3 Common Rookie Errors To Avoid When Buying Your First Property
Rookie real estate investors often overlook the fact that expenses paid to get title transferred into their name, and to get the property rent ready, can add thousands, even tens of thousands, of dollars to the total purchase price.
These ‘left field’ costs usually have to be paid from the investor’s pocket (rather than borrowed), and as such can become a cash trap for the unwary.
Professional investors, on the other hand, know the likely additional fees and charges and budget for them prior to any purchase.
Here are some of the extra costs that you need to be aware of when buying a property in the United States.
Keep this list handy and make sure you always work out these costs into your budget, before committing to a piece of real estate.
1. Not Planning for or Miscalculating Closing Costs
Closing costs usually fall into three broad categories:
Closing Cost #1: Transaction costs
Costs associated with having the title transferred into your name. They include title company charges and title insurance (if the purchase contract stipulates these charges are to be paid by the buyer), mandated government fees to record the title transfer, disbursements, minor bank fees, etc. Unlike other countries, transaction costs associated with the purchase of US real estate are quite reasonable – usually less than $1,000 and as such aren’t likely to cause much concern. Nonetheless, you should be diligent in determining what the transaction costs will be, both in nature and cost, before signing the purchase contract. This can be done by phoning up a local title company and asking what the standard costs are for the State and County where the target property is located. Be aware that in some countries, like Australia, transaction costs are substantially higher than in the US, primarily because of stamp duty which can be as much as 3% of the purchase price, or more!
In any location where transaction costs are higher than 1% of the purchase price, then be very cautious when using the flipping strategy (where you buy for one price and sell soon thereafter for more than you paid), because your profit margin will be eroded by the high transaction costs.
Closing Cost #2: Due diligence costs
Costs associated with you vetting the property and making sure that you’re not purchasing a lemon. Such costs include property and pest inspection, environmental assessments, survey, zoning reports, independent appraisal, etc. The amount of due diligence that is completed is up to the investor. At one extreme, no due diligence may be undertaken and hence no costs will be incurred. Alternatively, a barrage of reports may be commissioned at a cost of many thousands of dollars. Here’s a mantra to remember: “The more things you leave to chance, the more chance things can go wrong.”
In real estate, it is what you can’t see or don’t know that ends up costing the most; it’s better to be cautious than cavalier.
At a minimum, I recommend having a building and pest inspection (PCA – property condition assessment), and then asking the seller to rectify some or all of the non-trivial issues found, or else using the findings to justify a price reduction (also known as a ‘re-trade’).
The cost should be between $500 and $1000 depending on the size of the property.
Be sure that your inspector is properly licensed and qualified to do the work, carries the appropriate insurances in case of injury while doing the inspection, and that the report issued can be used for insurance purposes (e.g. in Florida the property inspection can include a wind assessment report that you may be able to send to your insurance company and qualify for a premium discount).
Other reports that you might like to commission depending on the circumstances include:
- Independent appraisal to verify the market value of the property. If you are borrowing, your lender will handle this, but if you are paying cash then an appraisal is a good check to ensure you are not paying too much.
- Environmental site assessment (ESA) that will look at the prior use and check known contamination databases to provide some comfort that there are not any recognized environmental conditions (REC) associated with the property
- Survey to check the boundaries and potential flooding issues (note your survey should also include an elevation certificate as this can help to later reduce your flood insurance premium)
- Zoning report to ensure the proposed use is allowed – particularly useful for commercial properties or if you plan to develop the site
- Specialist roof inspection by an engineer – important if you suspect problems with the roof as the building inspection will only be a cursory review
Closing Cost #3: Finance costs
Those costs associated with arranging finance, such as application fees, bank appraisal fees, mortgage broker fees, etc. Be very thorough when estimating finance costs, as there may be fee after fee after fee that are not obvious at first glance but rather are hidden in the fine print. These will all add up, and if your loan is less than $100,000, then the total percentage of fees relative to the loan can be as high as 5%, and even more! Be particularly careful with low interest rate loans, as the initial and ongoing fees can often be higher to compensate the lender for the lower interest rate they are providing. In addition to the fees charged by the lender for making the loan, you may also have to pay for their legal fees associated with the loan and registering the mortgage in the State where the property is located.Don’t go in blind as these costs can be thousands of dollars!
To guard against surprises, make sure you get a total fee estimate, broken down into each type of fee, from your banker or mortgage broker.
Remember too, that such fees are often negotiable, so don’t be afraid to ask for a discount or special concession.
2. Not Planning for Initial Repairs
In addition to closing costs, most investors complete various initial repairs or improvements immediately after purchase.
Examples include interior and exterior painting, roof repairs, purchase and installation of new appliances, replacement curtains, landscaping, etc. in order to make the property rent-ready and/or to justify a higher rent.
Under-estimating initial repairs is a very common mistake as it is easy to shrug off the likely actual costs, believing them to be minor or insignificant, only to later realize that the task is far more substantial and expensive than first thought.
Commissioning a building inspection will help you to prepare a scope of initial repairs that you plan to complete, and once done, have experienced tradespeople provide you with a written price quote before the agreed inspection period specified in the purchase contract expires.
3. Not Having Adequate Cash Reserves
Another important point to be made is that you are unlikely to be able to borrow the costs identified above and hence will need access to enough cash to pay your deposit and all of the expected transaction, due diligence, finance costs and initial repairs.
Running short of cash could be a disaster.
Not only is your deposit at risk, you can also be sued for any loss the buyer suffers if they cannot subsequently sell the property at the same price to another buyer.
Alternatively, you may be able to close, but not be able to get the property rent ready. If this happens, you may find it hard to find a tenant or charge the rent you had hoped to.
Final Words
Your total purchase price will be the sum of the contract price, closing costs and initial repairs.
Astute investors itemize and budget for each cost and ensure they have adequate cash reserves to pay for them.
Amateur investors tend to stumble along, hoping things will work out. When they don’t, the result is unnecessary and avoidable stress.
It’s your choice – so choose wisely.
Here’s my five point summary on the key takeaways today:
Five Point Summary
- Your total purchase price will be the contract price, plus closing costs, plus initial repairs. The extra costs can add up to thousands, even tens of thousands, of dollars.
- Closing costs and initial repairs usually have to be paid by the investor rather than borrowed. Make sure you have enough cash to pay them.
- It is unwise to try to save money by skimping on due diligence checks. In real estate, it’s what you don’t know that ends up costing you the most to fix! You can use your due diligence findings to re-trade the purchase price or else ask the seller to fix the issue before closing.
- Your cost of finance is usually a lot more than the loan application fee. Watch out for the hidden extras by reading the fine print carefully and asking for a summary of all the known costs.
- The flipping strategy is difficult to do successfully in jurisdictions where closing costs are more than 1% of the purchase price. Too much of the profit margin is gobbled up in transaction costs.
About the Author:
Steve McKnight is a professional investor who has bought more than 500 investment properties in the US, Australia and New Zealand. He also runs a $100m US commercial property fund.
Note: This article was originally published on MoneyMiniBlog.
Category: Real Estate
