No matter what real estate investing strategy you’re into, the most important thing about any deal should be conducting proper due diligence. While not every aspect of a deal can be verified before it’s done, most of the critical items can be. That’s why due diligence is so critical—to help ensure the profitability of your investment.
Turnkey rental properties are no exception. In fact, I would argue that due diligence is even more important with turnkeys than with other strategies.
In this article, we’ll go over what turnkey is and the checklist you need to follow for your investment to be profitable.
What is Turnkey Investing?
At its core, turnkey real estate investing is where you buy already rehabbed, tenant-filled, managed properties that are producing positive cash flow already.
A lot of the extra work that goes into real estate investing is cut out with these types of properties. With that comes a different way to approach deals. It’s easy to make mistakes.
The Biggest Mistake Turnkey Investors Make
In my 12 years of working with turnkeys, the biggest mistake I’ve seen investors make is not conducting proper due diligence on the turnkey properties they invest in. I believe this is due to the marketing of turnkey rental properties.
Turnkeys are pitched as being a hands-off investment strategy. Essentially, turnkeys sound as if they’re pre-packaged. When you buy a turnkey from a provider, you’re given a property address, a picture of the property, a pro forma, a tenant (in many cases), property management, and emotional assurance that all of the work is done for you and all you have to do is sign the closing documents and start collecting cash flow.
In a perfect world, this is exactly what happens.
However, we don’t live in a perfect world. And despite what many people assume, turnkey provider companies are made up of imperfect humans.
Because the marketing of turnkeys suggests investors are getting pre-packaged perfection, it’s easy to assume nothing could go wrong, and therefore no stress needs to be exerted over doing due diligence.
The worst thing a turnkey investor can do is to trust the turnkey provider to deliver perfection. I’ve never known a turnkey provider to blatantly mislead an investor or want to scam an investor intentionally, but because everyone’s human, errors happen.
No real estate investor, no matter the strategy, should trust other people to hand them their deal. All investors, including turnkey investors, need to take the reins on what they’re investing in and make an effort to verify everything they can.
Due Diligence Checklist
The hardest part about doing due diligence on a turnkey rental property is knowing all of the things you should check and how you should check them. The good news is that the list is fairly straightforward, and with some practice, it will become easier with each purchase.
1. Property condition
Major repairs and maintenance on a house can cost upwards of thousands to tens of thousands. With turnkeys, one of the aspects of that “perfect pre-packaged deal” is that the property has been recently rehabbed and CapEx items on the house have a significant lifespan remaining on them. The intention is for turnkey investors to not have any major repair items (less those caused by tenant damage) for a long period of time.
While it’s the turnkey provider’s intention to deliver a house in perfect condition to the investor, remember, you should throw the word “perfect” out the window. Your job as the investor is to verify that you are getting a property that is in fully turnkey condition.
There are the two things you need to do to confirm this:
- Get a third-party property inspection.
- Read the inspection report and ensure those items are fixed by the provider prior to closing.
You might be saying, “Well, #2 seems kind of obvious.” You’d be surprised. Everyone only hears that they need to get an inspection. I can’t tell you how many people either don’t read the inspection report or if they do, they don’t follow up on the repairs.
It’s 100% the responsibility of the investor to ensure everything about the condition of the property is as advertised prior to closing. If you miss something and then close on the property, any repairs that come up after that are your financial responsibility, not the turnkey provider.
Be as picky with a turnkey as you would any property and don’t just assume everything’s good because you’ll be the one to pay for it later.
2. The numbers
When a turnkey provider gives you a pro forma, they do so to the best of their ability, but that doesn’t mean they don’t make mistakes. And when you’re analyzing a property for cash flow, a major mistake on the pro forma can be the difference between positive and negative cash flow every month.
Therefore, you want to ensure that you agree with all of the numbers and the overall financial outlook.
There are very few numbers on a pro forma that can’t be verified; only a couple of them have to be estimated.
- Price – Rely on the appraisal to confirm you’re paying an appropriate price for the property. While it would seem optimal to run your own comps sooner in the buying process, most people make the mistake of not comparing like to like when it comes to the quality of the property. I’ve seen very few turnkey investors not get misled by nearby prices of foreclosed properties and non-upgraded properties. For the most part, you shouldn’t make a decision about the value of your property (i.e., if you’re overpaying) until you receive the appraisal. If you’re paying cash instead of financing, and therefore you don’t have a lender heading up the appraisal effort, order one on your own. It will be worth the investment!
- Rents – You can run rent reports through various online programs, but oftentimes those programs don’t offer the most accurate estimates. The best thing you can do to confirm the estimated rent on a property is to call at least a couple of third-party property managers in the area and get estimates. Property managers are boots on the ground every single day and will have the best idea of what a property may be able to rent for. If you’re buying a turnkey with tenants already placed, verifying the rent estimate isn’t as critical since it’s already been proven to an extent, given tenants are already paying it. However, it can’t hurt to get a couple of additional estimates just in case the current seller or property manager was able to get a tenant in at a price higher than market rent.
- Property taxes – Go to the tax assessor’s website for the county where the property is located and find the exact tax amount. What most people forget to do, though, is find out how property taxes are assessed in a county. For example, if the property tax changes with a sale, that means the amount is going to change once you buy the property. Make sure you’re aware of what it’s going to change and use that in your analysis. The property tax number used in a pro forma is the current tax amount, not a forecasted number.
- Insurance – Call and get an actual quote for property insurance.
- Maintenance & vacancy estimates – Estimates for maintenance and vacancy are the only numbers that can’t be known with certainty. The idea is to put some extra expense estimates into your cash flow calculations to help compensate for inevitable costs that every investor will run into. The standard estimates for a turnkey pro forma tend to be 5% of the rent amount for maintenance and 7% for vacancy. It would be wise to increase the maintenance estimate for older, cheaper homes (even if they are turnkey), and vacancy rates can be discussed with property managers as they will have a more accurate idea of current vacancy rates in that area.
- Additional expenses – Confirm with the turnkey provider if a particular property has additional expenses, such as homeowner’s association fees, owner-paid utilities, etc., and ensure those are included in the pro forma.
3. Property management
Many, if not most, turnkey investors don’t do thorough property management vetting! They assume that the property manager who comes with the property will be great. That’s the worst assumption you can make. You should interview a few different property managers just as you would if you were buying a rental property non-turnkey.
In those conversations with prospective property managers, ask them how rentable the property you’re considering is. Do people want to live there? Is it easy to find tenants for a property in that area? You’d be surprised how many properties aren’t as rentable as you think they are. Not that they can’t rent, but when a property doesn’t have strong rentability, it can cause increased vacancy times (which are expensive), and force you to lower the rent amount.
5. Tenant information
If your turnkey property comes with tenants, don’t just assume the property manager screened them properly. Confirm that they should be good tenants. Few things are more frustrating than non-payment and evictions early on!
Even with a thorough list of due diligence items, chances are you’re not going to get it 100% right the first time, or maybe even the second time. That’s okay! Real estate investing is very much an on-the-job training industry; the key is continuing to learn as you go and get better each time. Hopefully, though, with help getting started, you can at least cover some of the major items that could be most costly to you down the road and avoid those expenses as best as possible.
While it seems rare for turnkey investors to see their property before buying it, there are few better ways to do due diligence than putting your eyeballs on the property. You’ll get a feel for the neighborhood, the quality of the rehab, and you can even meet the turnkey provider face-to-face and see how you feel about them, which can go a long way.
Then lastly, one thing that many new turnkey investors don’t understand is the timing of due diligence.
Due diligence on the property needs to happen after the contract is signed.
Due diligence on the market and the provider should happen before the contract is signed.
Many investors lose out on great deals because they try to do all of their due diligence on the property before signing the contract. A turnkey provider won’t wait for you, so it’s likely that another investor will swoop in and get the property before you finish. In the sales contract, there should be a specified timeframe literally called the “due diligence period .”During that period is when you should go through your list of verifications. If at any point something doesn’t check out on the property, you can cancel the sales contract with no penalty (although, traditionally, you’ll lose your due diligence deposit.)
At the same time, the due diligence period that starts once under contract is not the time to decide how you feel about the market or the provider. You don’t have time to do that. All of that research should be done prior to signing a sales contract.
A turnkey investor should treat all of their investments as if they are not pre-packaged deals and verify each element as such. If you don’t do that, you’re putting the control of your investment into someone else’s hands, and as a real estate investor, that should be something you never do.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.