Are you interested in investing in rental properties? Investing in real estate is a tried and true method to build wealth, with the average 1-bedroom renting for more than $1,500 per month.
But where there’s investment potential, there’s also often risk, and real estate is no exception. A novice investor can easily end up in the red if they lack a clear understanding of ongoing real estate investment property costs: carrying costs.
Carrying costs in real estate, also called holding costs, are the recurring expenses that an investor pays while owning a rental property. If you under budget your carrying costs you can significantly diminish your expected profits.
“On your first few properties, assume everything will cost 20% more and take twice as long,” shares Jesse Blaine, a seasoned real estate investor who’s managed over 76 investment properties. “The biggest teacher is experience, and there’s so much you’ll learn after closing on your first property. My first property was a piece of land in Costa Rica that yielded a 50% return by dumb luck alone, and I was hooked.”
For all the details on carrying costs, we interviewed Blaine and J Scott, prolific real estate investor, entrepreneur, and partner at Bar Down Investments who’s purchased, built, rehabbed, sold, and held over $70M in property around the country.
What are carrying costs?
Carrying costs are the expenses an investment property incurs — they’re essentially the cost of owning a rental property.
“Carrying costs vary depending on several factors,” Scott notes. “Some areas are prone to disaster or heavy snowfall and require special insurance. Multi-family properties have higher costs from amenities. Short-term rentals have different holding costs than long-term rentals, and professional property management incurs additional costs over self-managed properties.”
The costs associated with these factors impact your bottom line. Real estate investors must accurately calculate a property’s estimated carrying costs in order to craft their investment strategy and set rental rates.
“Make sure you account for all the costs of acquisition and long-term ownership of the property,” Blaine advises. “Every little cost can add up, and if you don’t factor in enough margin, you can be caught by surprise and eat into your returns.”
An expert breakdown of carrying costs
According to Blaine, there are two carrying costs that may be difficult to predict, especially for a novice investor: maintenance costs and vacancy. The other carrying costs are highly predictable.
It’s best practice to always budget more for carrying costs than you expect you’ll need to cover high maintenance bills and prolonged vacancies. “We keep four to six months reserves for each property, depending on the market,” Blaine says. “You’ll sleep better at night.”
When creating a budget for your real estate investment, there are 11 carrying costs that Scott and Blaine advise taking into account.
Mortgage costs are likely the first carrying cost that comes to mind when it comes to rental investments. Most real estate investors are aware that they’ll need to charge a high enough rent to at least cover their monthly mortgage payments.
If this is your first rental property investment, note that your loan will likely have a higher interest rate than an owner-occupied residential home. Lenders consider loans for investment properties as higher risk since the owner is more likely to default on a loan that’s not their primary residence. Many mortgages for investment properties have interest rates that are 0.50% to 1% higher than with owner-occupied loans.
2. Landlord insurance policy
While landlord insurance isn’t required by law, many lenders require that landlords purchase insurance that covers loss of income and liabilities caused by renters and weather damage.
Landlord insurance policies typically cost around 25% more than homeowners insurance, or $1,478 on average annually. The actual annual cost will vary depending on your property’s size, value, and location.
3. Property taxes
As with any property, investors must pay property taxes on their rental. Property taxes vary depending on your local property tax rates and your property’s assessed value and size. To determine the taxes on a property, check with the property tax assessor’s office or website in your investment property’s municipality.
For reference, single-family homeowners paid an average property tax of $3,719 in 2020. Homeowners in New Jersey paid the highest average property tax of $9,196 on average, while Alabama homeowners paid the lowest average tax of $841.
4. Short-term rental taxes
Short-term rentals like Airbnb and VRBO are increasingly popular and can be highly lucrative. According to Airbnb, new hosts have earned more than $1 billion since March 2020 alone, with average rates at an all-time high of $245 per night. On average, a short-term rental will generate between $20,000 and $30,000 in rent a year. Sound like a majorly lucrative investment? It may well be, but not so fast — that revenue can come with a hefty tax bill.
Short-term rental taxes vary depending on city, county, and state laws. For instance, the state of Maine requires hosts to pay a 9% short-term rental tax, which means an investor who made $25,000 through short-term rentals would need to pay $2,250 in short-term rental taxes alone. In Florida, an investment with the same revenue would require an investor to pay just 6% sales tax, or $1,500.
Electricity, gas, water, AC, and monthly trash collection fees vary by location and property size. In most areas, there are no federal laws that require landlords to pay for tenant utilities, and landlord responsibilities for providing utilities vary by state. Typically, it’s up to you to determine which utilities you’ll include in rent and which the tenant will pay for directly.
Landlords typically handle utilities in one of three ways:
- You can include utilities in the monthly rent. Some landlords choose to only include some utilities in the rent. You might choose to cover water and sewer, for example, which costs between $30 to $200 per month on average, and leave the tenant responsible for the rest of the utilities. The downside of including utilities in your rent is that your property’s rent will appear higher than other similar properties. This could make it more difficult to find renters in some markets.
- You can charge tenants a monthly fee for utilities. This option is appealing if you want to keep the utilities in your name, but it does require you to perform some extra accounting each month. You’ll need to either charge flat monthly fees or charge tenants based on their actual usage. Research your state’s tenant utility rights first to ensure you’re in accordance with rental laws.
- You can make your tenants responsible for utilities. This means that your tenants will put utilities directly in their name. This requires the least budgeting for the landlord.
Many landlords use a combination of these options. However you choose to handle utilities, you’ll need to clearly describe which utilities are the tenant’s responsibility and which you’ll cover in the utility clause in your lease.
6. Homeowners association (HOA) dues
If your rental investment property is in an area governed by an HOA, you’ll need to pay monthly HOA fees. The average monthly HOA fee is around $200. Of course, HOA dues vary based on a property’s size, location, and amenities.
You can generally find the HOA information for a property on the listing or on the neighborhood’s website.
7. Routine maintenance
Routine maintenance items like painting, changing locks, and repairing appliances, and more add up fast. Necessary maintenance differs month to month, making it difficult for new investors to precisely budget for this carrying cost.
For instance, Scott shares that many investors don’t adequately budget for snow removal, which costs around $90 an hour; that expense can add up to hundreds of dollars per month or even per service for larger properties in areas with heavy snowfall. He cautions investors to plan to budget for items like snowfall and lawn care to avoid negative cash flow.
As a general rule, budget at least 1% of your property’s value for routine maintenance annually. For example, if your rental property is worth $250,000, set aside $2,000 a year or $167 a month. While your maintenance costs may turn out to be far less, it’s better to be over prepared than take a financial hit in a worst case scenario.
“Make sure you actually factor in enough to cover maintenance on your property,” Scott says. “If you use a property manager, they’ll probably use big companies for the work, and you’ll pay more than if you hire a handyman off Craigslist. Plus, your property manager will charge a fee to handle maintenance.”
8. Major repairs
Rental investors are on the hook for big-ticket repair items like roof damage, HVAC replacements, and plumbing upgrades which can make or break a property’s bottom line. Blaine advises investors to write these costs into offers on potential investment properties.
Look out for these expensive repair items when evaluating the value of an investment property:
- Roof replacement: $5,000 – $10,000
- HVAC replacement: $7,000 – $10,000
- Electrical rewiring: $4,000 – $12,000
- Water damage: $1,000 – $5,000
- Mold removal: $1,000 – $4,000
- Sinking or settling foundation: $4,000 – $10,000
Scott advises investors to think about forecasted depreciation and set aside $50 to $100 each month to go towards future repairs.
“One of the biggest mistakes I see investors make with carrying costs is not factoring in all capital costs,” Scott says. “For example, many investors think that if a property has a new roof, they don’t have to factor any roof costs into the investment. That’s short-term thinking.”
Scott recommends accounting for future repairs of major property components like roofing and plumbing in your budget. For example, an asphalt shingle roof costs an average of $8,366 to replace and is due for replacement every 20 years on average, according to the National Association of Home Builders. To account for this depreciation, factor approximately $418 a year, or $25 a month, into your carrying costs.
9. Property management fees
If you hire a property manager to manage your property, collect rents, and lease your units on your behalf, you’ll pay them a monthly fee. Like many carrying costs, property management fees vary depending on the size, location, and condition of your property, plus the level of service the company provides.
“Many investors don’t know their true property management costs because they fail to see the full picture,” Scott says. He shares that property manager fees often tally up to 12% to 15% of the gross rent.
10. Marketing vacancies
When you have a vacancy, you’ll likely need to post a listing online to attract new tenants. If you plan to list rental units on a long-term rental listing site, check what fees they charge landlords first.
- Apartments.com doesn’t charge landlords to list units, and instead charges tenants $24.99 to apply through their app.
- Apartment List won’t charge you to list a property, but they’ll charge you $349 when a tenant moves in.
- Zillow Rental Manager offers one free listing, then charges $9.99 per rental unit per week.
- Avail charges $5 per unit per month for premium features, although they also have a limited free plan.
Short-term rental sites like Airbnb and VRBO also charge hosts for their listings. Airbnb charges hosts a percentage fee per booking that’s typically around 3%. VRBO allows hosts to choose between two fee models. They can either pay an annual subscription fee of around $500 or pay-per-booking and pay 5% commission for the rental amount and included fees, plus a 3% payment processing fee.
11. Vacancy and turnover costs
“A novice investor may not realize that vacancy can quickly cost you quite a bit of money,” Blaine cautions. The longer a unit is empty, the more costs you’ll incur, down to the day.
The average renter stays in a building for 27.5 months, and there will always be at least a brief period of vacancy between tenants for completing repairs. Without generating income, a vacant property quickly becomes a money pit. The investor must cover mortgage payments, property taxes, and utilities out of pocket.
Rental vacancies are relatively low right now, according to the U.S. Census Bureau, with the national rental housing vacancy rate at 6.8% in the first quarter of 2021. Vacancy rates are even lower in areas with high rental demand. Still, vacancy is a risk that you must build into your projections to maximize returns.
“A lot of investors ignore vacancy,” Scott observes. “They think, ‘Rentals are in high demand — I’ll have no problem renting this thing!’” While that may be true, he cautions, there will still be inevitable vacant periods between tenants.
For the most accurate vacancy rates, work with a top real estate agent in your area to conduct a market analysis. Alternatively, you can get a rough idea by reviewing U.S. Census Data on your state’s rental vacancy rates.
“Even in the best case, you should factor in at least one week per year — about two percent vacancy. But I never assume less than five percent, just to be safe,” Blaine advises. “If you factor in this potential carrying cost beforehand but then end up with great long-term tenants and don’t have to pay it, it’s always a nice surprise. It doesn’t feel great when it goes the other way.”
Work with a top real estate agent who can help you do the math
Investing in rental properties is a promising way to generate steady income, but it can be a risky endeavor for a novice. A clear budget with all carrying costs accounted for will allow you to predict the profitability of a property and strategically price your rents.
If you’re not confident in calculating return on investment, work with an investor-friendly real estate agent who can help you calculate your property’s capital rate and make a competitive offer that suits your bottom line. HomeLight’s Agent Finder tool can connect you with Certified Investor Agent Specialists in your area who are trained to help you develop a better investment strategy.