Turnkey Investing: The Hidden Costs You Should Know About

by FI Fighter on May 15, 2015

in Real Estate Thoughts

turnkey

Turnkey Investing has become very popular with investors, especially over the last few years. In many cases, you have real estate investors (and prospective real estate investors) armed with a good amount of capital to deploy, but no local market to deploy it to.

For instance, if you are like me and happen to live in a very expensive housing market (Bay Area), or in other parts of the country where you can’t even buy a 1 bedroom shack for under half a million dollars, getting more “bang for your buck” is something you probably daydream about regularly. Today, in the Bay Area, a 20% downpayment for the aforementioned  $500,000 shack is still a significant $100,000, which is nothing to sneeze at. Once you add up PITI (principal, interest, property taxes, and insurance), to your horror (and perhaps surprise), you’ll quickly realize that the monthly rent won’t be able to support all your expenses! Forget about even setting aside a little extra for reserves (CAPEX, maintenance, and vacancy), which will inevitably happen…

So, it’s no wonder why many people have stopped investing in their local markets… the cash flow numbers don’t make sense anymore (and not every investor is as enamored with appreciation and total returns like I am). Unless you already have a very solid real estate portfolio (and overall portfolio) in place, or partners, the prospect of dishing out $100,000 only to lose money every month (negative cash flow!) is one that I don’t think appeals to many investors.

Turnkey Investing

Enter Turnkey Investing. By going outside your local market, there now exists a very easy and straight-forward way for out-of-state investors to pick up more affordable properties that generate positive cash flow.

Turnkey is nothing more than a fancy word used to describe a property that has been renovated to the point where it is rent-ready. For instance, I oversee all the renovations of my own local rental properties in the Bay Area, so you could easily argue that these properties are ALSO turnkey, even though they weren’t bought out-of-state, or through a turnkey company.

Turnkey Investing is a term used to describe out-of-state investing, where an investor purchases turnkey properties from a company who not only performs the renovations, but will also typically run the property management (PM) service for the investor as well, upon completion of the sale. Although not always the case, turnkey investing usually refers to buying properties from a “one-stop-shop” who will perform (or outsource within their own network) all the work (renovations, repairs, maintenance, etc.) and services (tenant screening, marketing, lease-up, PM, etc.) for you.

When you purchase from a turnkey company, they will guide the investor every step of the way, which is why turnkey investing is most suitable for novice real estate investors.

Of course, there are no free lunches. With turnkey investing, be prepared to pay full market value for any property that you purchase; that’s the price you pay for convenience and hand-holding. The turnkey company makes their money on the resale of the renovated property to you (essentially a flip). Chances are great that these turnkey companies picked up their properties at foreclosure, otherwise this business model wouldn’t work because there wouldn’t be enough margin in place for everyone to “win”. There’s a reason you don’t see turnkey companies operating in expensive markets that have little to zero foreclosures (e.g. Coastal California)…

Due Diligence

Although turnkey investing can be a viable investment platform to help an out-of-state investor locate a better cash flow market than their own local one, there are a few hidden costs that you should be aware of.

Once you have invested in real estate for a long enough period of time, you will know to never trust anyone’s (let alone a seller’s) pro forma. In an effort to better market their properties, a seller will ALWAYS try and present the “best case” scenario, which will most likely not reflect reality.

As part of the due diligence process, an investor needs to verify the numbers for themselves as best they can. When in doubt, it’s better (safer) to err on the side of caution and run more conservative projections. It’s much better to over-budget expenses and be pleasantly surprised at the end of the year when your actual results exceed your expectations, as opposed to under-budgeting and running into trouble later.

When it comes to turnkey investing, here are some common hidden costs that often get misrepresented or forgotten on a seller’s pro forma:

Lease Up Fees

Naturally, any company that is conducting business with you for the first time will want to get off on the right foot. Turnkey companies are no different, and as a part of their service, almost all of them will lease up your first tenant without charging you a fee. In many cases, a condition to closing a property is for the investor to have a tenant already leased, occupying the unit, and paying rent.

That’s all fine and dandy the first time around… But over the years, things will change. Your tenant will eventually move out and you will have to find another one. The next time around, you can be certain that you will have to pay a lease up fee.

A lease up fee is the expense needed to market and show your rental unit to prospective applicants. Also, it includes the expenses needed for the time it takes someone to screen tenants (background, criminal, employment checks).

Typically, lease up fees are 1 full month’s rent. For example, if a new tenant signs a 1-year lease and agrees to pay $1,000/month in rent, you will lose out the entire first month’s rent of $1,000 to pay for the lease up fee.

Lease up fees may or may not be negotiable. I’ve seen some PM companies charge 50%, and as low as 30%. Regardless, if you intend on relying on a PM company to perform this service for you, you must account for this expense in your pro forma.

HOA

When purchasing turnkey properties, even if you are buying single family homes (SFH), chances are good that you will also be on the hook for HOA fees. Conveniently enough, this is a hidden cost that I’ve seen too often neglected from a seller’s advertising materials. And HOA fees can vary greatly, so make sure you verify this cost before moving forward with any transaction.

HOA fees can be as low as 10’s of dollars a month to as a high as 100’s of dollars a month. Yes, I’ve seen a case where a SFH had HOA fees as high as what you might expect to find with townhouses and condo units!

As a reference point, my SFH turnkey property in Indianapolis, the HOA fee is $157.50/year, or $13.13/month.

Property Taxes

Property taxes are typically a heavy burden on expenses, so you need to verify with the county that the seller’s projected figures are indeed accurate and correct.

A sly and deceitful tactic that many turnkey companies employ is to advertise to the unsuspecting investor property tax figures from the previous tax year that will not be applicable to the new owner.

As a reference point, my SFH turnkey property in Indianapolis was advertised to me with property taxes set at $720/year, or $60/month.

What the seller failed to inform me was that the previous occupant was a homeowner living in Indianapolis, and therefore qualified for exemptions that an investor would not be able to claim.

Once I took over the home as an investor, the property taxes were re-assessed, and my property tax cap shot up from 1% (homestead property) to the max rate of 2% (all other residential property). My taxes increased to $2,010/year, or $167.50/month.

That’s an increase of over $100/month in expenses!!

Now, I’m not saying that all turnkey sellers are dishonest and will resort to utilizing such unscrupulous methods, but as an investor, you owe no one the benefit of the doubt. To be certain, verify for yourself.

Utilities and Landscaping

Utilities can be a killer expense, so make sure you verify who is responsible for paying what. For single family homes (SFH), it is typical (but not always) for the tenant to pay for: gas, electric, water, trash, and landscaping.

For townhouses and condos, water and trash may be bundled and included with the HOA bill. This is not always true, so if you have a HOA associated with your property, verify with the association and make certain where their responsibilities start and end.

For multi-family units (2+), typically (but not always) the water is not individually metered, so the landlord (owner) pays for water.

If you are purchasing a home in an area that experiences rougher climate (e.g. heavy snow), also verify who will pay for snow removal.

As a reference point, my tenant pays for: gas, electric, water, trash, landscaping, and snow removal for my SFH turnkey property in Indianapolis.

As a reference point, my tenant pays for gas and electric for my multi-family 2-flat property in Chicago. I, as the owner, am responsible for paying for: common area gas and electric, water, trash, landscaping, and snow removal.

Rent-Ready Turnover

If vacancies didn’t hurt badly enough, here’s another expense that is seldom accounted for — rent-ready turnover.

Once your old tenant vacates the premises, the PM company will need to go into the unit and perform routine maintenance to bring the property back to rent-ready condition. This may be as simple as re-painting the bedrooms and fixing a few minor issues, or it can involve a lot more work, such as having to install new carpet.

Typically, a tenant will have to put in a security deposit upon move-in to account for any unforeseen rent-ready expenses, but it is no guarantee that the deposit will cover all the damages. If you aren’t lucky, your old tenant will leave the unit behind in even worse condition than when they moved in.

Here are all the expenses associated with my previous (first) rent-ready turn in Indianapolis:

General repairs: $460
Trash out: $100
Carpet cleaning: $110
Market clean: $180

Total: $850

As a reference point, my current tenant in Indianapolis will not be re-newing her lease this upcoming May. Prior to departure, my PM has discovered that the garage door has been damaged; the tenant apparently drove her car partially through it, leaving it to come off the tracks. Assuming that her security deposit will be insufficient to cover all repair expenses, the owner (lucky me) will most likely have to pay the difference…

Sure, you could attempt to chase after the leaving tenant and hope that they pay, but realistically, how good are those odds?

To be safe, it’s a good idea to budget ample rent-ready turnover costs before they happen…

Eviction Fees

When at all possible, do everything that you can to avoid an eviction. I have been through two of them myself, and it is no fun at all! The importance of proper tenant screening cannot be overstated because an eviction or vacancy is just about the worst thing that can happen to vaporize your cash flow.

Previously, I evicted a tenant from one of my Chicago units, and it turned out to be a very costly affair!

Here are all the expenses associated with my eviction in Chicago:

Attorney Fee: $922
Settlement Fee: $750

Total: $1,672

Here are all the expenses associated with my eviction in Indianapolis:

Eviction Fee: $100
Township Filing Fee: $86
Writ-For-Possession: $13

Total: $199

To make matters worse, evictions can drag and take a lot of time to complete. So, not only are you coming out of pocket for the above costs, but the unit will also NOT be generating any rental income for the duration of the eviction period.

As a reference point, an eviction in Chicago can typically takes ~2 months.

As a reference point, an eviction in Indianapolis typically takes ~1 month.

Depending on where you buy (landlord friendly or not-so-friendly market), the time to complete an eviction can vary greatly…

Inspection Fees

If you are renting out to Section 8 tenants, there is a mandatory annual inspection that your unit must pass before a lease can be re-newed by the Section 8 authorities.

Depending on how many times it takes your unit to pass the inspection, the inspection fee will vary.

As a reference point, the CHA inspection fee in Chicago is $75. Units typically require 1-2 inspections before passing.

Abatement

To further touch on the subject of Section 8, if you are investing in these types of properties, it is important to know about the abatement process and how that works.

At any time, a rental unit can fall into abatement (e.g. failing annual inspection, or a tenant calls in at any time and files a complaint regarding a maintenance item that causes your unit to violate code), which will cause the Section 8 subsidy to stop immediately. Once a unit is in abatement, it becomes an imperative that your PM expedite the fixes/repairs so that an inspection with the Section 8 authorities can be scheduled ASAP.

Only when a unit passes the inspection will the abatement be lifted. Once the abatement is cleared, Section 8 subsidies will resume and continue forward. Typically, if your unit falls into abatement, it will take a few months for Section 8 to reimburse you for prior rents…

As a reference point, one of my units in Chicago fell into abatement in March when my tenant called CHA and alerted them of a maintenance item (of course I wish she had contacted the PM, instead!). Repairs were made and re-inspection of the unit were scheduled in April. However, due to the process, CHA will not resume payments for this unit (and back-pay the previous months’ rent) until May 01.

Although an abatement does not force you to pay any bills, the lost rent is what is ultimately damaging. So, if you are investing in properties that are reliant on Section 8, you need to make sure to budget a generous portion towards vacancy reserves. I would budget no less than 15% of gross rents, but probably closer to 20% to be on the safer side.

Conclusion

Turnkey Investing can make sense for an out-of-state investor who is looking to find a better cash flow market than perhaps the one in their own backyard. With that said, it is ALWAYS important to perform sufficient due diligence and to make sure to verify as much information as possible. When that isn’t possible, it becomes prudent to budget in extra buffer for unforeseen expenses that most likely will occur from time-to-time.

Over time, I have learned to set aside as an ABSOLUTE MINIMUM of 20% gross rents to allocate towards vacancy (missed rents, lease up fee, reserves for eviction/abatement) and maintenance (general repairs, CAPEX, rent-ready repairs, inspection repairs for Section 8, etc.) items when investing out-of-state (if you are dependent on a property management team; you can reduce costs greatly if you self-manage, of course).

Again, it is always safer and a better habit to err on the side of caution. Expenses do add up, and with rental properties, they tend to pile up when you least expect it.

It is imperative that any cash flow numbers you are running still make sense with all the above hidden costs factored in before you proceed with purchasing.

 

Happy Investing!

{ 5 comments… read them below or add one }

1 No Nonsense LandlordNo Gravatar May 15, 2015 at 1:32 pm

Great thoughts. Too many people see the money that can be mace in RE, and think it is easy. There is a reason the return is so high, RE is one of the riskiest investments you can make in the short run.

Great advice about the cost of a bad tenant. One bad tenant can kill your returns for an entire year or more.

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2 SpencerNo Gravatar May 17, 2015 at 4:43 am

Thanks FI for the dose of realism. Good detail and gives some depth on why (or part of why) you like investing locally.

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3 MartinNo Gravatar May 17, 2015 at 9:24 am

Oh my me, I am glad not to be involved in this type of investment. I am happy for you (and a bit envy you) that it works for you and feel good about it. For me this would be a burden. Like evictions, grrrr, happy I do not have to deal with it in stocks or options. But true, options offer another sort of troubles which you may not feel comfortable with, so we are now even. Good luck man!

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4 BrianNo Gravatar June 16, 2016 at 6:35 am

Thanks for the excellent blog post. I enjoy reading articles like this. One question for you. Are you afraid your underestimating CapEx expenditures. If you’re buying turnkey, likely you’ll have a new roof, new electric, new hvac, etc. But, after reading a few articles around the web, a conservative estimate to set aside for CapEx, seems to be in the $175/month range. If most turnkey properties cash-flow about $200/month after all/most expenses, doesn’t turnkey now seem more like a break-even?
I’m very interested in investing in turnkey, but once I read this article about capex, I’m not so sure that it works for me.

https://www.biggerpockets.com/renewsblog/2015/10/13/real-estate-capex-estimate-capital-expenditures/

Thanks for any insight you can provide. Looking forward to continuing to read the blog!

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5 PortiqoNo Gravatar January 11, 2017 at 12:25 am

This is a very useful post for new landlords and investors in the real estate industry. It is important to have a firm understand on all the costs and fees which you might face before stepping in this industry. Thanks for sharing this highly informative article.

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