What Does Closing Costs Cover In Our Return Estimate

Unlike many popular ROI calculations, we include closing costs in our return estimates. Below is the formula we use:

ROI = (Rent - DebtService - ManagementFee - Insurance - RETax - PeriodicFees) x (1 - StateIncomeTax) / (DownPayment + ClosingCosts)

There is no state income tax (StateIncomeTax) in Nevada but we include this factor because Las Vegas properties may be compared to properties in other states who may have state income taxes. For financed purchases we use 3% as closing costs and for cash purchases we use $2000 as closing costs.

We occasionally get questions concerning vacancy rate and maintenance provision plus other costs like the property manager tenant acquisition cost. We will go into detail about these factors in a forthcoming article as well as why we do not include vacancy and maintenance factors in our return estimates. In this article we will focus on the closing cost factor (ClosingCosts).

Just as there are many definitions of return, there are many definitions of closing costs. Our definition of closing costs includes all of the following:

Note that not every property will have all of the above fees/costs.

Closing Cost Considerations

A few years ago I went through the records of many closings and added up all the closing costs and divided the total by the purchase price of the property. The percentages ran from 2% to 4%. With a little math I determined that for 95% of the properties, the closing costs was less than 3% of the purchase price. Below are the closing costs for four recent properties.

Cost Property 1 Property 2 Property 3 Property 4
Purchase Price 240000 270000 330000 270000
Close Sheet 4581 5161 6244 5116
Rental Fee 725 850 997 875
Inspection 295 295 295 295
Appraisal 500 550 525 550
Total Closing Costs 6101 6856 8061 6836
Closing Cost % 2.5% 2.5% 2.4% 2.5%

Notes:

First Year Maintenance

As you can see from the above, excluding points that are optional, typical closing costs run about 2.5%. So, the additional 0.5% is intended to cover first year maintenance cost plus a maintenance reserve. For example, suppose you purchased a $300,000 property: 0.5% x $300,000 = $1,500. Since there is a home warranty in place, typically your cost will only be the $70/incident call out fee. The first year is likely to be your highest maintenance cost. Assuming 3 call-outs in the first year (which is high): $70 x 3 = $210. If we round this up to $300, the remaining is $1,200. This is your maintenance reserve.

Not Considered

Assume the tax qualifying purchase price is $300,000 and that 80% is depreciable. Also, that you combined state and federal marginal tax rate is 25%. Also, that the IRS useful life is 27.5 years. Your tax savings would be:

($300,000 x 80%) / 27.5 x 25% = $2,181

$2,000/Yr is a huge maintenance reserve for the properties we select due to the age, condition, construction, climate and tenant screening. On average, $300/Yr should cover everything.

Summary

By including a 3% closing costs for financed purchases, we allow a reasonable approximation for all closing costs, tenant acquisition cost, first year maintenance and a maintenance reserve in our return estimates.