There’s been a fair amount of buzz on BiggerPockets about turnkey rental properties, and as I was thinking about what to write this week, one of my employees actually asked me this question: “How do turnkey rentals compare to performing notes?”
As someone who has owned hundreds of properties and thousands of notes nationwide, this can be an interesting question.
A few friends of mine run very efficient turnkey rental property businesses with several variations depending on their business models.
For example, some tie a money partner to a property purchase to cover acquisition and rehab funding before connecting their finished property to an end investor, who would then keep it as a buy-and-hold rental. Others set up an equity fund with private, accredited investors to streamline the acquisition and renovation side of things before flipping out each property to a retail investor.
In both scenarios, there’s usually assistance with property management as far as finding tenants and performing routine maintenance.
When it comes to performing notes, it’s a very similar process. Many note investors or note funds acquire distressed notes before rehabbing the paper and then flipping the re-performing note and mortgage out to a “cash flow” investor, who prefers mailbox money without having to deal with tenants.
These types of re-performing assets are usually placed with a servicer, who manages all the accounting for the investor and borrower, along with all the monthly and year end statements, as well as any late notices that may occur.
Related: Turnkey Real Estate Investing: Can You Really Have Your Cake and Eat It Too?
Now, let’s look further into these two options as a possible investment choice.
Advantages and Disadvantages
When it comes to turnkey rentals, more often than not, they are a passive, hands-off type of investment. There’s also many tax advantages from depreciation, as well as some potential upside appreciation.
As long as the turnkey company is reputable, it can be very beneficial for some investors, especially if there’s no comparable type of investment in the investor’s home state. In some markets, the numbers work better, and the property may be in an emerging market to boot.
A possible disadvantage is that if the market were to change or the turnkey company were to go out of business, you could get stuck with an out-of-state rental to manage. At that point, you might have to go shopping for a new property management company (even if hiring one wasn’t in your original budget).
Also, as with owning any rental property, there may be the added expense or loss related to vacancies, maintenance, and tenant turnovers.
With performing notes, you don’t have any real tax advantages other than you’re taxed at a lower rate than earned income, unless you own the note in your self-directed IRA. But either way, there’s no depreciation deductions.
Although there is no true appreciation in the asset (the note), there can be what we call phantom appreciation, where a note may have become more valuable due to an increase in market value of the underlying collateral (the property). Another advantage is that you wouldn’t have to cover expenses, such as maintenance or vacancies.
A possible disadvantage with owning a note would be if the borrower were to default on their payment. At that point, you might need to utilize specialty servicing, where the mortgage servicer performs collections. That being said, some note buyers may offer a warranty protecting the investor’s investment principal in the event of borrower default.
So, due diligence is equally as important whether you’re considering doing business with a turnkey rental property or a performing note seller.
With either option, your capital may be tied up in one deal, whereas some may fair better with the diversification of a fund that manages many assets or properties. However, others may prefer the control of actually owning the asset instead of shares of a company.
Related: The Investor’s Guide to Performing Due Diligence on Real Estate Notes
At the end of the day, it probably depends more on the track record and reputation of the outfit your dealing with.
So let me ask you, which do you prefer — turnkey rentals or performing note investing?