After several long years cooped up in our homes, Americans are ready to travel. Savvy investors can take advantage of the ongoing vacation travel explosion through strategic investment in vacation rental properties. But how good of investments are short term rentals actually? Let’s find out.
What is a vacation rental property?
Vacation rental properties, also known as “short-term rental” properties, are lodging properties used by travelers for a limited period of time (less than 30 consecutive nights), similar to a hotel or motel. This segment of the real estate sector is just as diverse as your traditional long-term rental property, and runs the gamut from ultra-luxe single-family properties in highly desirable vacation destinations to multifamily workforce housing for traveling nurses in dense urban areas. There is also a range in the level of service offered by a short-term property, with full, partial, and self-service models on offer.
There are four main types of short-term rental properties, including:
- Traditional Leisure Vacation Rentals: Beachfront condo in Maui, Ski Lodge in Aspen
- Short-Term Urban Rentals: Apartment near a hospital, Condo in an up and coming neighborhood
- Primary Residential/Shared Home Rentals: A 4 bedroom home in a suburban community or a home with an ADU for short-term stays
- Others: RVs, Houseboats, Campers, Treehouses, Yurts, Tents, Glamping Setups
Things to Consider When Buying a Vacation Rental Property
The right vacation rental property can be an income-producing and appreciating asset for its owner. But every rose has its thorns, and the wrong vacation property can lead to significant financial losses- particularly for green investors just getting into the space. That doesn’t mean that every novice investor fails- all of the greats had to start somewhere- but you need to consider the big questions- the how, why, what, and where’s behind a given vacation rental investment.
Let’s look at a list of the questions you need to ask yourself before taking the plunge on a vacation rental home or short-term property.
Where do you plan to purchase your vacation property?
Location is everything in the world of real estate. A focus on the right location is even more critical with vacation properties- after all, who wants to vacation in Hoboken, New Jersey, over the big Island of Hawaii? When considering investing in a vacation property, put yourself in your future guests’ brain- think about who they are, their budget, what they want out of a vacation, and so on. Choose a market that you’re familiar with- there may be incredible deals on Bali vacation homes, but unless you’re a local or have a great deal of experience dealing with Indonesia, it’s probably best to stick with something you know- at least at first.
Are you looking for a new job or a source of truly passive income?
If you’ve performed even a cursory evaluation of the real estate investment space, you’ll find countless companies, influencers, and real estate professionals singing the praises of “passive income” through investments in real estate, from multifamily apartment rents to monthly self-storage unit fees, to short-term vacation rental income. This promotion of the ease and passivity of real estate income is misleading at best.
A lot of work goes into finding, acquiring, and managing a rental property, and if you plan to own the property directly, you’ll have to put some level of sweat equity into the upfront setup and ongoing maintenance. Whether that takes the form of ongoing management duties, finding and negotiating purchases, property sales, and so on, the income you derive from your investment will not be truly passive.
However, you can cut your workload immensely and achieve true passive income Nirvana through fractional ownership, either through a traditional REIT that pays dividends or through real estate crowdfunding and fractional ownership of managed properties like Getaway.
Pros and Cons of Owning Vacation Rental Property
Like any investment asset, vacation properties have the potential to be an excellent source of long-term cash flow and property appreciation value. Let’s examine some pros and cons of owning a vacation rental property.
Pros of Owning a Vacation Rental Property
Regular Income
This is a big one. The extra income you earn from a rental property is probably the biggest draw for most investors. According to data released by lender Earnest, Airbnb hosts typically make about $924 a month. That data only applies to a single platform; it doesn’t count independent operators, other scaled firms operating vacation rentals, or other websites like VRBO, Booking.com, etc. A well-managed rental property, in the right location, with the right features can bring in a good amount of consistent income for investors.
Equity Appreciation (Property Value Growth)
All real estate investors pray for property appreciation. Having a regular income to pay the mortgage is great-but you can also benefit from the value of your investment property climbing over the years. Imagine the returns you would have seen buying a condo in San Francisco or Manhattan in the early 1980s. Combine that with favorable tax treatment and high rental rates, and you’re looking at a relatively secure financial future. Property growth tends to mirror inflation through higher rents and equity appreciation. That means that a vacation property can be a powerful hedge against the ever-declining dollar.
Tax Benefits
Real estate is arguably the most tax-advantaged investment class in the United States. As an investor, you’ll benefit from numerous tax reduction, deferral, and elimination strategies, whether you’re investing in fractional vacation real estate through crowdfunding or directly owning and managing a property. You’ll also benefit from business deductions, as a functioning vacation rental also receives favorable tax treatment, like expense deductions due to daily operations and property depreciation.
Cons of Owning a Vacation Rental Property
If your goal is making money and not being in the red, you’ve got to take a high-level view of any asset and learn about the good, the bad, and the ugly. Cons of vacation rental properties include:
Unforeseen Expenses
You’ll see issues arise in the ordinary course of business as a vacation rental owner. That’s one of the reasons you receive such favorable tax treatment. Normal wear and tear, guest damages, customer service problems, lawn, pool, and common area maintenance can eat into your bottom line.
Dealing With Regulations
Nobody likes dealing with their local planning board, tax authorities, or local code enforcement tyrant. Now imagine you have to deal with someone in a small city across the country! As a direct owner, you will need to navigate a wealth of rules and regulations surrounding vacation properties. With crowdfunded, fractional and managed vacation real estate, the company will handle all of the legalese.
Can a vacation rental be profitable?
Short answer? Absolutely. The global vacation rental market is projected to grow to almost $83 billion in 2022, up from about [$75 billion in 2021](https://www.grandviewresearch.com/industry-analysis/vacation-rental-market#:~:text=The global vacation rental market size was estimated at USD,USD 82.63 billion in 2022.). But you are by no means guaranteed to turn a profit- and you can even take a substantial loss if you make the wrong choices. Novice vacation rental owners can run into many problems, from falling afoul of local regulatory bodies, choosing the wrong markets, or overextending their leverage across their vacation property portfolio.
With that being said, vacation rentals can be a powerful driver of profit- just look at this Millenial that set up a single glamping tent in Hawaii and pulls in $28,000 per year. That’s to say nothing of the tremendous opportunities, lower costs, and additional profit that comes at scale with professional management.
Vacation rentals are profitable when:
- You purchase a property in a desirable location with low vacancy rates.
- You buy in an area that has long-term growth potential.
- You perform all of your required due diligence- you don’t want to buy a seaside cottage with major structural issues from the salty air or a condo building in Florida with structural issues.
- You manage and market the property effectively from furniture setup to pricing to guest communications.
- You comply with all local, state, and federal regulations for your vacation rental business.
What is a good rate of return on a vacation rental property?
When assessing real estate investments, three key investment metrics are most commonly used: Internal Rate of Return (IRR), Cap Rate (Cap Rate), and Cash on Cash (CoC).
IRR
Internal Rate of Return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual dollar value of the project. It is the annual return that makes the NPV equal to zero.
Generally speaking, the higher an internal rate of return, the more desirable an investment is to undertake. IRR is uniform for investments of varying types and, as such, can be used to rank multiple prospective investments or projects on a relatively even basis. In general, when comparing investment options with other similar characteristics, the investment with the highest IRR probably would be considered the best.
Cap Rate
Cap Rate is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market.
While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money, and future cash flows from property improvements, among other factors.
Cash on Cash
A cash-on-cash (CoC) return is a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property. Put simply, cash-on-cash return measures the annual return the investor made on the property in relation to the amount of mortgage paid during the same year. It is considered relatively easy to understand and one of the most important real estate ROI calculations. CoC is one of the best indicators of how well you are ‘putting your money to work’. Generally speaking, you want your real estate investments to meet or beat the S&P’s annual return.
What is considered to be a “good” return will change based on market conditions, inflation, economic growth, etc. You can get a ballpark idea of the potential rate of return by either looking at an annualized return, which is cash on cash plus annual property appreciation. Looking at total annualized return, you would be thrilled to hit anywhere above 15%+. If you use cap rate as your determiner, you’re looking at 6%+ being a good return and using cash on cash rate calculation; you should be happy anywhere at or above 8%.
Simple Vacation Rental Property Cash on Cash Calculation
Calculating CoC for a rental property is relatively simple.
Here's a step-by-step guide:
- Determine your expected top line rental income. This is the amount of money you expect to collect annually.
- Calculate your annual expenses. This includes all operating expenses like mortgage payments, insurance, property taxes, maintenance, utilities, licensing fees, etc.
- Subtract your expenses from your expected annual rental income. This is your annual profit (or loss).
- Divide your annual profit (or loss) by your total cash investment amount. This is your CoC return.
For example, let's say you're thinking about buying a rental property for $100,000. You pay $20,000 in cash for your down payment. In addition to the down payment, you invest an additional $20,000 for remodeling and furniture. Now you have invested $40,000 of cash into the deal. You expect to collect $1,500 in rent each month, totalling $18,000 in annual revenue. Your monthly expenses (mortgage, insurance, taxes, etc.) come to $1,000, totally $12,000 per year. This gives you an annual profit of $6,000. Divide $6,000 by $40,000, and you get a CoC of 15%.
Vacation Rental Property Investment ROI: Cap Rate
The cap rate is a measure of the property's potential return on investment. It's calculated by dividing the property's annual net operating income (NOI) by its purchase price. Cap rates are a “quick and dirty” view of the potential profitability of a real estate asset.
Cap rates are best used while doing initial research on large groups of properties, once you’ve narrowed down the field of prospective properties, you’ll want to use a more accurate, data-based method.
For example, let's say you're considering a property that has an NOI of $24,000 and a purchase price of $200,000. The property's cap rate would be 12% ($24,000/$200,000). Note: net operating income is all of the operating expenses of a property with the exception of debt service or your mortgage costs. Because the cap rate calculation doesn’t take into account the cost of debt, investors can compare investments apples to apples irregardless of their mortgage terms.
When evaluating a deal, a higher cap rate is better than a lower cap rate because it indicates a higher potential return on your investment.
Of course, the cap rate is just one factor to consider when assessing a rental property. You'll also want to look at the property's location, condition, and other factors that could affect its profitability.
How to Buy a Vacation Rental Property
Let’s look at a few ways you can buy a vacation rental property.
Direct Ownership
This method is what you’re probably most familiar with. You’ll be responsible for purchasing a second property, maybe in your city, town, or a nearby tourist hotspot, and taking care of everything on your own. That means finding and buying a property, getting it ready for tenants, navigating the complex legal minefields inherent to the vacation rental industry, and so on. You can also contract most or all of these duties to outside management firms, but they tend to take a significant percentage of your cash flow from the property- and through the awesome power of compound interest, that 2-6% annually turns into a big chunk of change at the end of the investment’s lifecycle.
Investing in Vacation Rental Companies/REITs
You can also invest in popular vacation rental REITs, also known as lodging REITs. These are typically (though not always) publicly-traded companies that work in the vacation rental space. They offer a way to quickly jump into the space with just a few clicks on your Charles Schwab or Robinhood app. Keep in mind that with a REIT or vacation/lodging company investment, you’re generally investing in a whole portfolio of properties in disparate locations.
You’re also betting on that firm’s corporate structure, team, business acumen, etc. While you don’t need to pay upfront fees to invest in a REIT, as a partial owner, you’ll be paying executive and employee compensation, the firm’s running costs, bond and debt payments, etc. You can look at some popular lodging REITs on this list compiled by NAREIT.
Fractional Vacation Property Ownership
With the passage of the 2017 TCJA, or Tax Cuts and Jobs Act, the United States Congress ushered in a new era of democratized real estate ownership. The bill allowed small investors to invest in fractional real estate projects, sometimes for as little as $100. This was the first step to democratizing access to real estate investing for the masses.
Investors can purchase fractional ownership stakes, interests, or “tokens,” that represent how much of the property they own. This number can be as high or as low as they want it to be. Tokenized real estate offers significant upsides, like regular cash flow, price appreciation, and tax benefits. Additionally, it allows investors to add a level of diversity to their portfolios that was previously only attainable through investing in large-scale REITs.
Fractional ownership also gives investors the ability to invest in several different projects or one project they like- making fractional vacation property ownership an excellent option for someone looking to dip their toes into the space without an extensive time or capital commitment.
Final Thoughts
To answer the question posed at the beginning of this article- yes, a vacation property can be a good or even great investment. But for your investment to be classified as a good or great investment, it’s crucial to do your due diligence, truly understand the markets where you acquire properties, invest within your appetite for risk, and maintain a diverse portfolio. You don’t want to stick your entire net worth into a single rental property and put all your eggs in one basket. As always, you should obtain professional advice as is appropriate to protect your interests, including any legal, accounting, financial or other relevant advice to make informed decisions based on your circumstances.
