rents by 50/mo per unit, I’ve increased the value of my building; if I appeal my tax bill and win a reduction, I’ve increased the value of my building. If I do the same actions with my rental house, the value is unchanged. The value of my house is roughly the same as the surrounding houses. My house is not inherently more valuable because its rented out and my neighbor’s house is not worth less because he lives in it. While the ludicrousness of this is obvious on houses, the flawed logic is a little less apparent with 2-4 flats. This is probably why Chicago turnkey operators are focusing on them. I don’t know how they are getting the banks to make loans at these inflated valuations, but I’m guessing they couldn’t get them to play this game with SFHs.
I’ll preface this by saying I’m just a landlord. Unless you’re looking to rent a 2 BR in the South Deering neighborhood, I’ve got nothing to sell anyone. I don’t personally know any turnkey operators in Chicago and have no vendetta against them. I’m just sharing my opinion.
Chicago is segregated and my comments do not apply to the north side, South Loop, Hyde Park, Kenwood, or gentrified areas. The areas of Chicago that have high rents relative to home prices are on the southside, "west side", and southern suburbs. That’s where the turnkey operators work, that’s also where my properties are. For the purposes of this discussion, these areas I'm referring to when I say Chicago.
Chicago turnkey properties are overpriced by a lot, like 90-100k too much. Every example I’ve seen on their websites is priced at least twice what the property is worth as a rental. I’m not talking about appraised value, as a buy and hold investor, that’s not necessarily relevant. Value for me is measured by lost opportunity cost (ie. what else can I get for my money).
There is no financial justification for paying 70k+ per unit for 2-4 flats in the neighborhoods where these turnkey properties are located. I won't refer to a specific example because it wouldn’t be fair to pick on one operator when they’re all doing the same thing, but if someone wants to post the specifics about their particular deal, I’ll be happy to respond with specific comparisons.
So let’s say an operator is selling a duplex for 170k that is rented out for 2200/mo, located in a marginal (with regard to the type of tenant it will attract) neighborhood.
Alternative 1: That same amount of money could be used to buy and fix up a couple of brick bungalows in Chatham or Pill Hill, two of the most desirable neighborhoods in Chicago. They'll rent for a combined 2700, to a higher quality tenant (resulting in less turnover, less management, higher ROI). While the properties may still not experience future appreciation (refer to the article in link above) there is appreciation baked in, achieved by buying it undervalued. In this example, a cost basis of ~65% of current market value. Overall, this strategy is less work, less risk, and earns a higher return than the stereotypical turnkey duplex.
Alternative 2: For those willing to assume more work and risk, in exchange for a higher ROI. The 170k could be used to buy 4 houses in neighborhoods similar to where the turnkey property is located. This would bring in 5000/mo rent. Many of the issues would be the same, but compared to equivalent multifamilies, detached houses are able to attract the best of the applicant pool and command higher rents.
Alternative 3: If asset appreciation is more important than interim cash flow, there are areas where gentrification is most likely to occur. These areas are obvious, and that anticipation is reflected in the prices. In the short run, the property bought for 170k might look and operate a lot like the turnkey duplex. But over the course of ownership, the IRR may be vastly superior because of exit strategies like a condo conversion 10 years down the road.
No matter what the investment goal is, turnkey properties aren't a good way to get there. I’m throwing down the gauntlet to any turnkey advocate. Please challenge me on any of this as it pertains to Chicago. I’d love to hear your case. If you provide the details of a deal we can analyze it here for all to see.
