Posted by Hannah Lapin ● Apr 2, 2021 10:00:00 AM
Guide to Investing in Vacation Rentals
There’s a lot of appeal to investing in a vacation rental property. Not only does it provide a great spot for you and your family to travel, but it’s also an opportunity to diversify your investment portfolio and build wealth over time. Perhaps you’re looking into purchasing your first rental, or maybe you’re toying with the idea of investing in even more locations. Regardless, before diving into this quickly growing market you’ll benefit from exploring some of the nuances.
In this comprehensive guide, we’re breaking down the vacation rental investment process, including:
- Getting your ducks in a row before you commit to investing
- Finding the perfect vacation rental property
- Choosing a lender and understanding the nuances of short-term rental (STR) financing
- Managing and maintaining your vacation rental
The Time to Invest is Now
Short-term rentals (STRs), including vacation rentals, are an exciting and rapidly growing new asset class. Airbnb and HomeAway, among others, are raising awareness of this increasingly popular, large opportunity. In fact, the vacation rental industry is projected to reach over $13 million in rental revenue in the United States in 2021, and the Coronavirus pandemic has only accelerated the industry’s demand.
Since vacation rentals are perceived by many as a safer travel option than hotels, a wider market of people are trying them, and liking them.
“For travelers, especially during this tenuous era where the very air and unclean surfaces can lead to hospitalization or worse, the individualized attention one might find renting from an Airbnb-type property rather than a monstrous hotel brand can bring some solace to travelers of every level of germaphobe.” - Travel Writer Michael Alpiner, Forbes
Alpiner further notes, “vacation rentals often give the traveler more space for less money overall” and the “convenience factor is substantial.” Statista highlights the tremendous growth of the market with powerful 2021 vacation rental statistics:
- Vacation revenue in the US is expected to show an annual growth rate of 10.55%;
- The average revenue per user is expected to amount $299.96 in 2021; and
- Vacation rental user penetration is 13.3% in 2021, which is expected to hit 18.1% by 2025.
Are You Ready to Invest in Short-Term Rentals?
The vacation rental industry is clearly booming, yet before diving in it is important to evaluate this strategy from different angles. Consider consulting your financial and other advisors for personalized advice.
Making Sure You are Financially Ready
Many new investors do not realize that a larger down payment is needed for investment properties than for owner-occupied homes. With consumer mortgages, you often can put down as little as 3%, yet with investment properties, you will likely need at least 20% of the purchase price.
You also are going to need to make sure you have enough money to fully stock your vacation rental property with furniture and amenities, in addition to any closing costs, insurance, vacancy expenses, and, of course, your down payment.
Weighing the Pros and Cons of Vacation Rentals as an Investment Strategy
Highly Lucrative: You may be able to generate higher returns with vacation rentals than long-term rentals. Typically, you will generate more rental revenue with a well-performing vacation rental. These higher revenues typically are partially offset by higher operating expenses.
High Demand and Marketing Potential: With the amount of vacation rental listing sites available, not only is it easy to market your property to potential vacationers, but there is also a growing amount of demand for vacation rentals.
High Appreciation Potential: Higher priced properties in desirable locations tend to appreciate more than your run of the mill long-term rental property.
Personal Use: Owner's can use the property for a limited number of days each year without losing their tax benefits.
Regulations: Many cities and homeowner associations have regulations and even bans on short-term rentals. That’s why it is extremely important to check the requirements in your area before purchasing a vacation rental. Some cities, however, such as beach towns, are very supportive of short-term rentals. It’s always a good idea to confirm.
Off-Season: Vacation rentals tend to be seasonal. For example, summer is a great time to go to the beach, but November is not as big of a draw. Lodgify has great tips to increase off-season bookings.
Management: When you have guests checking in and out every three days, your short-term rentals need cleaning every three days. You also must get new guests their keys and collect keys from departing guests. It can be a lot of work and particularly challenging if you live in another city. That’s why a good property management company can be a game changer.
Volatility: Consumer spending on travel and leisure is subject to changing economic conditions. Often during recessions, consumers spend less on travel and leisure. Plan accordingly to be able to handle an increase in vacancy in the event of an economic slowdown.
If you have fully evaluated the STR investment strategy and would like to move forward, here is our guide to finding, financing, and maintaining vacation rentals backed by our decades of experience and industry expertise.
Finding the Perfect Vacation Investment Property Location
Location, location, location. Finding an ideal location for a new vacation rental home is paramount, and the process can be quite involved. If you don’t already have a realtor in the areas you are looking, you should consider partnering with one. Realtors can offer great insight about the area and keep you top of mind when scouring properties for other clients. For your own due diligence, you should also conduct a geographical competitive analysis that compares the various markets you’re interested in.
Some vacation rental factors to consider:
- Walk-ability to entertainment, food, etc.
- Occupancy rates
- Current supply and demand in the area
- Average revenue for rentals in the area
- Crime rate
Evaluating the Revenue Potential of a Vacation Home
Once you have found a great vacation rental home, it is essential to evaluate the property for its income potential. We recommend using AirDNA to give you a clear picture of your expected earnings and vacancies. AirDNA has both free and paid tools that provide you insights on a single property’s:
- Annual Revenue
- Average Daily Revenue
- Occupancy Rate
- Cap Rate
- Net Operating Income
- And more
You will also have larger market insights and top market listings at your fingertips. While we will always encourage you to consult your own advisors or personalized advice, AirDNA can provide you with extra insights into a property’s investability.
Finding a Vacation Rental Lender
Your financing options fall into three main buckets: conventional, portfolio and alternative. We’ll start with the simplest case.
If you are buying your first vacation property, you probably should start by looking at a conventional mortgage (Quicken, Wells Fargo, Chase, etc.) similar to the loan you have on your primary residence. To qualify, you’ll need to put 10%-20% down, have two to 12 months cash reserves (the amount depends on your credit score and down payment), and your monthly combined mortgage payments on your primary residence and second home (including taxes, insurance and any HOA dues) cannot exceed 45% of your gross monthly income. In meeting this requirement, the lender will assume you won’t generate any income from renting your new home. So you’ll need to meet the gross monthly income requirement without any rent credit. Plan on 60-120 days to close. Also plan on providing your full tax returns, a lot of income and asset verification documentation, and a variety of letters of explanation.
Portfolio and Alternative Mortgage Solutions
But what if you are self-employed, or maybe asset-rich but with little taxable monthly income, or maybe you already own a number of rental homes? In these situations, you should skip conventional and go straight to evaluating portfolio and alternative mortgage solutions. Portfolio is just a fancy way of saying, “community bank.” If you have good credit and have an ongoing relationship with a local bank, then you should talk to them to see if they might finance your new home purchase
Typically, these loans will be a bit more expensive in terms of fees and rate than a conventional loan. Also, they usually will amortize over 15 or 20 years rather than 30 years, and include a “balloon” payment after five or 10 years. But your local community bank will hold this loan in their loan portfolio (hence the name), so they can be a bit more flexible than a conventional lender. Again, plan on a lot of documentation and 60-120 days to close.
Alternative mortgage lenders typically offer a faster, smoother process with more approval flexibility, but at higher costs.
The Nuances of Financing Vacation Rentals
Investors typically turn to alternative lenders like Visio Lending for a few reasons. The first situation is if they are self-employed, including owning their own business. Another reason would be that they already own too many properties to qualify for another conventional mortgage. Finally, and importantly, they may turn to an alternative lender because they want to own their investment properties in a legal entity to protect their other assets. That is not allowed with conventional mortgages. Here are some of the key nuances of financing an STR or vacation rental:
Residential properties need residential appraisals
Traditionally, for rental properties, appraisers fill out a 1007 report on comparable rents for long-term leases; think a year or more. Appraisers primarily appraise homes for owner-occupiers. Every once in a while they are asked to appraise a home as a long-term rental. In most markets, they rarely are hired to appraise an STR or vacation rental. Getting an accurate appraisal of an STR or vacation rental’s potential gross rents, therefore, can be difficult because most appraisers are unsure how to determine short-term rents.
As an alternative lender, Visio is able to use a common sense approach to determining STR rents. Visio considers any actual rent performance available on the property and then augments that information with comparable data from a variety of data sources. Unlike a licensed appraiser, Visio is not limited in the information it can use to establish an appropriate rent estimate.
Let’s say you generate $3,000 per month on an STR and only $2,000 a month on a long-term lease for the same property. While it might look like the STR is far more lucrative, in reality the turnover and maintenance costs associated with an STR are higher so you need to make some adjustments before drawing a conclusion.
At Visio, we adjust our models for STRs by adjusting the gross rents used in our underwriting calculations to normalize them against long-term rentals. Our goal is to do as much as we can to STRs to make comparing them to long-term rentals apples to apples, instead of apples and oranges.
Owning a vacation rental in Orlando by Disney World is a different ballgame than owning one in the heart of an elite neighborhood in Boston. While a large part of Orlando’s economy relies on tourists, in a more suburban neighborhood, the city might not be as open to short-term renters and might pass regulations restricting them. This can be tricky for a lender, particularly in cases where the owner designed or modified the house for short-term rentals. A 9 bed, 9 bath house might be fantastic for vacationers, but not for many consumers. So what happens if the short-term use becomes outlawed? This is an issue any lender needs to consider when underwriting a loan.
Managing and Maintaining Your Vacation Rental
You’ve purchased and stocked your vacation rental, and now comes the hard part. First and foremost, you are going to want to make sure you can manage the property yourself or have property management in place and that you are properly insured.
Hiring a Property Manager
If you are a DYI-er, there are many free property management tools to help you manage your vacation rental. Keep in mind, you will need to market the property, clean in between tenants, handle any maintenance, key distribution, and accounting, among many other tasks.
Many professional STR investors choose to hire local property management companies. To determine which strategy is best for you, ask yourself these questions:
- Do I have the time to screen and interact with customers?
- Is the property close enough for me to access when need be?
- Do I have the capacity to handle the number of properties I own?
- Am I able to coordinate bookings and cleaning?
For those of you who answered, “No,” check out our tips on how to hire a property management company.
Marketing Your Vacation Rental
The vacation rental market is highly competitive, so it is important to make your property stand out relative to the competition. If you choose to work with a property management company, they will most likely take this off your plate. For those doing your own marketing, there are plenty of popular sites to list your rental, including Airbnb and VRBO. Here are some tips to make your property stand out:
- Hire a professional photographer to showcase your property with high quality photos.
- Mention the property’s proximity to local attractions, including shopping, dining, and trails.
- Feature positive reviews of guests’ stays.
- Highlighting your cleanliness and offer a flexible cancellation policy.
Making Sure Your Vacation Rental is Properly Insured
If you rent your vacation rental out the majority of the year, it is considered a business, and therefore a standard homeowner’s insurance policy is not adequate coverage. We recommend specifically asking your insurance provider about their vacation rental coverage or shopping around for a vacation rental policy. Here is what you should be looking for:
This includes coverage for the property and all property structures including the garage, fences, swimming pool etc. Property protection could also provide coverage for your personal property, such as the furniture.
Liability coverage is extremely important for a rental property and provides the coverage for medical bills or legal expenses if a guest is injured at your vacation rental property.
Loss of Rent Coverage
If you are unable to rent out your property due to a fire, flood, or guest damage, Loss of Rent Coverage will help cover your lost rental income.
Supplemental Coverage Based on LocationEarthquake Coverage- If your vacation rental is in California or another area at risk for earthquakes, you should be covered.
Flood Coverage- Is your vacation rental property in an area prone to flooding like Florida? Flood insurance is a must.
Volcano Coverage- We require all Hawaii vacation rentals we finance to have volcano insurance.
Your vacation rentals are investments, and therefore you should obtain the best coverage possible to protect them. Keep in mind, vacation rental insurance policies will never cover any maintenance and repairs or guests’ belongings.
Keeping Diligent Tax Records
Full-time rental businesses are eligible for “ordinary and necessary” tax deductions related to business expenses, some of which may surprise you. In order to take advantage of these deductions, it is important to keep meticulous records of all tax deductible expenses including:
- Advertising Expenses
- Maintenance Costs
- Property Management Fees
- Travel Expenses
- Legal and Professional Expenses
- Office Expenses
- Mortgage Interest
A Look at Visio Lending’s Leading Vacation Rental Loan Program
Recognizing the nuances associated with financing short-term rentals, Visio Lending spearheaded a program that is underwritten based on vacation rental income rather than an investor’s income and assets. Here is why our vacation rental product is the best on the market:
- We offer common sense underwriting of your short-term rentals.
- Our loans are full, 30-year terms with no balloons.
- We are a low documentation lender and do not require tax returns or personal income statements.
- We lend to corporate entities, so investors can protect their identity and assets.
- Our pricing is simple and haggle-free.