Becoming a real estate investor requires you to make a number of important decisions, including the type of properties you want to purchase. Whether you're investing in commercial real estate or residential rental property, you'll ultimately need to decide if a turnkey property or value-add property is the better investment for you. Learn the pros and cons of each to help you determine which is a better buy for you.
What is a value-add property?
A value-add property is an underperforming or distressed investment property that's in need of minor to major improvements in order to meet market standards. Most value-add properties are underperforming, meaning they may have high vacancy rates, below-market rental rates, or are being managed poorly. The term can also include properties that can be approved by adding value such as remodeling, introducing more effective management systems, using better marketing, or increasing rental rates.
Pros of a value-add investment property
Most distressed properties that are underperforming are valued based on their current condition and income, meaning you can purchase these investment properties for far cheaper than you could a turnkey property. The discount a buyer may receive when purchasing a value-add property provides the opportunity to earn a higher return on investment (ROI) than a turnkey rental property would produce.
Cons of a value-add investment property
The biggest con to buying value-add properties is the amount of work, participation, and management it requires by the investor. Many value-add properties require a full renovation, which, if you're a new or inexperienced investor, can be challenging to manage at first.
If the property is vacant or underperforming, it may produce a negative cash flow or possibly no cash flow at all. This means the investor is responsible for paying holding costs, debt service like a mortgage, and the cost to rehab or improve the property until it's rented again. If you're buying a property with multiple units, you do have the benefit of having some units continue to produce income while you renovate the vacant ones, but it's still a high upfront investment with no guarantee as to when income will start producing again.
Who value-add properties are best for
Value-add investments are best for active real estate investors who have the knowledge and time to manage and improve a property, whether it be through more effective management systems, renovations, marketing, or a combination of those. This method of investing can produce great returns (greater than 10%) but the investor has to work for their return and be comfortable floating the property with their own funds before it ever produces positive cash flow or the desired pro-forma income.
What is a turnkey property?
In real estate, a turnkey investment is a property that's currently rented and operating at market standards. The property requires no major improvements and will have a third-party management company in place, requiring little involvement from the property owner after purchase.
Pros of a turnkey investment property
The biggest pro of buying a turnkey investment property is that it's a more passive investment that will require ongoing supervision from the property owner, but very little day-to-day management or involvement. It will also produce income upon purchase, allowing the investor to start earning a return on their money immediately.
Cons of a turnkey investment property
The biggest con of buying a turnkey investment property is the lower yield they typically produce. While not always the case, most turnkey rental properties are priced higher than a value-add property would be because of the convenience they offer since they are already renovated, rented, and operating at market levels. This means the return on investment is lower than you may be able to achieve with a value-add property.
Another con to investing in turnkey real estate is that you inherit the previous tenant and property management company. While they may be a wonderful property manager and tenant, they also might not -- which means what was supposed to be a hands-off investment is now an active investment that requires you to find new management or deal with an undesirable tenant and lease in the meantime.
Who turnkey properties are best for
Turnkey properties are an ideal investment for those who are short on time to actively manage a big renovation project like a value-add property would require or don't have the expertise or experience of managing a rehab. A turnkey property is a great option for investors searching for passive income that requires as little active management as possible while still accomplishing a modest return on investment (typically around 8% or less, although it may be higher depending on the market).
So, which is the better buy?
Knowing which investment is right for you largely depends on your goals as an investor and what you're trying to achieve through real estate. There is no perfect answer showing which investment property is better to buy, as it really comes down to your financial goals, risk tolerance, experience, and available time.