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:
- Escrow fees
- Property inspection fees
- Loan origination fees
- Misc closing fees charged by the title company
- Lenders title insurance
- Prepaid insurance
- One year home warranty
- Prepaid taxes
- HOA capital contribution (if any)
- HOA transfer fees
- First year maintenance - A one year home warranty is included in the closing costs. The call out fee is $70/incident.
- Maintenance reserve - The amount of the reserve depends on multiple factors but is usually about 0.5% of the purchase price.
- Property management startup cost. The property manager charges 1/2 of the first month's rent for finding the tenant and paying referral fees to the Realtor who showed the property and brought the tenant.
- What is not included is loan discount points.
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|
|Total Closing Costs||6101||6856||8061||6836|
|Closing Cost %||2.5%||2.5%||2.4%||2.5%|
- Close Sheet - This is the difference between the purchase price and the cost to close. This does not include points.
- Rental Fee - The property manager charges 1/2 of the first months rent.
- Inspection - The property inspection cost.
- Appraisal - Cost of the appraisal which is paid outside of the close sheet costs.
- Closing Cost - The sum of Close Sheet + Rental Fee + Inspection + Appraisal. Discount point cost is not included.
- No payment the first month - With a mortgage, you pay in arrears so there is no payment the first month. In vast majority cases, we've completed rehab and had a paying tenant in place before the first mortgage payment is due.
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.
- Depreciation - The IRS mandates that you depreciate investment real estate. How beneficial depreciation actually is depends on your tax situation. However, in general depreciation will increase return by about 3%. 3% is usually more than enough to cover maintenance and vacancy each year. Note that 3% will not cover maintenance or vacancy for any property. 3% works for the properties we select due to our selection process and tenant screening. The age and condition of the property plus the quality of tenant has a huge impact on your maintenance cost. So you can see the impact of depreciation, below is a (very) simplistic example.
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.
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.