Every industry has expenses associated with the cost of doing business. In real estate, however, those cost may not be as apparent, especially for new and aspiring investors. I know this because I got to explain some of those expenses to two different investors involved in two different deals this week.
I would like to talk you through both scenarios so you’ll be better prepared to account for these expenses in the future.
The first investor was looking at a flip project in Cartersville. The investor was trying to come up with an offer and was doing what Stephen Covey called “Begin with the end in mind,” in his book “The 7 Habits of Highly Effective People.”
For a flip, this means finding out what the property will be worth all fixed up, subtracting all the expenses, subtracting an acceptable profit, and offering to purchase the property for the resulting number.
The investor figured he could sell the house for $165,000 and estimated it needed $35,000 in repairs. After factoring in an acceptable profit of $30,000, he surmised he could offer $100,000 for the property. He got that number by subtracting the rehab and then the profit amounts from $165,000.
This was a great start, I told him, but there were some other costs he needed to account for such as realtor fees, closing costs and holding costs.
You see, every time you sell a property, you put about 11 percent of the sales price toward realtor commissions and closing costs. For this house, that is an additional $18,150 that the investor hadn’t factored into his offer.
If he had stayed with that offer, he would’ve reduced his profit by 60 percent after he covered commissions and closing costs. And to quote the character Jack Sparrow from “Pirates of the Caribbean,” that would be “Not good!”
Next, I was speaking with an investor who was about to turn a property into his first rental. He figured he could rent the house for $1,100 a month. And since his mortgage payment was $500, he was expecting a monthly cash flow of $600.
On a deal where the mortgage payment is closer to the rent rate, accounting this way can get a landlord into trouble real quick. Let me explain.
The cost of doing business associated with a rental property is unique in that, other than the mortgage payment, most of the things you have to pay for are not fixed. Nor are they paid on a routine basis.
Because of that, you have to anticipate those costs and pay them to yourself monthly so that you have funds ready when an unforeseen event, like a water heater break, takes place. You do this by taking a percentage of the gross rents and setting them aside. We refer to this practice as taking into account the expense factor.
The costs you are trying to anticipate are property taxes and insurance as well as both current and future repairs. The expense factor should also account for the inevitable vacancy that will occur when you have tenant turnover.
Because there is so much variability in those factors that is property specific, the expense factor is something you will need to calculate for yourself. But for our business, in our area, and on most of our properties, we set aside 35 percent of the gross rents to cover our expense factor.
Using that number on the house that rented for $1,100 means you will only have $715 coming in after the expense factor is deducted. Taking out the mortgage leaves $215 a month. That’s not a bad deal, but it’s a far cry from the $600 they were hoping for.
So if you’re flipping a property or you intend to keep it and rent it out, don’t forget to remember your expenses when you evaluate the deal.
Joe and Ashley English buy houses and mobile homes in Northwest Georgia. For more information or to ask a question, go to www.cashflowwithjoe.com or call Joe at 678-986-6813.