When you’ve committed yourself to something, it can be so tempting to just jump right in before you know everything there is to know. The advice one often hears is to just get started, learn as you go, and if you fail, fail quickly so that you can pick right up again.
Problem is that with real estate, you may not have the luxury to fail quickly if you signed a contract to buy a house. You might be stuck with a property that ends up under-rented, vacant, or unsaleable if you don’t do your research.
This is the story of what nearly was my first purchase. A turnkey property in Memphis.
It was December 2013. I had just finished Graduate school after 2.5 years of being a student while working full-time. Those years sucked. I had been waiting anxiously to finish school for months, as I planned to make my jump into real estate.
I graduated and got a little overzealous. I went on a sprint toward acquiring my first property and nearly jumped into the wrong one. I had read a ton of articles, read books, listened to podcasts, and then began interviewing turnkey companies. I came across one that seemed great. They said the right things and when interviewing their referrals, no one had any complaints.
They sent me a cash flow pro-forma with over 10% returns. Was it too good to be true I thought. Well, let’s see.
First of all, let’s dive into some numbers. This was a turnkey property in Tennessee. Never mind that I had never been to Tennessee, didn’t know anyone in Tennessee, and was brand new at this time. Oh what a Perfect Storm.
Never mind all those mistakes, but let’s just take a look at the numbers (i.e. the Pro-Forma) sent by the turnkey company. This was a newly rehabbed 3 bedroom, 2 bath single family home being sold for $88k. With a 20% down payment and approximately 3% closing costs, my total cash invested would have been about $20,217.
If you’re seeing the nearly 11% cash on cash return and nodding in excitement, look again. What expenses are being assumed here? Does anything look a little too optimistic here?
How about the 5% vacancy assumption? At 5%, you’re assuming that a vacancy will only last a bit more than 2 weeks. Is this accurate? Well, that depends. How long your house may sit vacant will depend on many factors such as market timing, house size, condition, location, and price. If you don’t have personal experience to draw from like I didn’t at the time, talk to a couple property managers or investors in that area to gauge what an appropriate vacancy estimate should be.
After doing a little research, I learned that similar properties in the area typically sat vacant between 2 weeks (in the summer) up to 8 weeks (in the winter)! I was surprised to see such a wide range and that it was largely driven by the time of year. I don’t get snow here where I live, but it makes sense that in the dead cold of winter, you’re not going to get many potential renters looking to fill your vacancy. Since you can’t completely control when you’ll have a vacancy and that this may affect whether your vacancy is a couple weeks or longer, I figure bumping up the vacancy loss to 1 month or 8% (1 /12 = 0.08) would be a safer move.
Helpful Tip: If you have to start a lease during the winter months, try to have you tenant sign an extended lease such as an 18 month lease. This way, your lease will end around summer time and the idea is that all future leases can then be an annual renewal that is cycled during the most desirable time to rent.
The maintenance estimate at only 5% or $537 annually is also looking very slim. Despite this property being rehabbed, things still need to be maintained and if it’s an older house, all the more reason to expect more in terms of repairs. So I’d double this estimate and book keep 10%. Doing so would cover minor repairs and routine maintenance.
The annual insurance estimate at only $475 also stuck out as exceedingly low. This property is nearly 1500 square feet and the estimates I received were higher at around 600 to $700 annually.
I can look at the rent as well to see if it’s on the high side (I’d bet $100 that the turnkey’s rent estimate is), but let’s just see where our returns are now after applying our new expense estimates. Here are the adjusted numbers:
By applying a small correction to the vacancy, maintenance, and insurance numbers, the cash flow reduced by about 50%. Instead of making close to $200/month, this property may average just under $100/month with a cash on cash return of 6%. Hardly anything to get excited about.
We’ve looked at the numbers, now let’s review some qualitative measures. For instance, where’s the property located? What are the local schools like? Is there much crime in this neighborhood?
Here’s a snapshot of the schools that are closest to this property and their ratings given by Great Schools.
These scores are out of 10. 10 being amazing schools that you’d like to send your own kids to and a 1 being a school that’s failing in many ways.
GreatSchools provides a 1 through 10 rating for a school’s performance relative to other schools in the state based on state standardized tests. As an investor, parent, or just someone interested in the quality of the local public schools, the ratings allow you to compare the performance of particular grade levels and groups of students to comparable groups in other schools in the state. So a school rating of a 9 or 10 means that the majority of these kids are scoring proficient or above across all grades and subjects. Whereas a 1 or 2, means these students are scoring lower across all grades and subjects when compared to other students in the state.
It’s no secret that the achievement gap is highly reflected in test scores and has shown to be correlated to one’s socio-economic status. This isn’t the point of the post, but as an out of state investor who’s looking to hedge my investment by buying rental property in stable communities that are safe, desirable to live in, and have a positive long term outlook, one of my best indicators to use is school ratings. So I generally look for properties that are near good schools. Interestingly, many high cash flow properties on paper tend to be around very low ranked schools. While these may show great returns, generally, they are in high risk areas, are undesirable in that families with kids are not looking to move there, and long term the property values don’t appear to have much or any up-side.
Here’s a heat map of the local crime in the area from Trulia. Remember, green means it’s safer, yellow has a bit of crime, and red is just plain dangerous!
This house was in a pretty rough area. When looking at specific crimes that have been committed in just the last month near the house, the abbreviated list includes: aggravated assault, drugs/narcotics violation/felony arrest, aggravated robbery, 5 cases of residential burglary , armed robbery, shoplifting, and many more. You get the picture. It’s a rough area.
Also, in my research when talking to investors and property managers in the area, they only confirmed the high crime I was seeing online. One local manager I spoke to shared a conversation he had with a friend in the OCU (Organized Crime Unit) for the local police department and said that this area is the most gang infested area of Memphis right now. Take for example the unfortunate case of a contractor doing some work in the area at a job site who was murdered in October of 2013.
If the numbers alone weren’t enough to send you running the other way, the local crime and schools should have made the decision much clearer.
Property Value – Long Term
It’s been over 2 years since first considering this property and I know I made the right choice. I went back to this property and noticed someone in fact did buy this turnkey. Some other investor, possibly from out of state who may never have even seen the property in person, bought it at a list price of $88k.
This price was well above most comps in the area and the current Zillow Zestimate for what its worth, estimates the property at $80.5k. Not to mention, if you look at the property’s value over the past 10 years, the purchased turnkey price of $88k sits nearly at its 10 year historical maximum. Meaning, as an investor, you purchased without any equity…a very dangerous place to be in.
Fortunately, I did not go through with this property. I had gotten as far as a verbal agreement with the turnkey provider, received the purchase agreement, printed, and just never signed anything.
To think that I seriously considered purchasing this house when I first started is kind of embarrassing. Though to be fair, I was a complete newbie at the time and I was learning…still learning. Luckily, I did my homework and reached out to several people with much more experience and knowledge than me before signing.
I hope you take away a couple lessons from this experience of mine. If you’re just starting out with real estate like I was back then, reach out to more experienced investors and get their opinion on a property you’re considering. If you don’t know where to find them, go over to Bigger Pockets and even post a forum question about your potential investment. That’s what I did.
More importantly, learn your market. I would have never gotten into this situation if I had taken the right steps to just learn my market first. Before considering the purchase of a property, I should have really gotten to understand my market. Where are the high risk areas to avoid? What returns are reasonable and the expected cash flow for properties of various classes (A-D)? What’s my risk tolerance and what sort of numbers am I shooting for?
Personally, I believe that in order to really learn about an out of state market, you have to be willing to make a trip out there. If you don’t, then just understand that you’re taking a huge risk in buying property where you don’t have first hand knowledge of what the area really is like.
Lastly, while it’s important to take action when you’re new, don’t move forward too quickly until you have a good handle on your cash flow analysis, the property specifics, and your market.