Airbnb and VRBO (“vacation rentals by owner”) have pushed vacation rentals into the mainstream. Travelers now have even more options beyond standard hotels. When traveling with a large group, think vacationing families or friends in their 20s, renting a vacation home can be a cost-effective alternative to traditional options.
This opening in the travel market presents a good opportunity for real estate investors. If a property is in an ideal location, remodeled to fit a non-offending, generic aesthetic and can be acquired at or below market value, it can be a great fit for this investment strategy. This type of investment can generate significantly more in monthly income as a vacation rental than as a traditional rental.
What are some pros and cons of using an investment property this way?
As an investor, my goal is to maximize returns. When considering whether to add a property to my portfolio, I always examine market efficiency, or in simpler terms, the most profitable and best use for that particular property. Discovering what that is for each property is a unique journey and is an integral part of your due diligence. Properties located in the “arts district” of a metropolitan area are often clear short-term rental winners, while a single-family home located an hour from downtown, not so much.
In a rapidly appreciating market, the most alluring pro of short-term rentals is the flexibility to adjust rents down to the per-night level, compared to the traditional locked-in monthly rent for several months to a year. An investor can deploy a pricing strategy responding to local market factors, such as the swings in tourism between seasons or even when one-off events like the Super Bowl come to town. A great example of this strategy is Phoenix, Arizona, where my real estate funding company is based. In the past decade, the Phoenix metropolitan area has innovated niche markets for tourism and will even host the Super Bowl for the third time in 15 years in 2023. When priced and marketed well, an investor could collect a month’s worth of “traditional” rent from a week of short-term rental income during the peak season.
A real challenge to short-term rentals is unfriendly regulatory environments. In 2019, the Arizona legislature passed new neutral statutes targeting bad actors in the short-term rental space. However, other markets in coastal cities like New York are hit with tightening regulations concerning where and how a short-term rental can operate.
How do lenders value potential rental income?
When it comes to establishing the value of residential properties, three possible conventional approaches are used:
1. The sales comparison approach determines value based on comparable homes in the property’s area and the price they are selling for during a given period, usually the past three months.
2. The cost approach seeks to determine how much a property would cost if it were destroyed and needed to be rebuilt. This is sometimes also referred to as reproduction cost or replacement cost. This method can also vary depending on whether the property will be rebuilt to the same specifications.
3. The income approach seeks to incorporate income derived from the property (or any potential income) as an aid in identifying the market value of the home.
Each lender is different and will use the approach that fits their underwriting standards. There is a strong and obvious argument that can be made that investors who deal in short-term rentals would prefer lenders to use the third method as it pushes the valuation a bit higher. Keep in mind, however, if a lender does use the income approach, they will come in on the more conservative side and base their valuation on long-term rental pricing, limiting financing possibilities.
Are there other benefits to listing your investment property as a short-term rental?
One positive is you don’t need to reinvent the wheel in terms of marketability. In the pre-internet days, an investor might have advertised in the local paper and worked with travel agencies to get their property advertised. Now, with platforms like Airbnb, VRBO, HomeAway and existing giants like Travelocity and Expedia entering the space, your short-term rental can be merely a few taps away on an app.
Often an afterthought in the short-term rental process is preserving the home’s physical condition. In Arizona, for example, state law indicates vacation rentals cannot be used for events that would require a permit. Think guests using the property as a reception hall for a wedding or an unruly group hosting this year’s biggest block party, uses which are both banned. Short stays will be the typical investor’s bread and butter, so the possibility of fewer turnover repairs compared to changing between yearly tenants is a valid consideration. For further safeguards, some platforms will insure hosts’ properties against damage or even make guests purchase additional insurance.
A final peripheral bonus to choosing short-term rentals over long-term tenancy is peace of mind. Investors know the property is continually kept clean and inspected, as the property is turned over from guest to guest.
Overall, if investors do their due diligence, short-term rentals in favorable locations have a higher value proposition than leasing a property out for the long-term. Properties are easily marketable and provide investors with market flexibility. The short-term rental strategy can generate higher cash flow and offer investors in “soft” resale markets an opportunity to hold onto their property until their market recovers.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms.
Do I qualify?