Investing in real estate is all about the math, and one calculation investors use to figure out if a property is a smart buy is the total cost of ownership, or TCO. If you're wondering, "What is TCO?" -- you're in luck. We've taken the time to break down exactly what this calculation is, how it works, and how you can apply it to real estate. This article will help you understand why you need to consider the full picture of the expense in your cost accounting.
What is TCO: total cost of ownership?
In business, the acronym TCO stands for "total cost of ownership." This calculation is used to look at the overall cost of owning a particular asset, rather than just its initial purchase price. Sometimes also known as a "life cycle cost" or "cycle cost analysis," the total operating cost takes into account the purchase price, any operating costs, and, if applicable, the cost of eventually putting the item up for resale.
By and large, companies use a total operating cost calculation to get a fuller picture of an asset's total economic value and to protect themselves against unnecessary future losses. This calculation is especially helpful when comparing two potential assets before making a purchase, as it allows for a side-by-side comparison of which one will end up costing more in the long run.
How to calculate an asset's total cost of ownership
At its core, doing TCO calculations is a matter of simple addition. In order to find the total operating cost for an asset, you simply need to add up all the direct and indirect costs associated with that item. The more difficult part of doing an ownership TCO analysis is projecting the potential cost for expenses that aren't necessarily cut and dry.
However, there are ways around this. If you've been in business for a while, odds are, you may be able to use past expenses to give you a better idea of what you can expect to spend. If you're newer to the business, you may want to do some research into the average cost for your potential new acquisition.
Calculating TCO: A simple example
In order to give you a better idea of how calculating an item's total cost of ownership works, let's use the example of buying a new car. Here, you have the following expenses to consider:
- The purchase price plus financing costs.
- The insurance policy.
- Ongoing maintenance costs.
- Any repairs.
- The cost of fuel.
While those line items will give you a relatively full picture of the cost of ownership, you'll also want to remember to take into account any circumstances that are unique to your asset. In the above example, for instance, you would want to account for the fact that a car is a depreciating asset.
Using TCO in real estate investing
Now that you understand what an asset's life cycle cost is and how to calculate it, the next step is learning how to apply it to your real estate investments. In truth, the process is much the same as in the car example above, but since there are many different costs that go into owning and operating a home, the projections get more complicated.
Below is a list of the potential costs you might want to take into account if you're using TCO calculations to decide if an investment property is a smart buy.
Though your down payment is essentially part of the purchase price, it's worth noting that while first-time buyers may not need to have a 20% down payment, those looking to finance an investment property are typically held to a higher standard. You'll want to be prepared to put at least 20% down upfront.
Closing costs typically amount to an additional 1% to 2% of the property's purchase price and are split between the buyer and the seller.
Repairs or renovations
If you're planning on doing any repairs or renovations to the property before you rent it out or put it up for resale, you'll want to have estimates done for them so you can include them in your calculations.
Your best bet to get an exact amount for current property taxes is to contact the county assessor. You should make sure you know how much you'll be expected to pay after closing because it could be very different from what the seller is paying now.
You can contact your insurance agent to get an estimate for what the insurance costs will be on your new property. You should also check with your real estate agent to see if any supplemental policies like flood insurance are required.
Maintenance and repairs
This category may be hard to estimate, especially since you have no way of knowing what repairs will be needed. However, as a general rule of thumb, you can expect to spend 1% to 4% of the property value per year.
Though these costs will also vary and eventually may even be the responsibility of the tenant, it's in your best interest to know what they are. For a fair picture, ask the seller to provide estimates.
If you've bought in a planned community or condo association, you'll likely have homeowners association fees to consider. Though those may vary as well, the association can provide you with the specific fees for your property.
Property management fees
Even if you're planning on managing the unit on your own, you still have to consider any fees associated with marketing the property and finding tenants. If you're hiring someone to manage it for you, his or her fee also goes in this category.
Like the depreciation factor in the car example, if you're planning on renting out the property, you'll also want to include its projected rental values in your calculations. However, don't forget to account for a vacancy rate in your projections.
Selling closing costs
On the other hand, if your plan is to flip the property, you should account for the second set of closing costs that you'll encounter when you eventually sell.
Keeping the above costs in mind, consider the following example on calculating the total cost of ownership on a piece of real estate that's being flipped:
|Buying closing costs||$3,000|
|Selling closing costs||$3,000|
|Total cost of ownership (TCO)||$180,600|
Given this information, before making an offer, you would want to verify that renovated properties in the area are selling for an amount high enough above $180,000 to meet your desired return on investment (ROI). That way, you will have a better shot at walking away from the flip with a profit in hand.
The bottom line
When you invest in real estate, keeping your expenses under control is one of the keys to success. With that in mind, you can use a TCO calculation to get a much fuller picture of what taking on a new asset will cost. Keep this equation in your back pocket for the next time you're thinking about buying something new.
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