Turnkey Investing: Ways to Mitigate Risk for Out-of-State Investors

by FI Fighter on May 22, 2014

in Real Estate Thoughts

turnkey

In a previous article, I talked about ways a real estate investor can mitigate risk in a rising market. One of the options I touched on was to invest in a better cash flow market. For many investors, unfortunately, focusing on better returns means having to leave the local area, or investing out-of-state.

Out-of-state investing is becoming more popular and common these days. There are many turnkey companies, and as word-of-mouth spreads, it will become increasingly easier for investors to locate the good, reputable companies out there. I’ve been investing in turnkey properties for almost a year now, and am still in the “test driving” phase of things. I currently own properties in Indianapolis and Chicago. I have plans to get started in Dallas or Houston later this year.

As I mentioned when I first got started, I’ll have to try this whole turnkey thing out for a few years before I can declare definitively whether or not it really works. For my own situation, the verdict is still out, but I do update my progress each month in the form of Cash Flow Statements. Any obstacles or hurdles I face, I make sure to document and share with readers.

With that said, I can empathize with anyone who’s looking to get started with turnkey investing and feels a bit nervous, or uneasy about the whole process. Purchasing real estate in your own local market (one that you understand) can be scary enough as it is!

So, how does one go about mitigating risk while investing in turnkey properties out-of-state?

Focus on Quality

First off, there are no guarantees with ANY rental properties, whether it be turnkey or not. For instance, you and I could go buy properties next door to each other tomorrow, and over 30 years, encounter vastly different results. With rental property, there will ALWAYS be unknown variables that you simply can’t account for in advance.

However, you can definitely do your part to increase your odds of success with a rental investment. When in doubt, you can mitigate risk substantially by focusing on purchasing quality properties. It’s very easy for an investor to start off chasing after yield, or Return On Investment (ROI), but if you are just starting out with turnkey investing and want to be careful, focus on buying something good.

What does it mean to “buy something good”? Well, for starters, it probably means not buying the cheapest house that’s available. In any market, if you want higher quality, it will come at a price. There are no free lunches. ROI is important, but to reduce risk, sacrifice a few percentage points and focus on quality, quality, quality.

If you buy high quality, you will have the following advantages:

  • More demand from tenants and easier to rent.
  • Greater ability and flexibility to raise rents over time.
  • Better neighborhood location which attracts better tenant applicants (higher income, better credit score, etc.).
  • Higher probability of locating long-term tenants.
  • Stronger potential for price appreciation.
  • Easier to sell.

In my own classification of buy-and-hold properties, I would say “high quality” properties are those that reside in Class A+, Class A, and Class B neighborhoods. To locate cash flow in today’s market, and still buy high quality, your best bet is probably found in Class B.

If the returns leave a lot to be desired in the Class B space, you might need to consider Class C. It is still possible to locate quality in Class C, but it may take a lot more effort. Again, there are no free lunches. In general, if ROI goes up, so does the risk.

Do Your Research

There are so many great online tools out there, that it should be relatively easy, even for an out-of-state investor, to conduct proper research. These days, you really don’t have an excuse for not performing your due diligence! Yes, of course it’s ALWAYS best to actually go out and visit the property you’re considering purchasing (and the prospective turnkey company), but if your schedule doesn’t permit for that, do the next best thing — research online!

Want to know what the surrounding neighborhood is like? Is the property close to schools, freeways, stores, jobs, etc.? Use Google Street View and drive around virtually.

Do you have questions about the desirability of the neighborhood? Do you want to know if the schools are up to par? Check out the school ratings using Zillow or Redfin.

Are you concerned with crime? Is buying into a safe neighborhood of supreme importance to you? Give Trulia Crime Map a go.

Do you have doubts that the seller proforma is overestimating rents? Use Craigslist and look for nearby comps and see what rent is going for.

Want to know what the local investors think of your property and its potential? Network with the local folks over at Bigger Pockets forum.

Plan Your Exit Strategy

Before ever signing a contract or agreeing to purchase a turnkey property, you should have a very CLEAR understanding of what you are looking for with your investment, and what your long-term strategy is.

  • Are you purchasing this property primarily for cash flow or price appreciation?
  • Is this property a long-term buy-and-hold, or do you plan to sell it someday?

It’s important to ask these questions because unlike with stocks, it can be extremely difficult, costly, and time-consuming trying to liquidate a property.

My own experience:

Chicago:

I own two 2-flats in South Chicago. My strategy with these properties is to keep them as long-term buy-and-holds for the cash flow that they provide. I purchased them purely for the cash flow, and do not hold my breath for ANY long-term appreciation.

Further, I don’t plan on selling these properties because they’re located in investor-rich territories. The market for home ownership is slim in these parts, so my only real exit strategy would be to sell back to another investor. When dealing with other investors, it’s almost impossible to sell for a strong profit because these folks will know how to run proper cash flow analysis. The reality is, there won’t be any emotional homebuyers to bail me out…

Indianapolis:

I also own a newer construction single family home in Indianapolis. This property is located in a desirable suburb, and I would guesstimate that there are more owner-occupied homes than there are investor owned properties. Again, I purchased this property purely for cash flow. Similar to my Chicago investments, I don’t anticipate seeing much future price appreciation.

However, should the need to sell ever arise, I have a lot more confidence in being able to unload this Indianapolis property. Since it is located in a strong owner-occupied neighborhood, and it is a single family home (the most desirable type of property out there), I don’t have any doubts that I will be able to sell it back for market value (or slightly above) to a prospective homeowner.

As you can see, I own three turnkey properties that I consider purely buy-and-holds (no price appreciation), and of the three, two of them would be more difficult to sell back. In my own situation, I’m willing to accept the fact that I am investing in these out-of-state properties strictly for cash flow and not for appreciation. Then again, I also own two local Bay Area properties that provide excellent potential for appreciation, so it makes it easier for me to make that type of compromise. If I didn’t own the two local properties, perhaps I might be targeting locations and homes that offered a bit more appreciation potential, but sacrificed some ROI…

It is important for any investor to map out their gameplan and figure out what the long-term exit strategy is. If you have never been a landlord before and are unsure if it is suitable for you, it may make a whole lot more sense to buy the right type of property that is more easily liquidated. Going back to the first point, this means again focusing on buying a higher quality home that has appeal to other homebuyers.

Also, in my own situation, because I already own a few properties in wonderful neighborhoods, I am more able to take on the calculated risk of chasing after higher yield in some potentially less desirable locations on a few properties… You have to figure out where exactly you are on your roadmap, and decide if such a strategy makes sense for your own situation.

Knowing my exit strategy for these properties (and overall portfolio) helps me plan for future purchases…

Assume the PM Leaves YOU Someday!

It’s all too easy to fall under the spell of a strong sales pitch. Let’s assume that the turnkey company you are considering working with has just given you a presentation and blown you away with their offering. Their product looks incredible, they are highly professional, their references all check out, and the ROI numbers look excellent on paper. All in all, this turnkey company appears to be a well-oiled machine!

Because everything looks so promising, you’ll naturally want to assume that the property management (PM) they have in place will do an outstanding job managing your investment…

Any maybe they will… at first. But what about in Year 2? Or more importantly, Year 5? Year 10? Will the turnkey company you’re working with today even still be in business later? Assume that they won’t. Who’s to say that the turnkey company won’t make a fortune selling properties to investors today, and start heading for the exits (towards the beach) tomorrow?

Should your PM one day decide to close shop and leave, will your investment still be able to stand on its own? Do you have full confidence in being able to hire an independent PM to take over management? If you have any doubts at all, you may want to reconsider whether or not the property and turnkey company you are considering are worth the risk.

Diversify Geographically

If you are going to be buying an out-of-state turnkey property, chances are good that the property won’t be within driving distance of you. Most likely, the property will be located at least a few hours away by plane…

If that’s the case, and presuming you want to go on purchasing more properties, would it really make ANY difference whether or not your properties are all located in say Chicago? Or, if they are spread out across multiple locations: Chicago, Dallas, Indianapolis, and Memphis?

Regardless, with you being out-of-state, the reality would be that the properties would all be VERY FAR away from you.

So, why not mitigate risk by diversifying geographically? That way, should the local economy in any one particular region experience a steep decline (Detroit anyone?), your entire portfolio wouldn’t be in jeopardy.

I once talked to an investor who told me to be extra careful with investing out-of-state. He told me about his most dreadful experience, and how he lost EVERYTHING. Apparently, this guy made a fortune flipping houses prior to the housing bust of 2008, and decided to roll all his profits into buying turnkey properties in a very specific market. He literally decided to put all of his eggs into one basket. Over time, the properties didn’t perform, and he became so burned out with them that he decided to just let them go. Most of the properties went into foreclosure, and he sold off the rest…

After he was done telling his story, I asked him why he chose to put all his capital into just one market. His reply? “Because I was a f*ckin idiot…” That taught me the importance of geographical diversification when investing out-of-state…

Use Multiple Turnkey Companies

Expanding on the idea of diversifying geographically, why not consider using multiple turnkey companies (especially when first starting out)? Again, why put all your eggs in one basket and risk the entire portfolio? No matter how solid you think the turnkey company you’re considering using is, you just cannot predict the future. What if the owner of the turnkey company decides to sell the business someday, or the leadership direction of the company changes drastically… for the worst?

And to err on the side of caution, you just never really know what goes on behind the scenes. Being out-of-state means that you have even less visibility into the day-to-day operations of the turnkey company. The last thing I want to read in the newspaper is an article about how my turnkey company has been scamming its investors… It sure would be even more painful to swallow this information if I knew I had 100% of my properties under control by this same company!

Over time, you will learn first-hand which companies are doing the best job, and delivering on their promises. You will know which investments in your portfolio are performing, and which ones aren’t. It is only after you finish the “test driving” phase, should you consider making the important decision of deciding where to entrust your money (the bulk of it) moving forward. Give it some time, gain some experience, and let the companies earn your trust before you go “all in”.

Buy One At a Time

There’s no need to rush into turnkey investing. Even if you do have the capital to invest heavily all in one go, it may be a shrewd move to “test drive” one property for a few months (or years) before signing up for another one.

Keep in mind, with turnkey companies, they are purchasing homes in areas where the ROI makes sense for an investor. In general, for a single family home, this means that the purchase price will fall in the “sweet spot” range of under $150,000. Rents don’t scale with purchase price, so the cash flow stops making sense as properties get increasingly more expensive.

What this means is that you don’t have to worry so much about making an impulsive decision! Even if the market is appreciating at a rapid rate, these turnkey properties won’t be climbing anywhere near as fast. For instance, I purchased a 2-flat in Chicago last summer for close to $160,000. At most, it would be worth $170,000 today… In comparison, my second Bay Area property was purchased last February for $290,000. It’s worth at the very least $400,000 today…

Don’t worry, you have plenty of time to purchase a turnkey property! Be patient, do your research, and wait for the right property to present itself before making any sudden moves.

Ask Lots of Questions

As part of your due diligence, you should be asking any prospective turnkey company a ton of questions. There are lots of options out there, so if you hear something you don’t like, do not be afraid to walk away. After all, the company you elect to purchase from will most likely also be managing your property for you. If you are a buy-and-hold investor, this means you will be establishing a long-term relationship. If the company doesn’t give you the right vibe, feel, or chemistry, keep on searching.

Summary

Turnkey investing can be a suitable investment for income investors who aren’t able to locate strong cash flow deals in their own local market. By making use of a turnkey company, you rely on local experts to do all the work for you: identify, acquire, rehab, and manage the property. You pay a premium for these services, and each month you collect semi-passive income. On the surface, this type of arrangement looks like it can be one that is mutually beneficial to both parties. As an out-of-state buyer, though, it is of paramount importance for you to do your due diligence (ask a lot of questions). Buying out-of-state will always be inherently more risky than purchasing locally, so to mitigate risk, focus on: buying quality, doing extensive research, and planning accordingly (exit strategy and possible future PM scenarios). When you are ready to make a move, consider proceeding with caution by starting out with just one property at a time. Over time, consider diversifying your investments geographically, and using a second source turnkey provider to further reduce risk.

{ 10 comments… read them below or add one }

1 No Nonsense LandlordNo Gravatar May 22, 2014 at 4:53 am

Great points. Turnkey can be good, but you need to be realistic. An apartment turn can be exponentially more expensive. An eviction a very bad deal.

Never assume that the PM will be looking out for your profits. They make more money on a bad tenant, than a good one.

Reply

2 FI FighterNo Gravatar May 23, 2014 at 11:08 pm

Eric,

Right, evictions can be painful, so one way to mitigate risk would be to buy in higher quality neighborhoods, which was mentioned in the first bullet point.

Nowhere in the article should it have implied that the PM was looking out for your best interests… In fact, I would say even if you have a great PM in place, always have a backup plan and plan for the worst-case… they leave one day and you have to find another one…

Take care!

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3 Andrew@LivingRichCheaplyNo Gravatar May 22, 2014 at 6:24 am

Living in NYC, it’s difficult to buy rental properties since housing costs are so high. Though I have friends who are thinking about it looking for the next “up and coming” neighborhood. The prices here do jump a lot so it is tempting but even places in bad but possible up and coming neighborhoods are expensive, comparatively. If I do a turnkey I would highly consider upstate New York where real estate is affordable. My wife went to school there and my brother in law still lives there. Maybe a place near the university. We’ll see. Interesting point about diversity…I would have thought being in one location with one turnkey company would be better since you’d be able to visit them all in one shot and maybe the turnkey company would give you a discount on multiple properties.

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4 FI FighterNo Gravatar May 23, 2014 at 11:11 pm

Andrew,

Sounds like you have some options, and as someone who also lives in an expensive area, I know how frustrating it can be trying to buy in the local market when the numbers don’t work.

Buying in one location with one company can have its benefits, like you mentioned, and you might be able to get discounts for buying in bulk…

To mitigate risk, I would spread out just to make sure I wasn’t overly invested in just one local economy. Similar to how stock investors buy into different industries… you have your energy stocks, consumer staples, tech, utilities, etc.

All the best!

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5 MrsFinancialFreedomNo Gravatar May 22, 2014 at 7:56 am

Before I started reading PF blogs, I had never heard of turn-key investing before and am not sure what it’s called or even if the ides exists over here in the uk. I’m sure it does but don’t know what the term is.

I think if I do go the REI route, I think I will have to buy in a different part of the UK as buying in my local area doesn’t seem to be stacking up cash flow wise at the moment. And if I do buy elsewhere, then I would definitely employ a management company to manage the property.

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6 FI FighterNo Gravatar May 23, 2014 at 11:13 pm

MrsFinancialFreedom,

Yeah, if the numbers in your local market don’t work, you may need to look elsewhere to make REI a viable option for you.

A PM is a good idea, and something I feel like I must have in place when I reach FI b/c I won’t want to be managing properties all day with my free time.

When running numbers, it would be a good idea to budget in PM fee, even if you self manage at first since you might want to go the PM route at some point…

Cheers!

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7 Dave @ The New York BudgetNo Gravatar May 22, 2014 at 3:07 pm

Another solid post! I like the common thread throughout all your sections that investing in real estate in general is not something to be taken lightly – even with all the due diligence in the world, the landscape can change and you might have to hustle to find a fix. If you aren’t willing to do that, it may not be the right thing for you.

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8 FI FighterNo Gravatar May 23, 2014 at 11:14 pm

Dave,

Definitely, REI always involves risk and isn’t suitable for everyone… The landscape can definitely change in a hurry and you have to be able to endure the rollercoaster rides.

That’s what makes buying right so important… You want to put yourself in the best possible position to succeed long-term.

All the best!

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9 A Frugal Family's JourneyNo Gravatar May 22, 2014 at 9:06 pm

Great post…I always wonder how you can sleep well at night even though your properties are spread out in so many different places. 🙂 I have given some thought of investing in a rental property and would like to add a property or two to our portfolio one day so this information is helpful.

Dividend Growth Stocks is a great income stream that I will continue to grow but I want multiple streams of income in case there is issues with one. 🙂

Thanks for posting…Best Wishes in your journey to FI!

Reply

10 FI FighterNo Gravatar May 23, 2014 at 11:16 pm

AFFJ,

I’ve accepted it since I plan on traveling overseas extensively in the future… so, to me, it doesn’t really matter where my properties are located… they will be very far away from me while I’m traveling.

I like your idea to diversify into different types of investments. I don’t have any DGI stocks at the moment, but I will definitely get back into the game once I’ve finished building my real estate portfolio.

All the best!

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