Accounting for fees in calculating returns?

Question

I'm new to these forums, so apologies if this is the wrong section or a repeat (I'm betting on repeat).

Short version: when calculating return on a mid- to long-term rental property what sorts of fees do you account for?

Long Version: I'm trying to work out very rough models of what sorts of returns I should expect so I can better shop for deals. Say my starting situation is this: $50k down on a $200k single-family rental property, giving me a $150k mortgage. After 5 years of break-even rental income, lets say the house is worth $230k and I now owe $135k on the mortgage. Without accounting for any fees and such, this would show $50k turning into $95k. BUT, that's in a magical world where I sell the house like I was selling a book at a garage sale.

So if we pretend the above could happen... how much should I expect to lose at the purchase, and how much at the sale? I assume the $200k house will actually cost me an extra percent or two in fees and closing costs (making the mortgage more like $154?). Then at the sale end, I'll pay 6% to realtors, plus other fees and such, right? So my math becomes:

Starting mortgage = 200,000 * (1 + <fee%>) - 50,000
Ending value = 230,000 * (1 - <fee%>) - <remaining mortgage>

If I expect 2% at the front end, and 8% at the back, this becomes a starting mortgage of $154k, final mortgage at about $140k, and a final result of turning that $50k into about $72k. In my spreadsheet I'd have more exact math, I'm just simplifying for discussion sake.

So, you account for these fees when doing your projections? What fees do you expect? And I guess while I'm at it: Are there tricks for reducing these fees?

Thanks,
Bill

Bill Ramsour · Answer

Thanks for your input Jeffrey! I agree break-even isn't a great target, I was just trying to make my math easier. Though my study so far has suggested that I can either tilt towards a higher cash-on-cash return, but in a lower appreciation market, or a tilt towards appreciation.   I think I prefer the latter, as I'm focused on preparing retirement income, but this digresses towards an entire different topic :)

Regardless, this does answer my question. Both your advice and your math make it clear that even if I want a property that will appreciate well, I need good cash-on-cash return.  Losing 8% whenever I sell makes a purely "appreciation play" not nearly as valuable.

Thanks again for the info, it's much appreciated,

-Bill

Jeffrey Holst · Answer

I wish I could be more helpful but I dont really spend time worrying too much about those fees in my projections.  I wouldnt buy a break even cash flow property though.

When we buy we know about what the closing costs etc will be but on deals of your size we would just assume a higher number for our projection ie 5K closing costs to buy and then usually just the 6-8% on the sale.  The key here though is if I had 50K to there is no way I would buy a house that breaks even.  Go find something that will give you at least a 12% cash on cash return which with 25% down leverage should be fairly easy, then you have an extra 6K a year to add in which will more than cover the fees you are worried about.