Find The Best Short-Term Rental Investment Opportunities.
Best Places To Invest In An Airbnb/Vacation Rental Property In 2020
With the rise of the short-term rental industry, buying a property for the purpose of putting it on the short-term rental market is an increasingly appealing option to a variety of investors. Airbnb real estate investing can be a lot of fun, but is not without it’s challenges.
The first questions investors have to answer is: Where should you look if you want to invest in a vacation rental property? Where’s the best city to own an Airbnb?
In this article we’ll take a look at:
– Is buying a vacation rental property a good investment?
– How investing in a short-term rental differs from investing in a long-term rental.
– Some key concepts to understand when analyzing short-term rental investments.
– How to find the best places to buy a vacation rental or other Airbnb real estate in 2020.
Is Buying a Vacation Rental Property a Good Investment?
In general, property investment brings a number of advantages:
1) Generate Passive Income: Owning a property allows you to rent it out, long-term or short-term, and generate passive cash flows from the asset for your troubles. However, as the owner, you are responsible for maintaining the property, paying obligations like mortgage payments and property taxes, and ensuring it stays occupied.
2) Capital Appreciation: The price of any property can vary with larger ‘macro’ factors such as economic growth, inflation, housing supply and demand and interest rates, and at a local level due to location-specific factors. Overall, it’s fair to say house prices in general tend to rise over the long-term, although there are frequent slumps in the housing market which can cause large drops in prices. Owning an asset that mostly appreciates in value over the long-term is an obvious plus.
Figure 1: All-Transactions House Price Index for the United States over the last 40+ years
3) Tax Advantages: There’s a huge variety of tax benefits to be gained when investing in a property. These can include a wide variety of deductions, the ability to write off the depreciation of the property value and other capital investments, pass-through deductions on rental income, paying capital gains rather than income tax on appreciation gains when selling a property, and the option to invest tax-free or tax-deferred when using schemes like 1031 exchanges.
4) Leverage Opportunities: Interest rates have been falling in the U.S. since the 1970s as the Federal Reserve cut their main policy rate. This policy rate, in addition to a variety of other loose monetary policy measures such as Quantitative Easing (which was conducted in the US, Japan, the UK, the Eurozone, and in other countries) have resulted in a long-term decline in interest rates, and that means mortgages are very cheap. Depending on where you are, you can get away with only putting down 10% of the value of a property in order to buy it. This leverage allows you to amplify your returns – but be careful, the more leverage you take on, the bigger the risk of issues when the market has a downturn.
Figure 2: Average 30-Year Fixed Rate Mortgage in the United States over the last 40+ years
5) Optionality: Unlike investing in financial assets like bonds and stocks, where you have little change of influencing the outcome, investing in real estate gives you control and optionality. If you invest in a property and it’s value appreciates significantly, you can sell it. Another option is to generate income from the property by renting it out. Other options include refinancing, leasing, subdividing, renovation and development.
Long-Term Rentals vs. Short-Term Rentals: Comparing The Risks
How do the risks of investing in a property for long-term rental compare to those for short-term rental?
The big difference between buying a property and then renting it out via conventional long-term contracts vs. putting it on the short-term rental market is simple – you take on a higher level of occupancy risk in return for higher returns.
What is occupancy risk? With a long-term contract you are locking in a tenant for a period of 6 months, 12 months or perhaps longer, so you know that your tenant is contractually obligated to pay you for that period. On the other hand, with a short-term rental the risk of your property remaining empty is much higher, as you are constantly trying to keep the property occupied with short-term guests. Competition for guests is fierce and keeping a property occupied is an entire industry in itself (vacation rental property management). Remember that even if your property isn’t occupied with guests, you still have to pay bills like mortgage payments, property tax and maintenance.
One advantage short-term rentals have over long-term rentals is a much lower level of tenant risk. Tenant risk is the risk that a long-term tenant reneges on the contract and doesn’t pay rent, which often leads to time-consuming legal and eviction procedures. Short-term rental guests tend to pay when they make the booking, thus removing this risk.
However, short-term rental tenants are more temporary, and so incidences of property damage or noise complaints tend to be much higher, as temporary guests have much less reason to behave themselves.
Your reward for taking the higher occupancy risk? According to The Telegraph, short-term rentals can provide rental income that’s up to 30% higher than long-term rentals. That’s why the vacation rental real estate market has been growing so fast.
The Capitalization Rate (Cap Rate)
When evaluating if a property would make a good short-term rental investment, one of the most popular metrics used by investors is the capitalization rate, or Cap Rate for short. This metric is popular because it’s a quick and easy way to estimate your investment returns using the net income your expect the property to generate. The Cap Rate of a property is calculated as net operating income/market value of the property, and is typically expressed as a percentage.
In simple terms, a Cap Rate is the rate of return you can expect over one year assuming you bought the property entirely with cash (i.e. with no leverage via mortgage financing). You can think of the Cap Rate as the un-levered return of the property.
Time for an example. Imagine you were considering purchasing a property that you think could generate $50,000 over the next year in short-term rental income and the property cost $300,000. You think the expenses involved in running the property as a short-term rental would amount to $20,000 a year. The Cap Rate would be calculated as following:
Rental Income (Gross Income): $50,000
Expenses (Operating Expenses NOT including Mortgage Expenses): $20,000
Net Income: $30,000 (Rental Income – Expenses)
Property Value: $300,000
Cap Rate: $30,000/$300,000
Cap Rate = 10%
If you were looking at two properties and one had a higher Cap Rate than the other, it would imply that the property with a higher Cap Rate would have a higher intrinsic profitability, and so is probably the better investment.
However, while the Cap Rate is a great metric to start with, it’s best used when comparing the relative profitability of similar properties, and should not be used in isolation. One major caveat is that, given that the Cap Rate assumes you purchased the property entirely with cash, this metric doesn’t take into account the effects of leverage.
Cap Rates vs. Cash-on-Cash Returns
Another popular return on investment calculation that real estate investors often use is called the Cash-on-Cash Return (CoC Return). The CoC Return is defined as net operating income/actual cash invested.
In a scenario where you purchase a property entirely with cash, the Cap Rate and the CoC Return are the same. When using mortgage financing, the two metrics will vary. Continuing with our example:
Rental Income (Gross Income): $50,000
Expenses (Operating Expenses including Mortgage Expenses): $30,000
Net Income: $20,000 (Rental Income – Expenses)
Property Value: $300,000
Mortgage Down Payment of 20% = $60,000
Cap Rate: $20,000/$60,000
Cash on Cash Return = 33.3%
The CoC Return will vary for different buyers even when they are considering the same property, as the terms of your mortgage depend on personal factors such your creditworthiness and the size of the down payment chosen by the buyer or required by the bank.
The Importance of Cash Flow
If you are indeed using mortgage financing to buy a property, this leverage allows you to amplify your returns. In our above example, you could buy the property in cash for $300,000 and achieve a rate of return equal to the Cap Rate of 10%.
Alternatively, you could finance your purchase with a mortgage and only pay upfront 20% of the property value ($60,000). You will then be earning the CoC Return of 33.3%, being sure to include your mortgage payments in your operating expenses.
It’s clear the main advantage of mortgage financing is that with a smaller initial investment, you can secure much higher rates of annual returns on the same property.
The downside with using mortgage financing for a short-term rental investment is that you will then have the risk of foreclosure if you don’t keep up with your mortgage payments. This can happen for a number of reasons, but the most obvious would be if your occupancy rate was lower than you expected and your property didn’t generate the rental income needed for you to be able to meet your mortgage repayment obligations.
That’s where cash flow comes in. Your monthly rental income minus your monthly expenses is the cash that is generated each month to help you pay these obligations. Choosing a property with enough positive cash flow (after expenses) is crucial.
Choosing The Best Market In Which To Buy An Airbnb Property/Vacation Rental
So in order to find the best Airbnb or Vacation Rental property to buy, we need to calculate some Cap Rates.
As described above, you need the following components to calculate the Cap Rate of a property:
1) Annual Rental Income – The estimate of how much short-term rental income a property can generate on an annual basis.
2) Annual Expenses – All the expenses involved in maintaining the property and offering it as a short-term rental property. These expenses typically include guest supplies, electricity, gas, water, cable/internet, pest control, homeowner’s association dues, property and short-term rental taxes, short-term rental licenses, cleaning costs, property maintenance, insurance premiums, marketing costs, guest support costs, and accounting costs.
3) Property Value – How much you will need to pay to buy the property
To get started on picking a market to invest in, we calculated cap rates for every town and city in the United States with at least 50 active short-term rentals in it.
For annual rental income (1), we used the median annual revenue per available listing from our database. For annual expenses (2), we assume a flat percentage of annual rental income of 30% would cover all expenses, and for property value (3) we used the Zillow Home Value Index (ZHVI), which gives the median house price in each area.
Then we calculated our cap rates – here’s the top 20 cities in the United States for vacation rental real estate.
The Cap Rates for our top 20 locations look reasonable, but aren’t hugely enticing. Cap Rates are good for relative comparison of investment opportunities, and there’s a number of reasons these returns might appear low in absolute terms:
1) We’re using median annual revenue and median house price. The vast majority of host revenue in any market goes to the top 30% of hosts, so the median is often surprisingly low, and that leads to annual revenue numbers which you should definitely be looking to beat if you are taking being a host seriously.
2) We’re assuming 30% of your rental income will be spent on expenses. This may be too high (or perhaps too low). If you can keep expenses lower than 30%, your Cap Rate will be higher.
3) In reality, you probably won’t buy the property all in cash, and will probably take a mortgage. In which case, depending on your down payment size, your CoC Return will probably be significantly higher than your Cap Rate.
Researching Airbnb Regulations & Taxes
Before making your final decision on a vacation rental real estate investment, you should research the local Airbnb rules and regulations in the area. You must also take into consideration zoning laws, taxes on Airbnb, required licenses or permits, and rental property codes.
Be sure to check the local government resources so that you understand under what conditions you can operate an Airbnb business in the specific area and what taxes and additional fees you’ll be expected to pay, and then you can factor them into your projected expenses.
Choosing A Property
Now you have a shortlist of neighborhoods where you see you could make a profitable investment. The final step is to decide which property specifically you want to buy.
When looking at which Airbnb or vacation rental property to invest in, there’s a huge number of factors to consider. You can simplify them down to three main groups:
1) Revenue Potential – Is the property likely to make more or less annual rental income than the number used in your Cap Rate calculations? Does the property have any unique features that might entice guests to pay more, or is there potential to add them (e.g. a hot tub). The best way to analyze this is to find the most similar properties in the same area that you can find, and look at how much they are earning. Are you likely to achieve the same revenues as them?
2) Expenses – Are your expenses likely to be higher than the 30% of rental income you assumed in your Cap Rate calculations? Maybe the property has certain issues that might increase your maintenance costs? How much does it cost to insure the property as a short-term rental? HOA dues? Short-term rental license fees? Finding out the actual dollar amount for every single one of your known expenses reduces the chance of a nasty surprise, and makes your estimations more likely to reflect reality.
3) Local Property Market & Mortgage – What have local house prices been doing and what are their prospects in the future? In order to answer this, it’s best to check out recent house price trends and if possible, schedule an appointment with a realtor who can give you the background of the area. Finding out ASAP what percentage of down payment you’ll have to make and what term and rates will be available to you is also a good idea.
Vacation Rental Investment: How To Analyze A Short-Term Rental Market
Let’s be frank: gaining equity in a property while vacationers pay off the mortgage is an enticing real estate investment opportunity. Over the last decade, the vacation rental industry has witnessed a boom in capital from both amateur investors and large, established real estate corporations.
The principal obstacle standing between eager investors and considerable returns is a comprehensive understanding of the short-term rental marketplace. Without accounting for location, seasonality, regulations, taxes, and all the key performance indicators, an investment could easily fizzle out. Here at AllTheRooms Analytics, our team of data scientists, analysts, and industry experts have compiled a rundown of the most important considerations. Here’s how to analyze a short-term rental market.
How To Analyze A Short-Term Rental Market
Find the Perfect Location
Location, location, location. Because short-term rentals are highly dependent upon proximity to attractions, the age-old mantra arguably holds more truth in the vacation rental space than it does in traditional real estate. Finding the perfect location for a new vacation rental home is paramount, and the process can be quite involved.
First, conduct a geographic competitive analysis that compares each market you’re considering. According to the most recent trend reports, beach locations are showing no sign of slowing down, however, a thorough geographic analysis should go beyond weather. Consider variables such as occupancy rates, RevPAR, ADR, supply, demand, and gross revenue for specific neighborhoods and cities. Using tools with visual heat maps make the process more streamlined and user-friendly.
Prospective investors should even consider non-industry-specific metrics like employment rate. Destinations that rank well in terms of the variables that define traditional real estate markets — school systems, employment rates, and proximity to certain amenities — often rank well for vacation rentals as well.
While real estate investors may be tempted to buy a vacation rental near their hometown or in large urban areas, data reports often show surprising, unexpected locations yielding the highest return on investment.
For example, in California, AllTheRooms data shows Sonoma, Salona Beach, Aptos, and Dana Point — cities with each less than 500 total Airbnb listings — are all among the top 10 in terms of revenue earned per available room. Additionally, on a country-wide scale, states like Delaware, South Carolina, Maine, and Wyoming all outperform California, New York, and Florida in terms of revenue per available room.
Cross-Reference Vacation Rental Data with Housing Market Data
Taken in a vacuum, vacation rental data only tells half the story. The next step is coupling the information with research on the least-expensive housing markets. Finding the sweet spot between low mortgage (or leasing) rates and high returns on investment is the name of the game.
Tools like Zillow and Homelight’s Home Value Estimator are helpful in determining home values and finding the best areas for buying vacation rental properties.
Zero-in on Property-Level Details
When preparing to buy a property, keep in mind that not all vacation rentals are made alike. Just because an overall market may be generally profitable, some property types could be far more successful than others.
In order to gauge how a six-bedroom house with plush amenities stacks up against a more modest two-bedroom apartment in the same location, it’s important to evaluate on a granular level. AllTheRooms’ Property Level Details Report is useful for anyone looking to understand the unique characteristics of individual properties, minimum and maximum daily rates, and other key indicators.
Understand Market-Specific Regulations
It’s no secret that the vacation rental landscape has become a bit messy with oversight and regulations. With cities like Amsterdam, Paris, Barcelona, and Santa Monica implementing varying degrees of crack-downs, regulations are one of the most important things to consider when investing in vacation rentals.
While there may be more revenue potential in one location, regulations may significantly impact its productivity. For example, San Francisco — Airbnb’s home city — has a limit on the number of nights property owners can rent out their entire house (90 nights). Places like Charleston, South Carolina have restrictions relating to the age and historical significance of a home, as well as whether or not the owner must be living on the premises.
Consider the Specific Tax Codes
Just like hotels, vacation rental owners are required to pay sales and occupancy taxes. Naturally, as rental properties become more and more popular, government agencies are becoming more strict in their enforcement of these policies.
Real estate investors should study property tax laws that vary widely by city, state, and county. However, some of this financial pressure can be relieved by certain tax write-offs that apply specifically to short-term rental hosts. For example, hosts earning passive income (income an investor earns from activities in which they are not directly involved) are able to deduct the interest paid on vacation rental mortgage come tax day.
Conduct an Event Impact Analysis
Another one of the most important considerations in regards to vacation rental investment is how a potential property can be affected by seasonality and events. Today, some of the most lucrative markets in the United States are highly dependent on intermittent seasonality and the lure of popular events.
Should investors aim for a market with more sustained occupancy rates, or for one that makes its money over a handful of weekends? AllTheRooms’ Event Analysis Reports take the headache out of answering this question. Our unique detailed analytics reports allow clients to discover how everything from sports tournaments to convention center events affect variables like supply, demand, and the profitability of any given market.
Event Impact Analysis also includes events like natural disasters that negatively impact certain markets. Investing in vulnerable areas like the fire-prone central valley of California or the tornado-prone Midwest poses a certain degree of potential risk. Plus, there are the insurance costs associated with these regions to be considered as well.
Calculate Expenses and Projected Revenues
Investing in a short-term rental property poses far more costs than one reserved for long-term rentals. There are inflated expenses related to upkeep, maintenance, furnishing, property management (especially if you plan to hire a property management software or representative), plus utilities and WiFi.
Lastly, and perhaps most importantly, real estate investors need to project revenues for long term periods. Using AllTheRooms’ projected bookings tool, real estate clients are able to accurately gauge month-by-month earnings for a six-month time period, including everything from occupancy rates to RevPAR, supply, and demand.
With careful research and a line of data analytics tools at your disposal, real estate investors can be prepared to make smart, sound decisions before launching into the vacation rental marketplace.