Vacation rentals have become popular as an alternative to traditional buy-and-hold rental properties. As a real estate investor, you may be considering buying a vacation rental property right now.
To help you decide if this strategy is right for you, I’m sharing the pros and cons of purchasing a vacation rental property, including what to look for in a vacation rental, their potential profitability opportunities, risks to avoid and whether vacation rental properties are something you should consider for your portfolio.
What is a vacation rental property?
First, some definitions. A vacation rental property – also known as a short-term rental (STR) – is the kind of property you’ll see advertised on sites like Airbnb and Vrbo. Wikipedia defines it this way:
“A vacation rental is the renting out of a furnished apartment, house, or professionally managed resort-condominium complex on a temporary basis to tourists as an alternative to a hotel.”
This is in contrast to homes rented out with traditional annual leases, and also in contrast to corporate housing, which is usually rented by companies relocating executives for months at a time in central business districts (CBDs).
Are vacation rental properties profitable?
In a word, yes. If you pick the right type of property in the right area and manage it well, vacation rentals can generate a high return on investment (ROI).
WHAT IS A GOOD ROI ON VACATION RENTAL PROPERTY?
Below is a pro forma for a lower-end vacation rental in Florida with some conservative projections.
- As shown in the pro forma, your all-in investment is $210K, which includes $35K for furnishings.
- Your first-year return is based on 80% occupancy with a $275 per night rate.
Property management for a vacation rental is higher than for a long-term rental, and the owner (you) has to pay the utilities. - All said, in your first year of operation, you’d net a 7.2% cash-on-cash return after expenses, and with rents increasing over time, it just goes up from there. Also, that cash flow is largely sheltered from taxes due to interest and depreciation write-offs (consult your CPA).
Also, since vacation rentals are almost always located in the most desirable locations, they offer great equity growth.
BEST OF BOTH WORLDS
Vacation rentals offer cash flow and long-term equity growth, so you “get paid now and get paid later.”
You might find similar returns by buying two or three single-family homes with the same amount of capital. Still, few residential properties offer the appreciation potential of a trophy property in a vacation area. And managing multiple properties is more time-consuming than managing one.
Why Is Now a Good Time To Buy Vacation Rental Property
We’ve all heard the cliché about real estate being about location, location, location. I disagree. I think real estate is about timing, timing, timing. During the 2008 financial crisis, you could have bought a dozen homes pretty easily. Try doing that today. Timing is everything. So why might now be a good time to consider investing in vacation rentals?
#1 LOW HOUSING INVENTORY
If you’ve been looking for investment property lately, you know that the inventory of single-family homes is limited. There are simply too many investors chasing too few deals.
That’s where vacation rental properties shine: Since they have a higher price point, there’s less competition from other investors who are priced out of this market or haven’t discovered this asset class yet. Also, if you’re a 1031 investor, it’s a lot easier to find a higher-priced vacation property than to find three or four traditional long-term rentals within your 45-day identification period.
#2 COMFORT LEVEL
For experienced single-family home investors, investing in a vacation rental is within their comfort zone. It’s not a big leap to go from single-family home investing to vacation rental investing. Other options you may be considering, like medical office buildings (MOBs), self-storage facilities or warehouses are completely different property types and have a steep learning curve.#2
#3 FIRST MOVER ADVANTAGE
In many markets with rising prices, getting in early is a competitive advantage while the numbers still work. Vacation rentals are located in the most desirable locations, and with home price appreciation, the deal that cash flows today will not cash flow tomorrow. Do yourself a favor by getting in now.
#4 LOWER INTEREST RATES
Another reason now is a good time to buy a vacation rental is lower interest rates, not pandemic era low, but historically lower.
Trivia question: What do an $800,000 mortgage at 5% and a $900,000 mortgage at 4% have in common? Answer: The same mortgage payment: $4,280 per month.
#5 PERSONAL USE
Many investors plan to use the vacation rental for personal vacations or even as an eventual primary residence when they retire. The sooner you buy your property, the longer you’ll be able to enjoy it for your own vacations. If you plan to eventually move in and make it your “forever home” when you retire, buying it now will be much cheaper than buying it 20 years from now. In fact, if you buy it now, you might own it free and clear 20 years from now.
What You Need to Know Before Buying A Vacation Rental Property
NUTS-AND-BOLTS
#1 BUSINESS
The first thing you must recognize when buying a vacation rental property is that you’re in the hotel/hospitality business, not the real estate business. You’re not a landlord. You are a “host.” You have guests, not tenants, and you are advertising constantly for those guests, not just once a year. You are also competing for those guests with other short-term rentals in your area. Maid service, cleaning, and laundry have to be done after each stay, so property management that specializes in vacation rentals is key.
#2 HIGHER PRICE POINTS
In many cases, a vacation rental will be a luxury property located in the most desirable areas. Think granite counter tops, brushed nickel finishes, stainless appliance package, pool, and Jacuzzi—and it will be located near the beach or other resort areas. You can expect prices to start at $500,000 and go up to $2 million.
However, some markets have lower-priced properties suitable for vacation rentals. For example, Ohio State University has a base of fanatical alumni who visit Columbus, Ohio, for football games, and short-term rental properties can be bought there for $250-300K.
#3 FINANCING
Do banks make loans as they would for any other house, or do they treat vacation rentals as commercial properties? In other words, do you qualify for the loan based on your ability to make the payments or whether the property’s cash flow can make the payments?
In most cases, you will qualify for the loan just as you would a long-term rental, i.e., your credit score, W-2 income, Debt-to-Income ratio (DTI) and tax returns. The only time the rental income comes into play is if you can’t qualify independently and you need the rental income to qualify.
#4 APPRAISALS
How are vacation rentals appraised? Is the appraisal based on comparable sales (“comps”) the way houses are appraised or is the appraisal based on net operating income (NOI) the way commercial property is appraised?
In most cases, the property will be appraised as a house, as that will provide the lender with a more conservative valuation. In areas where there are a large number of vacation rentals with established track records, the appraiser may factor NOI into the valuation.
#5 FURNISHINGS
In addition to the cost of the house, you will also have to spend $30-$50,000 on furnishings: furniture, bedding, towels, silverware, champagne glasses, etc. These expenses cannot be bundled with your loan and will have to be paid out-of-pocket in addition to your down payment. This is no place to skimp, as whether your vacation rental gets a five-star rating or a four-star rating will partly depend on the quality of the furnishings.
Tip: In some markets, you may be able to buy a property that has already been a short-term rental and, therefore, already has the furnishings in place. In that case, you would not have to pay extra for the furnishings, and you may be able to bundle them with your mortgage as part of the purchase price.
Six Risks You Should Know About
As prudent investors, we must always consider the possible risks when venturing into a new asset class. The following are six risks that should be on your radar. The first three are avoidable; the second three are not preventable but manageable.
#1 UNREALISTIC PROJECTIONS
As we saw in the previous example, rental income is based on what percent of the month you can keep your property rented (occupancy rate) and what the daily rate is. The seller is incented to tell you that the occupancy rate is 100%, and the daily rate is high.
Since you weren’t born yesterday, you’ll want to check the projections they give you. One way to do that is to visit short-term rental site like Airbnb.com, Vrbo.com, AirDNA.com (owned by Airbnb) and rabbu.com (an aggregator of vacation rental data from all providers).
Type in the address or zip code of the property you’re considering to see what properties similar to yours are renting for and their occupancy rates. Are the projections realistic?
Given the time it takes to do laundry and clean the rental between guests, I’d look closely at any projected occupancy rate above 80% (24 days out of 30). And how do the daily rates change? Are weekend rates higher than those during the week? Understand your market.
Another option is to buy a property that has already been a short-term rental and, therefore, has a track record of actual rent history. Looking at historical rents will eliminate a lot of the guesswork for that location and property.
Either way, if you think the projections are too optimistic, plug in more realistic assumptions and see if the investment still makes sense.
Do a sensitivity analysis. How low can daily rates go while still yielding positive cash flow? How low can your occupancy rates go while still yielding positive cash flow?
By checking the projections and doing a sensitivity analysis, you can invest with confidence. Any surprises you get will likely be to the upside.
#2 SEASONALITY
Some markets are active year-round (like a Florida beach area) and other markets are very seasonal (like a ski resort). Investing in a seasonal area introduces another layer of risk, as you may have four or more months of the year with little cash flow. You can avoid this risk by buying your property in an area that’s busy all year.
Here, Rabbu can provide some insights. You type in the address of the property you’re considering and it will tell you the average monthly gross rental income. If you click on the “View Seasonality Detail” link under the rental income number, it’ll show you a projection of how income varies by month in that market.
Here’s a seasonality report for a 2-bedroom in South Lake Tahoe, CA (a ski resort) from rabbu.com:
Notice how much the income fluctuates throughout the year! It’s busy during the summer and during ski season, but in between, it’s d-e-a-d. Depending on how much your mortgage is, your cash flow could be negative at least four months of the year.
For any property you’re considering, plug in the addresses and get a sense of what you’re getting yourself into. Hopefully, you can find a property that at least breaks even in its worst month or, at best, has strong demand year-round.
In reality, most markets will have some seasonality, but some markets are less seasonal than others.
If you must invest in a highly seasonal market, here are some considerations:
- Don’t close on the property right before the off-season. You may go months with insufficient cash flow and you’ll have to pay the expenses out-of-pocket. Ideally, you’ll want to time your purchase so that you close right before the busy season.
- During the busy season when times are good, stockpile cash so you can pay your mortgage and other bills during the slow months.
- Risk is an inherent part of investing, but if you’re taking on the extra risk of a highly-seasonal market, then you should be compensated for that risk. Are the returns in your seasonal market so significantly higher than those in a year-round market that you’re willing to incur that risk? If not, why take on a largely avoidable risk?
#3 PROPERTY MANAGEMENT
Property management is the Achilles heel of all real estate investing, but especially with vacation rentals. Whether your property gets 80% occupancy or 60% occupancy will depend in large part on your property manager, as will whether your property gets a five-star rating or a three-star rating.
You can identify the best short-term rental property managers using several methods:
- Ask the broker who’s selling you the property who the best property manager is for that area.
- Go online to Airbnb.com and Vrbo.com, and see which properties get the highest ratings. Find out what property manager they use and open a dialogue with them.
- Find out what makes a property rent quickly; what amenities are most in-demand (hot tubs, views, etc.,) and then go shopping.
Most investors buy the property first and then look for a property manager, almost as an afterthought. In this business, you might want to reverse that: Identify the best property manager first, pick her brain about what amenities to look for, find what areas she manages in, and then find the property last.
#4 EXCESSIVE COMPETITION
While you can somewhat protect yourself from unrealistic projections, seasonality and bad property management, you can’t do much about excessive competition.
You may buy a property and be successful with it, but others will see the opportunity and start entering the market themselves, and there’s not much you can do about that. There are no barriers to entry for anyone else to do what you’re doing.
However, there are some strategies you can use to give yourself an edge.
- First mover advantage: As noted earlier, if you’re one of the first to enter a particular market, you can get in when the numbers still make sense; once prices start rising, it’ll be too late for potential competitors to get in. Also, if you have a long track record of five-star reviews on vacation rental sites, it’ll be more challenging for a newcomer to compete with you.
- Picking the right amenities: When you did your preliminary research on revenue projections on Airbnb, Vrbo or Rabbu, you should have also kept an eye out for which amenities commanded a premium. What are guests willing to pay extra for? A pool? Hot tub? Spectacular views? By picking the properties that are most in demand, you can give yourself an edge over any competition.
- Picking markets with virtually unlimited demand: Jacksonville and St. Augustine, FL, get eight million tourists a year. It’ll be a long time before those markets are saturated with vacation rentals!
#5 RECESSION
Another variable you can’t control is the economic cycle. During recessions, people cut back on discretionary spending, like vacations. You can’t control that, but you can lessen its impact in several ways.
- The right amenities: Having a property with the most sought-after amenities insulates you somewhat from slack demand. If there are 10 vacation rentals in an area, and yours has the features everyone wants, you’ll feel the recession less than your competitors.
- Target your marketing to (relatively) recession-proof guests: Retirees don’t care about recessions or unemployment rates because they don’t need jobs. They have the same income regardless of what the economy is doing. Offering that group “seniors discount” could keep your property fully booked. Similarly, Ultra High Net Worth individuals aren’t affected much by the economic cycle, nor are some foreign visitors. Speak with your property manager about what works best in your market during the lean times.
#6 GOVERNMENT RESTRICTIONS
The last risk you can’t control is government action. Suppose you buy a property, do well with it for a few years, then suddenly the City Planning Commission decides to ban or partially restrict short-term rentals?
In actuality, this doesn’t happen that often, but it can. Municipalities that have passed some restrictions on short-term rentals include:
- New York City
- San Francisco
- Honolulu
- New Orleans
- Las Vegas
- Orlando
See a trend here? They’re all cities with a strong tourist industry and an even stronger hotel industry lobby.
While restrictions are generally unlikely in most metros, a prudent investor should always have a Plan B.
- Convert your property to a long-term rental: If the market is appreciating and you want to hold onto it, you have the option of renting it out as a long-term rental. By going to Zillow, Realtor.com or any of the other real estate sites, you can research what your property will rent for on a traditional annual lease. Just enter the zip code of the property, filter for the number of beds, baths and square footage and see what similar properties are renting for.
- Sell the property: Home price appreciation is highly likely since vacation rentals are in the most sought-after locations. Even if you’ve operated your property for only a few years, the appreciation should be high enough that you can still sell the property and make a capital gain after paying your selling expenses.
Are Vacation Properties Right for You?
By now, you have a good idea of how short-term vacation rentals work and how they differ from traditional long-term rentals. Are short-term vacation rentals for you? Here are some considerations.
Pros of Vacation Rental Properties
You should consider a vacation rental if:
- The investment (down payment, closing costs, etc.) represents no more than 10% of your overall net worth;
- You’re doing a large 1031 exchange and it’s easier to find one vacation rental than five long-term rentals within your deadlines;
- You like owning the most desirable properties in the most desirable locations;
- You want to have the property available for your own personal use or to even retire to someday.
Cons of Vacation Rental Properties
A vacation rental may not be for you at this time if:
- It causes you to put “all your eggs in one basket.” A financial planning rule of thumb is to put no more than 10% of your net worth into any investment. So, if you have a total of $250K to invest, you might be better off buying four $250K properties with 25% down rather than one vacation rental. Diversification carries less risk.
- This is your first investment. In the hospitality business, there are a lot of moving parts. Unless you’ve always been a wannabe hotelier, buying a bread-and-butter single-family home in a good neighborhood is the safest way to dip your toe into the world of investing. You can graduate to vacation rentals later after you have a traditional deal or two under your belt.
If you want more information or would like to discuss if there’s a place for a vacation rental property in your portfolio, you can speak to a RealWealth Investment Counselor by joining RealWealth. As seasoned real estate investors, investment counselors can offer you guidance and support, as well as connect you with turnkey property teams in top markets nationwide. Join RealWealth today! It only takes a few minutes and your membership is always 100% free!
