Summary: In this article, learn about the pros and cons of buying vacation rental property, including whether or not it’s profitable, how to choose a good opportunity and more.
Table of Contents
- Are vacation rental properties profitable?
- What is a good ROI on vacation rental property?
- Why is now a good time to buy vacation rental property?
- What you need to know before buying a vacation rental property
- Six vacation rental property risks you should know about
- Are vacation properties right for you?
In recent years, vacation rentals have become popular with investors as an alternative to traditional buy-and-hold rental properties. In this article, we will explore the opportunity that buying vacation rental properties can offer you as an investor, and whether these properties are something you should consider for your portfolio.
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?
WHAT IS A GOOD ROI ON VACATION RENTAL PROPERTY?
Below you’ll see 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) have 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. And 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 as well.
BEST OF BOTH WORLDS
Vacation rentals offer both 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, but 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?
LOW HOUSING INVENTORY
If you’ve been looking for investment property lately, you know that there is very little inventory of single-family homes available and too much competition for them. There are simply too many investors chasing too few deals-and that doesn’t even count the majority of buyers who are looking for a place to live.
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 for you to find one higher-priced vacation property than to try to find three or four traditional long-term rentals within your 45 day identification period.
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.
FIRST MOVER ADVANTAGE
In many markets with rising prices, it’s a competitive advantage to get in early 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. You do yourself a favor by getting in now.
LOW INTEREST RATES
Another reason now is a good time to buy a vacation rental is that interest rates are historically low, enabling you to buy more house for the same investment.
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.
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, and 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
The first thing you have to recognize when you buy a vacation rental property is that you’re in the hotel/hospitality business, not the real estate business. You’re not a landlord – you’re 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 has to be done after each stay, so property management that specializes in vacation rentals is key.
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 located near the beach or other resort areas. You can expect prices to start at $500,000 and go up to $2 million.
There are, however, some markets with lower-priced properties suitable for vacation rentals. For example, Ohio State University has a base of fanatical alumni who visit Columbus, OH for football games, and short-term rental properties can be bought there for $250-300K.
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 based on 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 on your own and you need the rental income to qualify.
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 a 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.
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 have them bundled into 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 avoidable, 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 sanity 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 data.rabbu.com (an aggregator of vacation rental data from all providers).
Type in the address or zip code of the property you’re considering and see what properties similar to yours are renting for, and what their occupancy rates are. 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 and still yield positive cash flow? How low can your occupancy rates go and still yield positive cash flow?
By sanity-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 altogether by buying your property in an area that’s busy all year long.
Here, data.rabbu can provide some insights. You type in the address of the property you’re considering and it’ll tell you your 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 data.rabbu:
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 for what you’re getting yourself into, and hopefully you can find a property that at least breaks-even in its worst month or, at best, a property with 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, make sure you 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 the returns 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; whether your property gets a five-star rating or a three-star rating will depend in large part on your property manager.
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 go find the property last.
#4 - EXCESSIVE COMPETITION
While you can somewhat protect yourself from unrealistic projections, seasonality and bad property management, you can’t really 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 really 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 the rental sites, it’ll be harder for a newcomer to compete with you.
- Picking the right amenities: When you did your preliminary research on revenue projections on Airbnb, Vrbo or data.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: Again, 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 a “seniors discount” to that group 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
- New Orleans
- Las Vegas
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: Since vacation rentals are in the most sought-after locations, home price appreciation is highly likely. 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.
CONCLUSION: 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 the traditional long-term rentals. Are short-term vacation rentals for you? Here are some considerations.
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.
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 one 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 you’d like to discuss if there’s a place for a vacation rental in your portfolio, you can speak to an Investment Counselor by getting a free membership to the RealWealth. Click here to sign up now. It only takes 5 minutes and your membership is always 100% free.