Carrying Costs

Speculators and real estate investors who purchase property with the primary goal of reselling for profit must be especially concerned with the project's carrying costs. Carrying costs refer to the net amount of expenditures that investors must outlay before the property is resold and profits are realized. The carrying cost usually excludes the purchase price and deducts operating income.

Unfortunately, uninformed real estate investors often look at just the purchase and resell prices. On the surface, buying a property for $100,000 and reselling it for $150,000 would seem like a no-brainer. This transaction, however, would be a disastrous decision if the carrying costs came to $60,000.

Savvy investors know that the purchase price is only part of the total expenses required by a real estate investment. Carrying costs include the operating expenses, as well as the acquisition costs, mortgage payments, capital improvements and selling costs.

For example, you may be looking to buy a seemingly undervalued house for $100,000 and resell it within six months for $120,000. That would seem like a reasonable investment for a $20,000 profit. But look again.

Purchase price

$100,000

Purchase closing costs

$4,000

Clean-up and decoration

$3,000

Mortgage interest payments (at 8%)

$3,600

Real estate taxes

$1,000

Hazard insurance

$300

Utilities

$600

Supplies

$300

Resale broker commission

$6,000

Resale closing costs

$2,500

Total 6-month carrying costs

$21,300

Total Investment

$121,300

Resale price

$120,000

Net gain/loss

-$1,300

As you can see in this example, the investor will lose about $1,300 in this investment. The net loss moreover does not take into account the investor's time or interest income lost by pulling cash out of savings to use as a down payment. This net loss also does not take into account possible capital gain taxes that the investor may incur, even with the operating loss.

Rule of thumb for quick buy-resale. In most cases, you must resell your property for a new price at least 11% more than your purchase price just to break even. Think about it! When you bought it, you probably had the typical total closing costs of about 3% of the purchase price. When you resell it, you can usually expect about 1.5% to 2% closing costs. On top of that, average commissions to real estate brokers will be about 5.5%. This doesn't include the cost of your time or the lost interest income you would have been earning off the money you took out of your savings to make the down payment for the purchase. This rule of thumb also assumes that you sell it right away. Every day you have to wait to re-sell the property mean additional costs!

Understanding carrying costs is often the difference between success and failure as a real estate investor, particularly for speculators. Actually, a savvy investor may still be able to make the above project work by successfully eliminating some of the expenses and/or increasing income. For example, the investor may decide to rent out the garage for storage and the house to seasonal renters for additional income of $5,000 over six months. That would make it a more profitable endeavor. But be careful nevertheless.

I laugh when I overhear people boasting that they bought a property and then resold it for a decent, but sizable profit. In most cases, the investor actually lost a lot of money-but just doesn't want people to know that he wasn't very smart. If you're feeling ornery, you can dig for details about the price; then drop the hammer and ask the braggart about his carrying costs.

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Responses

  • lalia
    What are carrying costs in real estate?
    8 months ago

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