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Airbnb Investment: The Guide To Buying A Vacation Rental Property

With the rise of the short-term rental industry, buying a property for the purpose of putting it on the vacation 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. 

Here at AllTheRooms, we talk to people looking to invest in an Airbnb property every day. We’re constantly listening to their feedback and working on new tools and features to help them find the right vacation rental market and a profitable Airbnb rental property.

When buying a short-term rental investment property, people tend to fall into one of two groups:

Group 1: Investors Who Know What Market They Want To Invest In – The vast majority of investors we talk to already know where they want to buy a vacation rental and they just need to work out which property to buy. These investors typically buy an Airbnb property in a market in which they want to own a vacation home for their own use either now or in the future, or in a market they feel they know well.

Group 2: Market-Agnostic Investors – The second group, which tends to be much smaller, is made up of the market-agnostic investors. These are investors who’s main criteria for choosing their preferred Airbnb investment market is yield – how much money can they make. This investment approach differs in that it requires an initial step of screening a large number of markets and then conducting deeper research into the markets which have attractive investment metrics.

In this article we’ll try to cover all bases. In Section One we provide the best practices used by successful vacation rental investors to decide which vacation rental investment property to buy when you already know in which market you want to invest. Section Two provides some tips on various tax and accounting topics that come up frequently when investing in an Airbnb rental property. In Section Three we take a look at the best U.S. Airbnb markets to invest in when you’re a market-agnostic short-term rental investor.

Contents

Section One: Investing In An Airbnb/Vacation Rental Property

Section Two: Short-Term Rental Investments - Taxes & Depreciation

Section Three: The Best Places To Buy A Vacation Rental Investment Property

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Section One: Investing In An Airbnb/Vacation Rental Property

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 historically 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 an Airbnb 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

Occupancy Risk

How do the risks of investing in a property for long-term rental compare to those for short-term rental?

One big difference in being a short-term rental host vs. a long-term rental landlord is that 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 has given birth to an entire industry of vacation rental property managers. 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.

Regulatory Risk

Another risk that is unique to short-term rentals is that of regulatory changes. 

Every aspect of a market’s short-term rental regulations can change with the passing of one ordinance. Your city or county government could change the short-term rental licensing requirements, or perhaps they might stop issuing licenses altogether. It’s possible that they change the zoning laws so that short-term rentals are no longer permitted in your neighborhood, or raise the taxes payable on short-term rental hosting income by a substantial amount.

The short-term rental regulations and tax laws that have been put in place in every market are all very new and subject to change, and that poses a significant risk to you as an investor in a short-term rental property. Long-term rental markets don’t have this issue, as the regulatory environment around long-term rentals is much more established and less volatile.

Step 1: Research Local Short-Term Rental Regulations & Taxes

Before making your final decision on a vacation rental real estate investment, you should research the local short-term rental 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 in to your projected expenses.

Step 2: Calculate The Projected Income Of Your Airbnb Investment Property

Calculate Expenses

Investing in a short-term rental property poses a much wider variety of potential costs than with long-term rentals. Common expenses that Airbnb hosts should project for 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, vacation rental insurance premiums, marketing costs, guest support costs, and accounting costs. 

It’s always best to overestimate your expenses rather than underestimate them and get a nasty surprise later, so try and be as realistic as possible when projecting your costs.

Project Revenues

When projecting revenues for your Airbnb investment property, the first rule to keep in mind is 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 generate accurate projections of your vacation rental’s earning power, the starting point should always be to analyse the revenues of comparable properties already operating in your chosen market. If you’re analyzing an investment in a 3 bed property with 2 bathrooms and a pool, filter your analysis to focus on how properties with those attributes are performing. Getting familiar with these properties is not only a good idea for calculating a realistic Airbnb revenue projection – these comparable vacation rental properties are also likely to be your competition if you decide to buy.

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Don't Forget Events!

When estimating your potential vacation rental host earnings, it’s important to factor in how a property’s earnings 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.

Proximity To Attractions

Some short-term rental markets and properties have a revenue generating capacity that is highly dependent upon proximity to attractions – the importance of location arguably has even greater impact in the vacation rental space than it does in traditional real estate. 

With that in mind, be sure to focus on other short-term rentals with a similar proximity to the attraction when looking for comparable properties to base your revenue projections on.

If the demand for your potential vacation rental investment property is highly dependent on a given attraction, then look out for potential pitfalls too. Does that attraction have seasonal opening schedules? Is it possible it will close? If there’s a risk, be sure to factor it into your projections.

How Strong Is Your Moat?

An economic ‘moat’ is a distinct advantage your Airbnb investment property has that will prevent new competitors from entering the market and reducing your property’s market share and profitability.

In the the world of Airbnb real estate, there’s a number of common moats which savvy vacation rental investors look for. Some examples are:

– Regulation: A limited number of short-term rental permits/licenses being available in a given area is probably the most definitive moat in the short-term rental business. While these limits are put in place to protect residents or the character of a neighborhood, they also act to constrain supply, allowing hosts in those areas to enjoy higher average Airbnb prices and occupancy rates.

– Proximity To An Attraction: There’s only so many properties right next to the main attraction in any given market. If you think this proximity is a key revenue driver in the market you’re considering, then that might help shield your vacation rental property’s profitability in the future.

– Unique Amenities: Pretty much anyone can add a hot tub to their property, so don’t bank on that to keep your Airbnb investment property occupied and generating revenues. However, if the property has a unique amenity, such as an amazing view that few other properties in the area have, you should be able to continue to enjoy some pricing power going forward.

Step 3: Assess The Break Even Metrics

By now you should know the market you are analyzing like the back of your hand. You should know the short-term rental laws and taxes for your area at the city, county and state level, and have realistic and well-considered projections of your short-term rental costs and revenues.

The next step is to calculate your net income – what will you have left from your host revenue after covering all the costs you have projected. Obviously we’re looking for profitability as a starting point in your model – otherwise you’ll need to go back to the drawing board and start over.

If you’re projected net income is showing good profitability, then that’s a great first step. Your next step should be to calculate your break even point – at what level of revenues will your property just make enough to cover your costs? You absolutely want to avoid buying a vacation rental property that is loss making, so backing out what you need to make to cover those costs is a good idea. This analysis should also involve calculating the implied occupancy rates and prices (average daily rates) that would make you just break even.

With those break even occupancy rates and ADRs, check out our historical Vrbo & Airbnb stats and check how frequently your competitive set saw their metrics drop below that break even level. If there are prolonged periods of below break even levels, which is common in highly seasonal markets, then consider your cash flow in those periods. You’ll need to cover those costs out of pocket during those weaker periods.

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Step 4: Understand Your Target Guest Profiles And What They Want

What type of guests would your potential vacation rental property attract? What type of guests does your set of comparable properties attract?

Nailing down what guest profile(s) your property will be relying on for bookings is hugely important for a number of reasons:

1) Your Target Guest Profile(s) Might Have Seasonality: If your property appeals to certain types of guests that only stay during specific periods, that could be a problem. You might make a killing during those periods, but you might struggle to keep your revenues up when that group aren’t traveling. This seasonality might even be hidden – it might be that the overall short-term rental market in your target area is strong all year as different guest profiles (that your Airbnb property may or may not appeal to) come and go throughout the year.

2) Your Target Guest Profile(s) Will Inform Your Marketing Strategy: Knowing which guest profiles you are targeting is essential for crafting your Airbnb property’s marketing strategy. The title of your listing, description, photos, and any additional marketing strategies your pursue should be tailored for your target audiences. Your guest profiles might also suggest which vacation rental host apps might be appropriate to tailor your guest experience for your target audience.

3) Your Target Guest Profiles(s) Will Inform What Changes/Improvements/Additions To The Property You Should Make: New short-term rental hosts typically take time after closing on a property to prepare the property for opening for bookings – the length of that period varies widely from a couple of weeks to a few months. 

So how can you identify which guest profiles you will be targeting? In some markets this will be obvious – e.g. Miami during Spring Break, or a ski-resort during snow season, but another great way to find out your target guest audience is by looking at the comparable properties you identified. Analyse these competing listings – what title and description do they use on their Airbnb listing? What kind of amenities do they highlight? What nearby attractions do they highlight? What experiences do they offer to their guests? These clues should point you in the right direction. If you want to take your detective work to the next leve, you could try and find out what marketing channels these comparable properties might be using. Do they promote their property on Instagram? If so, note what copy and images they use, and what else they might focus on in their marketing activity.

Section Two: Short-Term Rental Investments - Taxes & Depreciation

Can A Vacation Home Be Used In A 1031 Exchange?

Unless a property owner works as a professional accountant, understanding tax code and all the forms involved with property taxes can feel like a bad dream. Knowing the ins and outs of taxes for a vacation property might even feel a bit nightmarish. Especially when it comes to section 1031 of property taxes.

A 1031 exchange just means exchanging one income property for another one. There are a few benefits to exchanging investment properties, but first, a property owner must qualify for a 1031 exchange. Even during this first step, there is some confusion among property owners, mainly because there is a variety of opinions on these “property swaps”.

When done properly, though, it is entirely possible to use a 1031 exchange for selling and buying – or should we say swapping – a vacation home. There are a lot of grey areas with this type of property exchange, so read about the specific details below.

Basics of the 1031 Exchange Procedure

When reading the official documentation from the Internal Revenue Service on 1031 exchanging, there is very little clarity on the procedure. This is made obvious through this IRS statement:

“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”

This statement basically just means that an investor can sell a property and reinvest the earnings into a new property. In the process, all capital gains taxes will be deferred. But the process isn’t as easy as selling, buying, and deferring. There are very specific procedures involved, which is why getting expert tax advice is highly recommended.

Benefits of a 1031 Exchange for a Vacation Home

The obvious benefit of the 1031 exchange treatment for a vacation home is the deferred taxes. For a property owner qualifying for one, it is possible to acquire a new home and defer all taxes on the sale. Taxes won’t need to be paid until the property is sold, hopefully, many years later. The best part of all is that there is no limit on the number of exchanges that can be made.

This means that as soon as a property owner is ready to call it quits on the current vacation home, another exchange can be made for a replacement property. One might compare this to trading in a car after the lease is up. Sometimes all an individual needs is a change in scenery, and a 1031 exchange allows for this – without all the tax hassles that are normally involved with property investments.

An Example of a Vacation Home 1031 Exchange

Laying out the step by step procedure for undergoing a 1031 exchange would be too difficult, mainly since every homeowner’s situation is different. To help understand the process a bit better, here is an example of how a real estate investment would look like with or without a 1031 exchange:

A real estate investor has $400,000 to gain in addition to $400,000 in net proceeds after closing on a property. After the closing date, the tax liability adds up to $140,000 once all combined taxes are tallied up. These taxes include depreciation recapture, net investment income tax, and federal/state capital gain. After all the taxes have been paid, only $260,000 remains in net equity for another property investment.

Then, with the 25% down payment on a new mortgage that comes with a loan-to-value ratio of 75%, it would be possible to buy a replacement property valuing $1,040,000. However, when a 1031 exchange is filed for reinvesting, the entire $400,000 could be used for a property purchase (instead of just $240,000). This means that the new property could have a higher value of $1.6 million.

Who is Eligible for a Vacation Home 1031 Exchange?

The main requirement for a 1031 exchange is that the exchange is from one investment property to the other. Technically, a vacation home can almost always be considered an investment, no matter if it is being rented or it is meant to be used after retirement. But it takes more than just calling the property a “vacation home” for the IRS to consider these properties investments.

The first case for 1031 eligibility would be for a property owner to rent out the vacation home for an amount of time greater than 14 days per year. Another viable scenario would be for the owner to reside in the property for less than 14 days per year. If a property owner does not meet either of these requirements, all is not lost.

Even if the home is not considered an investment property right now, that doesn’t mean it can’t be transformed into an investment property in the future. In other words, if a property owner wishes to complete a 1031 exchange and trade in the old for the new, there are a few options. It is up to the property owner to decide which route is best.

The owner can either quickly turn the unit into a rental property and start vacation home marketing in order to start booking it out to guests. This will require some work and it certainly isn’t in the cards for every vacation homeowner. The other option is to leave the home vacant for most of the year and only reside in it for 14 days or less.

This means that the IRS will no longer consider it a primary residence for personal purposes. Now, it can officially be called an “investment property” and is eligible for a 1031 exchange. All in all, using a 1031 exchange is an amazing way to get a change of scenery without paying the absurd taxes that typically come along with property investment. It also allows for a higher investment amount, which in turn can lead to a more lucrative investment in the long run.

Can A Vacation Home Be Used As A Primary Residence?

For property owners with 2+ homes, it is more than likely that one serves as a primary home and another as a real estate investment. Earning a rental income is one of the main reasons for buying a second home. Investing in a vacation home can be quite lucrative if chosen to rent it out, and it might even turn into a full-time passive income.

Technically, though, as soon as someone starts renting out a second home, it is now considered an investment property. Since this property is meant to make money, it can no longer be considered a primary residence or even a second home. Even so, there’s very little question about whether or not a second home should be rented out if making some extra cash is on the agenda.

The only potential turn off – other than the work involved – is filing the yearly tax return. Property taxes for an investment property and even a second home are a completely different entity from residential property taxes. Not wanting to deal with mortgage insurance and tax complications is a major reason to keep the second home as-is, rather than use it to make rental income.

But what about calling a vacation home a primary residence, and is this even possible? Not only is it possible, but labeling a vacation property as a primary home might just be the smartest financial decision ever.

Primary Residence vs Second Home vs Investment Property

Before deciding on whether or not to deem vacation home as a primary residence, it is important to understand the differences between them. Not only that, understanding what it means to own an investment property is also a must.

What is a Primary Residence?

In short, a primary residence is a place to call home. It is where someone will most likely spend the majority of their time, quite possibly all of it. In terms of receiving a mortgage loan, a primary residence requires the lowest down payment of all home types. Some mortgage rates for purchasing a primary residence require as little as a 3% down payment.

The reason for this is because home loan lenders see primary residences as “low-risk” properties. There are a few requirements for considering a property as a primary residence. The first is that the property owner must reside in the home for the majority of the year (at least 6 months).

Another requirement is that the property must be located within a reasonable distance from a place of employment. Lastly, the resident must move in within 60 days of the closing date. In some cases, homeowners will need to prove their primary residence through official documentation like tax returns and government-issued ID.

What is a Second Home?

A second home is often referred to as a vacation home or even a home that is used while traveling for business. The mortgage interest rate for a second home is similar to that of a primary residence since it is also considered a low-risk investment by lenders.

Although the interest rate is similar, the down payment for a second home will be more – typically at least 10% of the property value. Similar to a primary residence, there are a few requirements if a property owner is in search of a second home:

  • The resident must reside in the home for at least some part of the year (14 days or more)
  • Location of the second home often must be within 50 miles of the primary residence (not always)
  • The property cannot be used as a rental or timeshare and it cannot be a part of a property management agreement

What is an Investment Property?

An investment property is exactly as it sounds; the entire point of owning it is for it to serve as some sort of investment. The most common type of investment property is to rent it out to either long term or short term rentals. Rental properties have the potential to bring in a high ROI. This is why more and more real estate investors are entering the vacation rental industry.

Investment properties are considered to be high-risk since it is impossible to know what the rental income will add up to. If someone applies for a mortgage, no matter how great that person’s credit score is, the monthly payment requirements might not be met if the rental property fails. For this reason, it is more difficult to be granted a mortgage for an investment property.

A Vacation Home as a Primary Residence

Now back to the original question, can a vacation home be a primary residence? Technically, yes, but only if the vacation home meets the requirements mentioned above for primary residency. The main requirement is that the owner must live in the property for a good portion of the year.

Why Turn a Vacation Home into a Primary Residence?

As mentioned before, a primary residence has the lowest mortgage rate out of the 3 property types (primary, secondary, and investment). Filing property taxes is much less complicated for a primary residence as well. These are just two of the many reasons for wanting a vacation property as a primary home.

The Owner Plans on Living There Full-Time in the Future

As soon as a person retires, it is extremely common to want to set up shop in the vacation home – especially if it is surrounded by the stunning beaches of Bermuda. For anyone who plans on moving to a vacation home full-time, consider making it an official primary residence.

The Owner Spends Lots of Time at the Vacation Home

This is enough of a reason to turn a secondary vacation home in a primary residence. Just remember that you’ll need to spend the majority of the year in this property, at least 6 months. In most cases, property owners have to provide tangible proof of this.

Take Advantage of a Different Tax System

Every state is different when it comes to income and property taxes. Anyone with properties in two different states needs to consider each state’s tax system when deciding on a primary residence. The smart decision is to choose a primary home based on which property is located in a state with a more beneficial tax system.

Airbnb Investment Properties - Depreciation & Deductibles

Dealing with the property taxes relating to a vacation rental home is enough to make some property owners throw in the towel and call it quits. Nobody enjoys doing their taxes, especially when a rental property is involved. Some accountants even claim to dislike working with clients who rent out vacation homes during the tax year.

The main reason for this aversion to rental-related taxes is the difficulty involved. Since a vacation home brings in a certain amount of rental income, completing the year-end tax reports can be tricky. Rental and personal properties have completely different sets of tax laws, namely because one generates an income while the other does not.

No matter how much income a vacation homeowner has generated throughout the year, nobody enjoys handing their hard-earned money over to the government. There is good news, though, and that rental properties come with a few unique tax benefits that residential properties for personal purposes do not.

Vacation Home Tax Benefits

The main benefit of renting out a home to vacationers is that rental property owners are eligible for tons of deductions. This means that almost all rental expenses can be deducted from the rental income come tax time. This, in turn, leads to less liability for rental property taxes, so it is essential to keep track of rental expenses throughout the year.

Tax Deductible Rental Expenses

Generally speaking, as long as a rental property owner can prove that money spent is meant for running the rental property, that expense can be deducted. This includes everything from rental marketing to repair and maintenance. Rental property owners are even able to write off the cost of towels and bedsheets used by guests. Here are a few of the most common deductible vacation rental expenses:

  • Maintenance, repairs, and cleaning costs
  • Rental insurance
  • Marketing and advertising
  • Utility costs
  • Rental supplies (towels, sheets, kitchen items, etc.)
  • Vacant rental property costs

The Basic Requirements for Rental Deductions

Reading about the deductible rental expenses might sound too good to be true. Well, deductions can indeed be made, but it is to meet the basic requirements as a rental property owner first. For property rentals in the US, the IRS has fairly strict requirements on who can deduct and what can be deducted.

The first requirement of the IRS is in regards to the number of days the property is rented annually. The current tax laws in the US state that the property must be rented out for at least 14 days during the year. For those of you doing this professionally, chances are the rental days exceed this by a great deal.

However, anything less than 15 days and the IRS considers the property to be a second home and certain itemized deductions won’t apply. The next requirement has to do with the amount of time the rental owner spends at the property himself or herself. If this time is more than 14 days per year, only a small portion of deductions can be made.

Depreciation Deductions with Vacation Homes

The real question among rental owners is whether or not the rental property is considered depreciable. To answer this question as simply as possible, vacation homes are depreciable. This means that the property owner can deduct the cost of buying and fixing up a rental property over time.

Investopedia says that “rather than taking one large deduction in the year you purchase (or improve) the property, depreciation distributes the deduction across the useful life of the property.” The depreciation requirements of the IRS are very specific. The deduction will only legally apply if the rental property fully meets these requirements, which can be found below.

The Renter Must Own the Property

Before depreciation can even be considered the individual applying for the deduction must own the property. Leasing a property out and submitting a depreciation deduction on year-end taxes won’t fly with the IRS. And no, don’t try to get away with the property being in the name of a family member.

The Property Must Generate an Income

The rental activities of a property must generate some sort of income. In other words, if money isn’t being made, the deduction for depreciation does not apply.

Determinable Useful Life is Required

A property that has a determinable useful life is essentially one that has an expiration date at some point in the future. This applies to most properties since no structure lasts forever. The apartment, condo, or house must have the potential to decay and wear out over time, eventually deeming it obsolete as a vacation home.

The Property is Expected to Last for 1+ Years

Lastly, depreciation can only be applied if the owner expected the rental business to last for at least one year. If at any time during the tax period the rental business ended, depreciation won’t apply.

When Does Depreciation Officially Begin?

As soon as a property becomes available for renting (and as long as it meets the above requirements) depreciation can begin. Here’s a more specific example for rental real estate tax depreciation:

The property purchase price is agreed to and the closing takes place on January 10th. However, the property is in need of some major renovation. After a few months of work, it is finally ready to be rented out to guests on March 31st.

On that day, the rental is advertised on listing sites, but the first renters arrive on April 17th. Even though the place wasn’t booked until mid-April, depreciation can be accounted for starting on March 31st. Since the property was ready to be rented on March 31st, that day marks the official start of depreciation.

What’s the Bottom Line with Depreciation?

Although it can quickly become complicated, you should consider depreciation a valuable vacation home tax tool. Don’t be afraid to hire a tax expert to help you figure out the ins and outs of rental property depreciation as April 15th approaches. Rental depreciation laws and requirements are constantly changing. Hiring a tax expert is the best way to ensure proper tax filing (and the most rewarding deductions).

Section Three: The Best Places To Buy A Vacation Rental Investment Property

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 or market 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 (try using our Airbnb profitability calculator to estimate this) 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 average 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 at a the market level.

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. 

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 10 cities in the United States for vacation rental real estate.

The 10 Best U.S. Markets To Invest In A Vacation Rental Property

City Median Annual Revenue (< 50 Listings) After Airbnb Fee (3%) ZHVI Operating Expenses Net Income Cap Rate
$8,287
$8,038
$52,270
$2,486
$5,552
11%
$10,161
$9,856
$92,916
$3,048
$6,808
7%
$12,271
$11,903
$114,794
$3,681
$8,222
7%
$7,996
$7,756
$75,456
$2,399
$5,357
7%
$12,255
$11,887
$116,400
$3,677
$8,210
7%
$10,546
$10,230
$102,354
$3,164
$7,066
7%
$3,857
$3,741
$41,133
$1,157
$2,584
6%
$7,994
$7,754
$85,317
$2,398
$5,356
6%
$11,557
$11,210
$132,182
$3,467
$7,743
6%
$7,717
$7,485
$90,565
$2,315
$5,170
6%

The Cap Rates for our top 10 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.