A Guide to Investing in Short-Term Vacation Rentals

Are you interested in investing in vacation rentals as a source of primary or supplemental income? If so, you are not alone. Read on to learn more about investing in long or short-term vacation units.

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Investing in Short-Term Vacations Rentals – 101

1

Know The Short-Term Vacation Rental Market

USDA loans are offered by the Department of Agriculture to enable individuals in rural areas to afford homes. In order to qualify for a loan, you must meet certain income restrictions, putting you below what the government considers low-income. These loans are offered with very little or no down payment. The loans are more restrictive than traditional ones, however. First, there are income limitations. In addition, the property you are buying must be in an approved location. Rural does not mean the home needs to be out in the country and far from neighbors, but the population of the area you are buying in must be under 35,000 residents. The house must be used as the buyer’s primary residence and can’t be income-producing. The house must also meet size and structural guidelines. If the buyer should move or sell the property before the loan is paid off, the remaining monies must be paid immediately. An additional benefit of this type of loan is that the terms for repayment are often longer than that of other loans.

Source – FRED – Federal Reserve Economic Data

The Census Bureau provides a detailed table identifying each state’s median home values (when adjusted for the year 2000 value of a dollar) from 1940 through 2000. During this time, median home values/investments rose in price – with the fastest growth recorded in the 1970s, followed by the 1980s, the decade with the slowest rise in real estate appreciation.

According to Technavio.com, the vacation rental market is anticipated to perform at a 7% CAGR – Compound Annual Growth Rate through the year 2024. The CAGR is defined as the ‘mean annual growth investment rate over a preset time – generally one that is longer than a year. The Compound Annual Growth Rate is also considered one of the most accurate metrics that can be used to measure an asset’s performance (or anything of value for that matter) over a given time.

Using a chart issued by Grandviewresearch.com will help clarify how the vacation rental market sector breaks down and how each part relative performance through 2027. Many economic and real estate analysts recognized these CAGR industries:

Homes
Apartments
Resorts or Condominiums
Others

Much of the vacation rental market is fueled by a few online industry giants and companies, which act as large databases of available vacation rentals properties set up to help vacationers find a home/apartment or another vacation rental that meets their vacation needs.

Another beneficial consideration of choosing to invest in short-term vacation rentals is that this slice of the real business very often requires a minimum amount of capital to get started and to operate compared to other popular investment options. However, depending on the investor’s ultimate strategy and risk tolerance, short-term rentals can be a positive or negative aspect of this investment type. The success of short-term vacation rentals is because their offering meets a real unmet need – a need for temporary housing for college students, school visitors, tourists, or those attending corporate events nearby. Arguably, the second-best part of owning a short-term vacation rental is that on a month-to-month or day-to-day comparison rate comparison, the short-term rental option usually commands higher rental fees.

And while the cost and expense to clean and keep the rentable unit are in demand, the higher expenses are typically offset by the higher rental figures. And if the rental market is year-round, the rental income rates may not only be significantly higher but consistent and lucrative.

Another beneficial consideration of choosing to invest in short-term vacation rentals is that this slice of the real business very often requires a minimum amount of capital to get started and to operate compared to other popular investment options. However, depending on the investor’s ultimate strategy and risk tolerance, short-term rentals can be a positive or negative aspect of this investment type. The success of short-term vacation rentals is because their offering meets a real unmet need – a need for temporary housing for college students, school visitors, tourists, or those attending corporate events nearby. Arguably, the second-best part of owning a short-term vacation rental is that on a month-to-month or day-to-day comparison rate comparison, the short-term rental option usually commands higher rental fees.

And while the cost and expense to clean and keep the rentable unit are in demand, the higher expenses are typically offset by the higher rental figures. And if the rental market is year-round, the rental income rates may not only be significantly higher but consistent and lucrative.

2

Understand Existing Laws & Stat Current Regarding Changes to Industry-Related Legislation

Short-term vacation unit investors must work with the legal boundaries defined at the project, local, state, and often federal levels. And while only a few states require an attorney to manage the closing process, the reality is that it is often prudent to hire an experienced attorney to represent your interests – in real-time, as a property owner and landlord working with an asset that is usually valued in terms of hundreds-of-thousands of dollars.

The short-term vacation rental market has experienced some recent explosive growth – with industry numbers blowing past some of the most aggressive growth estimates – primarily due to the internet’s use as an incredibly effective, modern sales tool. However, not everyone sees how problematic this can be when an industry’s growth is off the charts.

To complicate matters, each jurisdiction has the authority to define salient concepts and relevant rental market rules for its jurisdiction. But be cautious, as there are times when definitions and concepts differ.

Some jurisdictions allow for the rental of a one-room rental, while districts strictly forbid this practice.
Some jurisdictions may limit the number of people who can safely inhabit a home. This is typically defined as the number of people/beds in the unit.
Some jurisdictions may limit the minimum (i.e., one day) or the maximum (i.e., one month, etc.) of the defined rental period.
Some jurisdictions may require rental property owners to hold an operator’s license to legally practice a short-term vacation rental business.
Zoning laws vary from location to location. Zoning laws determine the legality of operating certain types of rental properties and have the potential to seriously limit one’s actions as a property owner/landlord.

This legislative tug-of-war is still in its infancy, so there is no way to know how this important legal issue will ultimately play out. History has taught that it takes compromise and the spirit of cooperation to find a fair and equal solution to this problem.

3

Know Thy Market’s Metrics

Any investment, real estate, or otherwise can be evaluated based on relevant financial data, which may include projected rental income minus the anticipated expenses, etc.

The Return on Investment (RIO) Ratio

What Is ROI?

ROIs are mathematical calculations that offer one way to identify the profits of an investment.

The formula for ROI is typically written as:

ROI = (Net Profit / Cost of Investment) x 100

Source – HarvardBusinessSchoolOnline

A financial analysis done appropriately by a potential vacation rental investor will often include a detailed analysis of the potential of rental income against projected expenses. Ultimately, this analysis will help to determine if the projected Return on Investment (ROI) of a particular investment meets the investor’s minimum investment criteria.

Short-term vacation rental investors utilize two types of ROI metrics, as follows:

Anticipated ROI – this ROI is used to determine the viability/profitability of a potential project using estimated expenses and other assumptions. Investors who wish to work from a conservative approach tend to overestimate costs and underestimate revenue to ensure there are no surprises.
Actual ROI, as its name denotes, represents the true return on investment and can only be calculated after the passage of a specific period or defined event.

What Is the Gross Yield?

A metric that represents, as a percentage, the revenue an asset generates based on the asset’s value (or investment outlay). Example – What would the yield be for a $600,000 property that generated a monthly rental income of $3,000?

Monthly Rent – $3,000 x 12 = $36,000 in Gross Annual Rent
Gross Yield – ($36,000 /$600,000)x 100 – 6% Per Year

What Is a Net Yield?

A net yield is similar to a gross yield, except that, as a metric, it is a bit more insightful. This is because a net yield accounts for those costs required to maintain the asset.

Example – What would the yield be for a $600,000 property that generated a monthly rental income of $3,000 with a $1,000 per month in expenses?

Monthly Rent – $3,000 – $1,000 (Expenses) = $2,000 x 12 = $24,000 in Net Annual Rent
Net Rental Yield is ($24,000 /$600,000)x 100 = 4% Per Year

What Is an Acceptable Return on an Investment/Rental Yield?

What should an investor shoot for when considering investing in a short-term vacation rental? Like most investments, financial or otherwise, it would be imprudent to arbitrarily choose a specific ROI that defines ‘the right investment’ criteria. This is because each investor and every property/investment is different, which means due diligence is required for each research situation.

Other Considerations for Short-Term Vacation Rental Properties

Rental income is essential but should not be the only factor to consider when evaluating a potential short-term vacation rental opportunity:

Occupancy Rates – what type of market is the property located in?
Holding period – how long do you intend to hold onto the investment? Long enough to recoup closing costs outlays?
Capital Gains – what are the tax ramifications of owning or selling?
Investment Strategy – how does this property fit with your investment objectives?
Risks – any planned projects or functional obsolescence in the property?
Rental Regulations – is the locality or state ready to implement restrictive rental rules that will impact rental units?

Managing Short-Term Rental Properties

One of the more important decisions when deciding to invest in a short-term vacation rental property is to recognize its management differs from other rental property investments. Client turnover on a regular basis (which is what maximizes rental income) is great on the wallet but time-consuming (and costly). Finding reliable support companies can be challenging, so another important decision to consider before buying a short-term vacation rental property is to know if you want to manage the property yourself or to use a professional management company. The answer to the following question is not always as obvious as one would expect.

Should I Hire a Professional Company to Manage My Property?

A successfully managed rental property generates a consistent stream of income, with most of the expenses covering the cost to run the property by those leasing the property.

In theory, it seems simple, but a broken water pipe at 3 am in January is anything but simple. The questions noted below will help refine your thinking:

Do you want to be responsible for managing situations as a property owner?
Would you prefer to hire someone to respond to both everyday and emergency situations?

This decision is hugely personal and depends on the financial aspects of the property and the owner’s personal preferences. Property managers offer a variety of helpful and time-consuming services that include rental inquiries, cleaning, maintenance issues, rent collections, and bookings, plus the ever-expected, unexpected issue, to name a few.

Innovative property management companies have begun to specialize their managerial functions towards the needs of short-term rental property owners. In addition to the traditional support functions – which include landscaping, repairs and maintenance, and snow removal, if applicable, etc., many property companies now offer services to meet the needs traditionally fulfilled by companies and team members in the hospitality realm, as follows:

The management of bookings & arrivals/checkouts, etc.
The management of guest services throughout their stay
Anticipating the needs of guests.
The creation of a full customer service experience

Understand the Short-Term Vacation Rental Financing Options

There are a variety of financing options to help achieve vacation rental ownership objectives. Speak with a mortgage consultant who can help refine your thinking and offer you program options you may never have even considered.

The Take-Away

Real estate investors should be ready to follow the path that leads to the next profitable real estate technique. This usually means the investor must stay focused on a moving target shifting in response to market, economic, or other impactful domestic/global conditions. Interested in learning more about short-term vacation rental properties and the available ways to finance them?

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