5 Ways Turnkey Companies Inflate Cash Flow Projections
I’m a firm believer that turnkeys can be a great investment, especially if you’re new to real estate or live in an expensive city, where cash flowing properties are hard to find.
My wife and I bought 4 turnkey rentals in Atlanta and Birmingham last year and plan to buy more in the future. Before we settled on the homes we bought, we looked at dozens of properties in several different markets. And contrary to what some turnkey companies would have you believe, not all of them are good investments.
Picking the right market definitely plays a huge role, but I also noticed that most turnkey sellers inflate the cash flow projections they list on their websites. I wouldn’t say they are blatantly lying, but definitely not telling the whole story. They are trying to sell their product and know that many investors are attracted by higher cap rates, COC returns and cash flow.
Based on my experience, here are 5 of the most common ways turnkey sellers inflate cash flow projections. I threw in some screenshots from the DealCheck mobile app I designed and always use to analyze rental properties to show how I run my numbers.
Things To Watch Out For When Analyzing Turnkeys
1) Vacancy Percentage Too Low
If you’re not familiar with the way vacancy works, it’s a percentage of time you expect a property to remain vacant each year. Your rental may be vacant while you’re searching for a new tenant or doing make-ready repairs in-between tenants.
Vacancy isn’t an actual “expense”, but instead reduces your rental income. For example, if it takes an average of 3 weeks to find a new tenant and you expect one tenant turnover per year, your vacancy rate will be 3 weeks / 52 weeks = 5.8%.
A property’s vacancy rate depends on the city, neighborhood and the property itself. A high-end condo in a trending neighborhood will likely have a lower vacancy rate because you will have no problem finding new tenants. On the other hand, a rental in a smaller town with less rental demand and not much curb appeal may take several weeks or even months to get rented out.
Many turnkey companies sell properties in lower-end markets and neighborhoods, where it often takes much longer than you think to find a tenant. In addition, lower quality tenants will put more wear on your property, so your make-ready repairs in between may be more substantial and take longer. Not to mention, dealing with Section 8 tenants may add weeks of extra time waiting for the paperwork to go through.
I often see vacancy rates advertised at around 5%, even in C-class neighborhoods. Don’t take the listed rate as-is, do your own research. Contact 2-3 property managers and ask them how long it takes to find a tenant for similar properties in the same area or look at active rental listings on Zillow or Trulia to see how long they have been up.
I personally use at least a 10% vacancy rate for single-family homes and 15% for multi-family properties. A bit on the conservative side? Sure. But I’m not going to be surprised when it takes 4 weeks to find a new tenant.
2) Tiny Maintenance and Cap Ex Allotments
Every rental will have maintenance and capital expenditure expenses. Maintenance and repair costs come up as things break due to normal wear and tear. Capital expenditures (cap ex for short) are larger expenses that only occur every few years, like replacing the roof, re-painting the house or buying new appliances.
Both maintenance and capital expenditures are typically listed as a percentage of the gross rent. So if the home rents for $1,000 a month and maintenance/cap ex is 10%, that comes out to $100 a month.
Almost every turnkey company I’ve looked at severely underestimates maintenance items and often omits capital expenditures all together. I’ve seen maintenance listed at 2% for a 1938 house that rents for $750/month. Do you really think it will take just $180 dollars PER YEAR to upkeep a 75+ year old home?
I base my maintenance and cap ex projections on the age of the house and tenant quality. Newer homes and homes that attract A-class tenants will usually have lower maintenance costs than older homes or those that will be rented out to Section 8.
At a minimum, I allocate 10% (or $100, whichever is less) to maintenance and cap ex, even for my nicest properties. For homes that are older than 50 years or Section 8 properties, I bump that up to 15%.
3) Using Past Year’s Property Tax Numbers
Another often problematic area is property taxes. Almost always turnkey providers list last year’s property tax values, NOT the ones you will actually end up paying.
Why are your property taxes likely going to increase? First, property taxes are based on the county’s assessed value of the property and in most states, that value will be equal or close to the last sales price. When you buy the home, you’re always going to pay more than what the turnkey company paid for it, so it’s assessed value and property taxes will go up.
In addition, many turnkey companies buy their properties from homeowners who foreclose. Many states and counties offer homestead exemptions that lower property taxes if you live in the home. Since you’re buying a rental, that exemption will disappear and your taxes will go up.
So how do you calculate an accurate property tax value that will be close to what you’ll end up paying? It’s pretty simple:
- Find the county’s property tax records online.
- Look at the previous 2-3 tax bills and figure out what percentage of the home’s assessed value is due as taxes each year.
Use the percentage and your purchase price to calculate the new tax, removing any exemptions in the process.
4) Omitting Vacancy in the First Year
Many turnkey providers will use a 0% vacancy rate for the first year’s cash flow projections. The rationale is that if a property is already rented out, the current tenant “should” stay there for at least a year, so you will have no vacancies.
Well, it’s great when that happens, but it’s better to prepare for the worst and factor in the vacancy into the first year, along with all future years. Vacancies can happen at any time, for a variety of reasons, even just months after you purchase a home.
I bought a turnkey in Atlanta with a tenant already in place last March. Everything was going fine, until about 3 months in when the tenant stopped paying rent due to financial hardships. Between the eviction process, make-ready repairs and finding a new tenant, the home was vacant for about 5 weeks (9.6% vacancy!).
If you’re realistic with your first year’s expectations and projections, you have less chance to get surprised and to end up in the hole. Leaving a budget for vacancy for the first year is a great way to do that.
5) Inflated Yearly Rental Income Increase
Over longer periods of time (think 5+ years), rent tends to go up in most cities across the US due to economic growth and inflation. But this increase is NEVER guaranteed and rent in different cities increased by varying percentages each year. It could stay flat or even drop from time to time.
Nevertheless, I routinely see turnkey sellers write in a 3% or 4% rental income increase in all of their cash flow projections. This is somewhat deceiving and inflates the numbers pretty quickly after the first few years.
They may even use this as a marketing trick to sell you a poor investment, pointing out that in a couple of years your cash flow will be much higher than in the first year.
I like to set my yearly rental income increase at 1-2%, depending on the area and the property. And I definitely don’t rely on it to make the property a worthwhile purchase. If it happens, great! If not – I’m still getting a solid cap rate and cash flow.
Always Do Your Own Cash Flow Analysis. Many investors I meet have a notion that all turnkey properties are great and that they can skip the whole “analysis” and “due diligence” part because it’s been done for them. This is definitely NOT the case.
I treat a turnkey purchase as any other property purchase and that includes doing a full cash flow analysis that I perform myself, without relying on the numbers somebody sent me.
This has saved me from buying bad rentals that would have drained my money year after year. This also helps me to have realistic expectations about each property’s cash flow and returns. In almost all cases, our properties have done substantially better than what I projected, but I also have a safety net in case something happens.
If you’re looking for a quick and easy way to analyze turnkey properties right on your phone or tablet, check out the mobile app I designed called DealCheck (available for iOS and Android). It will help you crunch all of the numbers in less than a minute and even create professional PDF reports you can save and email to your mortgage broker or partners.
If you’ve come across any other ways turnkey companies inflate cash flow numbers, share it in the comments below!
Anton is an entrepreneur and real estate investor from San Diego, CA. He is the founder of DealCheck – the #1 mobile app for real estate investors to quickly analyze rental properties and flips, compare RE deals and create professional PDF reports. You can download DealCheck free for iOS and Android.