Real Estate 043: Turn-Key Properties, too good to be True?

What is a Turn-Key property?

There is no formal definition of "turn-key", and its meaning can differ from region to region, company to company. However, I can better explain this by sharing what I believe is a turn-key property and you can make  your own informed judgment.

To me, turn-key properties mean that they are generally older homes that have been restored and are considered "rent-ready" by you or the property management company. During the initial purchase of your turn-key property, you should receive a seller's disclosure and statement of work (SOW) from the seller informing you of the items that were replaced or serviced during the rehab.

Typically, if you have purchased a "turn-key" property from a legit provider, you should have received a property with little to no deferred maintenance (i.e. big ticket items that cost $1-5K or more such as roof, HVAC, hot water heater, furnace, etc. with useful life less than 5 years).

BENEFITS

As mentioned in my previous post, if you work with a TurnKey Company, you will eliminate 3 (acquisition, rehab, maintenance/management) of the 4 steps of the investment property process. These are very beneficial for people who do not have time to conduct the research, oversee the rehab, and manage their properties.

Acquisition: 
The TurnKey provider identifies the distressed property (REO, foreclosure, etc.) and purchases the property. They own the title. If they do not own the title, you are working with a middleman/marketer!

Rehab: 
The TurnKey provider will perform the rehab and replace CapEx items and make them "rent ready". Be very wary of "lip stick on a pig" where bad turnkeys will purchase a property, apply some paint, clean the floors, and sell them as "turnkey". These properties may look nice and show good returns on paper, but they will cause maintenance problems down the road and bleed you out slowly. Make sure you talk to other investors, ask for the Statement of Work (SOW) of what was replaced/seller disclosures, and ask about the warranties on the rehab (most places give 90 days, good turnkeys give up to 1 year).

The last thing you want is to buy a lipstick on a pig thinking you have great numbers and a beautiful property during year 1, only to find out that there are thousands of dollars worth of work needed in years 2-5 that will put you in the red.

Simple illustration (Bad Turnkey): if you have purchased a property for $100,000, downpayment and closing costs of $24,000 and rent is $1,100 (1.1% rent to value ratio), now take into account mortgage estimated $400, insurance $70, management $110, taxes $70, vacancy $88 and maintenance $88 for total expenses of $826. Your Gross rental income of $1,100 - total expenses $826 = $276 which is a 13.8% cash on cash - awesome, right? 

Not so fast. $276 a month will equate to $3,312/year, but a lipstick on a pig may result in replacement of the HVAC $5K, roof $5-10K, hot water heater $1.2K, furnace $3-5K. In addition to these major repairs, the $88 reserve/month for maintenance not be enough to cover  routine maintenance calls on plumbing, toilets, etc. if they were not properly reviewed/rehabbed from the beginning. Hope I didn't scare you as this is an extreme example and one to ensure that you do your due diligence before working with TurnKey providers.

Management/Maintenance: 
The Turnkey providers will typically charge 8-12% of the monthly rental income in fees as well as have other fees such as lease up fees (marketing/placing a new tenant), lease renewal fees, and other fees. In exchange for their fees, they provide services such as finding a tenant, periodic check up on your property, proper bookkeeping, and answering maintenance calls, to name a few. I feel that these services alone are well worth the fee. Its less headache for you and more time for you to enjoy doing things you love and spend time with loved ones.

Maintenance calls vary by property management company, as they may have an in-house handyman or outsourced contractor. They may charge only cost of the repair + markup, or cost + standard $40/hr (example). Typically, property managers will maintain a $500 reserve for each rental property and will approve repairs below this threshold, anything above this amount is communicated to you (owner) for approval of the repair.

DRAWBACKS

Now that we have covered some of the benefits of turn-key providers, let's dive into some of the cons of using a turn-key company.

1. You are paying market price: 
If you work with a turn-key provider, the fact is that you will be purchasing the property at market price (little to no equity). There is a saying that money is made in real estate when you buy (low) or sell (high). When you are buying at market value, you are technically going in knowing that your transaction costs alone will keep you from selling the property before 5 years at break even (exit plans are limited). You will need to hold the property for at least 10-15 years for you to break even (unless there is crazy market appreciation - this will not be true for linear markets in the midwest). However, not to fear, if you have analyzed the property carefully, it should cash flow, and that is what buy & hold investors, like myself care about.

You will notice that the appraisal of the property will come in at or slightly above purchase price. In situations where the appraisal comes in lower than the purchase price, I highly recommend you re-evaluate the deal to negotiate with the seller to reduce the price, or walk away/find another deal. There are simply too many deals for you to bring cash to the table to close, simply because the property is not appraising for the asking price.

2. Requires large capital: 
As mentioned in the previous post, there are many ways to obtain financing for your rental properties. The most common approach is conventional financing through a portfolio lender. Portfolio lenders are lenders who specialize in working with investors and offer conventional products such as the Freddie Mac/Fannie Mae loans. Portfolio lenders typically have rates 1% above the current interest rates that you may be able to obtain for your primary residence (i.e. 4.25% + 1% = 5.25%). However, these lenders are well versed in working with investors, turnkey companies, and market realtors and can provide guidance in financing your first 10 properties with Fannie Mae.

Note: your first 4 properties require 20% down payment, but properties 5-10 require 25% down payment. This is something you may want to think about when strategizing the purchase price of the first 4 homes. For example, if you buy low end homes at 50K for your first 4, its a 10K downpayment per home. However, if you planned to acquire homes in the 100-150K range, that could result in an additional 5-7.5K downpayment per property.

I believe that scaling your rental portfolio carefully and quickly is critical in your success. I like to use the Pareto principle/Law of Averages and assume that at any given time, 20% of my portfolio may losers and 80% may be winners. That is, 20% may have bad/trouble tenants, high turnover, maintenance, etc. However, if I am careful, the income from the other 8 (out of 10) should be more than enough to cover the issues found in the 2.

3. Lipstick on a pig: (sub-par rehab)

I hope this helps you understand the key pros and cons of using a turn-key company (I used one for my first rental). Some questions that you might want to ask yourself before choosing to go the turn-key route are:

• Does it make financial sense (rent to value, cash flow) to invest in my local market

• Do I have the right team and knowledge to do this on my own?

• Am I willing to manage my own property in a local market?

• How passive do I want to be (Note: Turn-Key does not mean its fully passive, however, a good turnkey company does mean you have the support of an experienced provider at your fingertips to provide guidance)

• What are my exit strategies? (Sell on MLS, sell to an investor, re-sell to a turn-key, owner finance sell to a tenant)

Whatever you decide to do, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision.  Work with people who have vested interest in your success! 

Good Luck!

Real Estate 040: Why Invest In Real Estate?

If you have stumbled upon my blog, I am assuming you are looking for ways to start saving money, increase your income, or find ways to create additional streams of passive income (cash flow). I love to read business, self-help books, and the more I read these books, blogs, and success stories, the more I realized that over 90% of these people built their wealth through real estate (the other 10% were a mix of entrepreneurs, celebrities, athletes, and employees who struck gold w/ start-up company stocks). For me, real estate is great not only because it is a tangible, hard asset, but it provides a basic human need - a roof over your head. 

There are a couple additional reasons why I like real estate as investments (not your primary residence, which I will discuss this in another blog post):

1. Leverage
If you have read the book Rich Dad Poor Dad, by Robert Kiyosaki, you will be familiar with the term "other people's money" or OPM. This is a fundamental concept shared in Rich Dad Poor Dad where by using good debt, or OPM, you can significantly increase your return on investment (ROI). For example, most real estate conventional mortgages will allow you to put down as low as 5% cash (with good credit and income, of course) for the purchase of your home. That means 95% of the home is financed by the bank. Now, this is a very simple illustration, and there are many different things to consider when choosing the amount of downpayment (i.e. Private Mortgage Insurance (PMI), interest rate, mortgage payment, etc.). However, by using leverage, you are able to preserve your hard earned capital for other future investments. 

Example:
Purchase Price: $500,000
Downpayment: 20% ($100,000)
LTV: 80% ($400,000)

You cannot pay $20 dollars for an apple stock worth $100 and have the bank finance $80 (Not speaking about futures, options, margins, which is a whole different ball game). In a place like California where I live, real estate prices for a single family residence is so high (average $450,000) that without proper leverage, it would take me 10+ years to save enough money to buy a piece of real estate, let alone buy multiple. By using other people's money intelligently and analyzing the risk-reward, you can slowly build a portfolio that is leveraged and bring in cash flow for you every month.

Note: Other people's money can be anything from: Bank Financing, Private Lenders, Hard Money Lenders, Friends and Family, Home Equity Line of Credit (HELOC), and more.

2. Diversification
You may have heard the term, don't put all your eggs in one basket. This would have been good advice to the Enron employees who put their life savings, retirement funds, and other monies into the Company Stock which eventually plummeted to zero in the wake of the greatest accounting scandal that has rocked Corporate America. Although this is an extreme example, I personally am not comfortable having my retirement funds solely in the stock market. Although we have seen large gains (20%+ for my mutual funds during 2017 alone), I also know that these are all time highs, and this rise can't go on forever. I have diversified within my retirement account mutual funds to have a mix of cash, equity, bonds, U.S./International, REITs, however, if done carefully, tangible real estate properties will also be a great hedge against inflation as well as a means of diversification. Not only can you diversify in the type of properties: Single Family, Multi Family, Apartments, Commercial Buildings, but also in different markets like the West, Midwest, South, and Eastern states in the U.S.

3. Appreciation
Living in California, I have seen the tremendous appreciation that properties in my backyard have undergone in a short period of time. I was exposed to real estate during my parent's purchase of their primary residence back in 2012. Single Family homes with a typical 3 bed 2 bath around 1200-1600 sq ft were around $300-$350K in a decent B class neighborhood with an average school - places where you wouldn't mind raising a family. Looking at recent comps on Zillow or Redfin, I was shocked to see that these same homes that I walked through during 2012 are now selling for 500K or more, which equates to an annual return of 8.5% or total return of a whopping 56.3%!!! (Let me know if you find a mutual fund you can use leverage AND get those kind of returns!).

Now granted, I like to refer to the post Great Recession as the "golden years" roughly 2010-2014 where you can pretty much throw a dart in the U.S. housing market and come out ahead with massive appreciation (some markets more than others - coastal vs. linear). However, I personally don't rely on "appreciation" when I am analyzing real estate properties because it is like gambling. During the height of the housing boom in 2004-2006, people were drunk with appreciation until it all came crashing down, as such, I focus more on cash flow. That is, money in my pocket every month after all expenses (mortgage, insurance, tax, maintenance, vacancy, and property management have been paid).

4. Cash Flow
This is actually my top reason of why I invest in real estate, but naturally found itself here after appreciation. As mentioned previously, appreciation is "icing on the cake", but not my main focus. My main focus is to ensure that the property that I am investing in creates positive cash flow after all expenses are paid, and if it appreciates over time (hopefully outpacing inflation), then great! On the flip side, if there is another housing price correction and prices go down 15-20%, I am not that concerned, because although my rent may go down, I would have created enough cushion to make sure that the property is cash flowing and making money until housing prices go back in 6-10 years, just like it did in 2008-2016. In addition, if an investor was to take into account monthly cash flow + appreciation of rental properties, the total return on investment would be significantly higher than the average return of a S&P 500 mutual fund during the same period.

Cash flow will vary depending on the purchase price, down payment, interest rate, rental income, and other expenses/reserves. You want to be conservative during your analysis as there will always be unforeseen expenses, and being overly optimistic will set you up for a big disappointment.

5. Depreciation (Tax Savings) and Loan Pay Down
By using IRS rules, you can significantly reduce your tax liability through your investment properties. It should not be a surprise to you that some of the wealthiest people make more money but pay less taxes that the average middle or lower class using these methods. If you have an investment property, you can deduct all mortgage interest, property taxes, insurance, maintenance, repairs, and other fees (flying out to the Midwest to check on your rental property? expense it!). 

Depreciation is a powerful tool in which you can depreciate the value of your investment property over 27.5 years. Using the example above (Purchase Price: $500,000 - land value $100,000 = building $400,000), you can annually expense $14,545 each year. If you rental income was $3,000/month or $36,000/year, your taxable income would immediately be reduced by depreciation (We will later cover how depreciation will lower your tax basis, and how savvy investors use 1031 exchange to continually defer taxes and build wealth).

Loan Paydown is also another side benefit of owning rental properties. My strategy with real estate is buy and hold rentals. From running numbers and speaking with multiple investors, you will not be able to make money from real estate properties if you sell in less than 5 years simply because of transaction costs (i.e. agent commissions, escrow, title, etc.) unless you are buying 15-20% below market value, doing value add rehabs aiming for forced appreciation, or the market appreciates significantly during that period. With buy and hold rentals, if you do a careful analysis, you will make cash flow monthly, and benefit from the tenant paying down your mortgage debt every month that property is being leased. Please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!

Real Estate 008: BRRRR method of investing

In my previous posts, I have discussed different strategies to meet your real estate investing goals. I have recently come across a method that has been popularized by Brandon Turner at BiggerPockets.com but has existed and been used by savvy real estate investors who want to start investing using little to no money down. So what is it? The BRRRR method - stands for Buy, Rehab, Rent, Refinance, and Repeat. Lets take a closer look at each step below:

1. Buy

They say you make money in real estate in three ways: 1) buy 2) sell 3) cash flow. Knowing your numbers used in your BRRRR strategy is just as important as wholesaling, flipping, or buy and hold rentals. The main focus of the BRRRR strategy is to pull out all your money (in some cases, you may be able to pull out more than what you've put in) and end up with a cash flowing property with some equity. A general rule of thumb is to look for a purchase price that is 75% of the after repair value of the property.

For example: A home that has an after repair value of $150,000 * 75% (cash out refinance) - $25,000 est. rehab costs = $87,500 maximum purchase price.

If you are able to purchase below $87,500 or perform a quality rehab for under $25,000, then you will end up with more equity/less cash out of pocket. Note that the above calculation is a simple illustration and there are usually refinancing costs involved with the lender.

2. Rehab

The rehab budget is always an area of discussion among investors for many reasons. Here are my thoughts on the dollar amount on spent rehab and value add upgrades:

• There is a key distinction between primary residence (Owner Occupied) and rental properties (Leased). Simply put, renters may not need, nor would they pay the extra $25-50/month in rent to have all the bells and whistles that you would want for yourself. Granted, if there are two homes in a neighborhood with all things being equal and 1 has granite countertops/backsplash and the other has none, it may be more appealing and rent out faster. However, you have to decide for yourself, at what cost? For me, I am mostly focused on replacing key CapEx items with little useful life to reduce deferred maintenance as well as making the house livable and suitable for the market/neighborhood (an A class neighborhood will definitely have different upgrades than a C class neighborhood).

• You also have to decide what value add upgrades - new kitchen/new bath/new flooring will being the most return on investment. This is a great conversation with your property manager and rehab crew as they will have the most insight into the neighborhood and experience dealing with tenants.

3. Rent

The next key step is renting out the property after it has been properly rehabbed. Whether you decide to buy and hold or sell the property as "turn-key" alternative, renting the property will help you obtain refinancing with the lender. You can advertise and rent out the property by yourself, or I would personally recommend using a property manager who typically charge 8-12% of the rental income. Their marketing efforts, tenant screening, and maintenance handling should be well worth their fees. Make sure to received referrals from active investors in the market and interview multiple property managers. Remember, a good PM can make a good deal into a solid deal, whereas a bad PM can turn a solid deal into a horrible deal.

4. Refinance

You have crunched the numbers, bought/rehabbed/rented the property, so now you are ready to refinance and pull out your cash (downpayment + rehab costs). Depending on the lender, there will be different seasoning requirements. A traditional refinance may require a 12 month period for which you will have to maintain the property then request a refinance. However, there are many portfolio lenders who have 6 month seasoning requirements or some who can start the refinance process the day after closing (zero seasoning). The lender will order their own appraiser to go to the property and draft an appraisal. 

In the example mentioned earlier, lets look at two scenarios with the same expected ARV of $150,000.

Example 1: Purchase price of $50,000 (bought distressed/foreclosed/divorce/REO) and put in $25,000 amount of repairs for an all in cost of $75,000. The bank appraises it for $140,000. You request a cash out refinance and the bank gives you $105,000 (75% of the appraised value). Now you can fully pay off the $50,000 loan and $25,000 rehab costs (if you used private financing or hard money lender) and have $30,000 in excess cash + 25% in equity.

Example 2: Purchase price of $75,000 (normal sale) and put in $20,000 worth of repairs for an all in cost of $95,000. The bank appraises it for $135,000. The bank does not allow for refinances greater than your all in cost. In this case, you will get back $95,000 to pay off the $75,000 purchase and $20,000 in rehab, and the remaining amount will be left in equity ($135-95K = $40K/135K = 30%).

5. Repeat

The above examples are cases of success stories in which you were able to cash out your initial investment and maintain equity of 25% or greater in the home. Now you will rinse and repeat the process and scale your rental portfolio!

Few thoughts on BRRRR vs. TurnKey/buying off MLS

Although I have bought my first rental property from a turnkey company, I eventually want to try the BRRRR method for a couple reasons: 

• Ability to cash out refinance and retain equity in the home

• Control over the type/quality/amount of rehab

• Ability to retain your "seed" capital for other investments (typical buy will lock up 20-25% cash each time you by, thereby significantly lowering your buying power)

• Allows for faster scaling of your rental portfolio

• Higher return on investment (more of other people's money = higher ROI)

However, there are also a couple reasons why I do not want to jump on the BRRRR bandwagon just yet:

• More risk is placed on the project owner overall (you are buying/rehabbing/renting/refinancing)

• Risk of appraisal coming in lower than expected (not being able to break even)

• Risk of rehab delays (A turnkey is already rehabbed and tenanted)

• Longer process than buying turnkey/MLS

• Risk of being unable to cash out refinance

  • Seasoning requirements

The BRRRR method has been a very popular method for investors to increase their return on investment as well as overall net worth due to the fact that they are leveraging other people's money and if done correctly, able to repeat the process over and over. However, if it was so easy, why doesn't everyone do it? As mentioned in the reasons above, the BRRRR takes careful planning, finding the right deals, using the right team, and comes with its own set of headaches as things can go wrong during the process. What is your strategy? I would love to hear your thoughts on BRRRR vs buying turnkey/MLS.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!