[Editor's Note: This guest post was submitted by Stephen Sorenson, who enjoys a double life as a tech professional and a real-estate developer. He and his wife have operated a vacation rental property development and management business since 2003 called Classy Cabins AZ. In this article, he attempts to make the case for investing passively in vacation properties. While I'm not sure I was convinced, I think it is a worthwhile conversation to have, so I've turned it into a bit of a Pro/Con post. We have no financial relationship.]
Pro: Vacation Rentals Are a Great Investment
As a busy professional, you may have little time to spend as an active investor. Whether it's doing research in the stock market or bond market or looking at real estate, there is a substantial time commitment. Even the time necessary to meet with financial advisors, then weed through their offerings to decide if they are for you is heavy. It's also a fact that you should invest as early as you can to let the magic of compounding work. And then invest regularly. It all adds up to quite a bit of time and energy.
Fortunately, now is a great time to be interested in “passive” investments as there are many more choices than there used to be. In fact, you can find ways to invest passively in nearly any asset class from stocks and bonds, to durable equipment, to various kinds of real estate. There have been big changes in many markets as technology advances. In the stock market equities field, there are now fully automated systems that allow you to place money in the system, and just let it do what it does after you indicate some basic preferences. Or, you can simply invest in index funds or ETFs. But, if the stock market just isn't your cup of tea, perhaps real estate is better. It's been said a zillion times, but it's true; more wealth has been amassed through real estate than through any other class of asset.
Recently there has been a spate of changes in nearly all real estate markets. For active investors, and for passive investors supporting those activities, fix & flips, fix & hold, and other strategies are immensely popular. How many other kinds of investments have so many reality TV shows devoted to them? But popularity brings with it a lot of players. Competition always puts pressure on returns and today, that kind of investment is extremely competitive with billions of dollars of both domestic and foreign money snapping up properties and bidding up the prices as they go. So, what happens when a particular segment gets really crowded? Investors start looking for other places to do what they do.
Vacation Rental Market Trends
In just the past dozen years, vacation rental properties have undergone huge and fundamental changes, and just in the last few years have attracted the attention of investors of all stripes and sizes from Mom & Pop to Institutional investors. What's happened? What's driving the changes? And more importantly, are there great opportunities there?
Rise of the Internet
Our business started 14 years ago with our first vacation rental cabin. At the time, near the Grand Canyon, there were 14 listings on the first large vacation rental site, VRBO.com. With the advent of the internet and world wide web came the ability for the owner of a vacation property to list it online – and that was a HUGE change. Before that, if you had a vacation rental you marketed it by letting travel agents know, and by posting signs and maybe newspaper ads. But the internet changed everything in that market as in so many others. While VRBO was one of the first and the biggest site at the time, many more would appear as internet access became ubiquitous and speedy. A group of smart investors started HomeAway.com, which purchased VRBO, and several other listing sites. Flipkey started up, then was snapped up by TripAdvisor. And Airbnb, now the 800 lb gorilla of the vacation rental market is a household name all over the world. In our area, there are now 1400 vacation rental properties, a 100-fold increase, but with changes in demand, the inventory is still constrained.
Surge in Supply and Demand
With the changes making access to vacation rentals easier came expanded marketing efforts by the listing sites and by individual owners. The market for vacation rentals has surged. It's become so big that hotel marketing websites are almost all carrying vacation rental listings alongside their hotel listings. Most travelers now consider vacation rentals a viable alternative to hotels, and a large and growing segment of travelers prefer vacation rentals when they travel. During the last real estate bust, a large number of vacation homes suddenly became unaffordable for their owners. A large number of those owners chose to try renting the homes out rather than lose them to the bank. Some investors even decided to buy up houses during the downturn and re-purpose them as vacation rentals.
So the original seasoned and experienced vacation rental operators, mostly single home operations, suddenly came face to face with large numbers of newly christened owners and their rentals in the market. There was a bloodbath of sorts. So many stories of people failing at renting out their homes, despite obviously huge demand and easy listings. What's the real story behind it all? The hastily fielded vacation homes were not designed to be vacation rentals and they weren't run by experienced vacation rental professionals. Two categories of vacation rentals emerged. There are a lot of vacation rentals in the market which are cheap to rent but don't offer a good experience for the traveler. So, they don't get rented as often as their owners’ hope. On the other hand, there are professionally managed vacation rentals that have much higher occupancy and offer a much better travel experience but that have higher nightly rates. As with any product category, there are widely varying degrees of quality to be found.
Investment Returns
For an investor looking for passive returns in real estate, ownership in professionally managed rentals are what you should consider investing in. While the AVERAGE return on vacation rentals is just slightly higher than the average return on single-family rentals, the returns available from well-run vacation rental operators are above market. The average single-family rental home gross rental yields (gross rents/sales price) returns around 9%. That’s gross, not net. You might expect a secured investment in a vacation rental to return 7-14%, NET, before appreciation, depending on whether you wanted regular and predictable cash returns or were willing to simply participate in the profits on a quarterly basis including seasonal swings.
How to Look for Passive Investment Opportunities
When looking for an investment opportunity in vacation rentals, here are some things to keep in mind:
- Look for operators who have an established business, with a track record of success.
- They ought to have properties which enjoy higher occupancy rates and higher nightly rates than superficially similar properties.
- Check out the properties they have now and see what kind of reviews they get.
- You are looking for operators who understand they are providing an experience for travelers.
- Talk to them, make sure they are trustworthy and will provide proper reporting to you on a quarterly basis.
- You should expect to be able to view the books on a property at any time. Look for an accounting of bookings and income, all expenses, bank statements, and a quarterly narrative comparing actual performance to plan with a discussion on the factors leading to variances.
- Vacation Rentals in all markets are seasonal, and even local event driven.
- Verify your investment is secured by an interest in the property.
- Look for quarterly premiums or profit sharing, and an annual allocation of depreciation for your taxes.
- Look for proper LLC Operating Agreements and Subscriptions Agreements that set out the terms clearly.
Customer Experience
Our own experience in the market over 14 years has validated our core tenets and shown up nicely in our bottom line. What you are actually selling isn't necessarily the same as the merchandise. The more successful vacation rental operators understand they aren't just providing a larger hotel room. Travelers who want to stay in a vacation rental are very much “experience” travelers. They want a place that looks great, like a magazine spread. They also want their stay to be a happy experience enhanced by the accommodations. Properties which cater to families and groups of friends need to provide awesome gathering spaces, pleasing views, and fully equipped kitchens, excellent bedding…the list goes on. And finally, the customer experience dealing with the operator is just as important. From initial inquiries, through booking, to thoughtful communications before during and after the stay, those experiences should make the guests feel listened-to and taken care of.
It is this understanding of what the customer really wants that makes the difference between extra successful operators which command higher occupancy and nightly rates and those that make up the bulk of cheaper and non-differentiated vacation rental properties. If you think investing in the hot vacation rental market is for you, now you know what to look for–the savvy operators with a superior product and a track record are looking for investors to grow their businesses faster.
Con: Tread Carefully, Every Deal is Unique
I'm not going to pretend I'm an expert in real estate, much less in the relatively small niche of vacation rental real estate. Katie and I travel a lot and have stayed in resorts, hotels, campgrounds, vacation homes through AirBNB and VRBO, cabins, and even wilderness areas. However, we have never invested in those properties and have little interest in landlording as a profession ever again. And if I don't want to landlord, I certainly don't want to run a hotel. So, all of our real estate investments are now passive by pretty much any definition of the word. In fact, we are even moving away from selecting the individual properties and notes we invest in to just hiring a professional to do that. It kind of reduces everything to a bit of a numbers game: How likely am I to get my money back, what am I likely to make on it, and how is that return going to be taxed. Beyond that, I really don't care if I'm investing in single family homes, multi-family, commercial, storage, trailer parks, vacation homes, mortgages, or hard money loans. I really don't. I just like mailbox money. But there are a few truisms about investing that I think are worth consideration when being pitched.
# 1 Stocks aren't evil
Usually when someone wants to sell you something they point out the problems with investing in the stock market:
- Stocks are volatile,
- A large percentage of the return comes from price appreciation
- Company management can be corrupt
- You have little control over how the business is run
- People lost their retirement in 2008!
- More Gazillionaires got that way through real estate
- Whole Life Insurance provides guarantees
The list goes on and on. But after hearing this dozens of times, maybe you ought to consider why everyone compares themselves to the stock market. Maybe there is a reason it is the gold standard, especially for those looking for a passive investment return.
# 2 Some investments are more cyclical than others
When it comes to stocks, cyclical stocks are those which do well in economic booms when people have more money to spend. Just like stocks, some real estate assets are more cyclical than others. Guess which ones are the most cyclical? That's right. Vacation homes. In a down market, guess what is the first thing you cut out to save money. Hint: it's not rent and groceries.
# 3 Diversification and fees matter
Just because you move from one asset class to another doesn't mean you should forget the basic principles of investing most learn with stocks–diversification matters. It protects you from what you don't know. So if you haven't sat down face to face and eaten a meal with those who are running a company or a property, it probably should not make up a very large percentage of your portfolio. If you have no influence over how the business is run (and it's pretty hard to consider it a passive investment if you don't), then you should probably have more than one of them in your portfolio. Fees still matter. While managers can and often do provide additional value (particularly in less efficient asset classes), every dollar you pay them is still a dollar that comes out of your return.
# 4 Location, location, location
The most important factor in real estate is location. It always has been and always will be. I don't care how fancy your property is or how well run it is if it isn't close to where I want to be. Everyone else feels the same way.
# 5 Track record
While past performance is no guarantee of future performance, if you're looking for a general partner or syndicator, a nice long, strong track record should be a requirement. How long is long enough? How strong is strong enough? It depends on the alternatives, but just like you don't want to be in a teaching hospital on July 3rd, you probably don't want to be an LP in someone's first limited partnership.
Maybe vacation rentals are the hot new asset class in real estate. Maybe they aren't. I have no idea. But tread carefully and run the numbers because every deal is unique.
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What do you think? Do you own a vacation rental individually or via a syndication? Why or why not? Do you think this is a good asset class to invest in? How much higher returns do you expect over apartment buildings during good times? How much worse in bad times? Comment below!
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I’m interested in the idea of investing more in real estate, but not in vacation properties.
I’m a big believer in “if it ain’t broke, don’t fix it.” If passive index fund investing can get me to my goals, I don’t have a huge urge or desire to stray too far from that. I do think that real estate will eventually make up 15-20% of my portfolio, but it will likely be through syndicated funds.
Personally, I would not be interested in owning a property in a vacation location that is remote from where I am. Sounds like more work and hassle than I am willing to bargain for.
In terms of real estate subsections, as you mentioned above, the vacation rental property is probably the most at risk as it will be the most impacted during economic downturns. Thus with that risk you need to have a high enough return to make it worthwhile. You mention net returns can be 7-14% (without appreciation factored) which in my mind does not justify this bump up in risk as you can get those sort of returns with more stable real estate asset classes like multi-family large apartment complexes.
Location of vacation rentals is also very important. If you are in a hurricane prone area (ie Florida) I am sure there are all sorts of headaches and hassles to deal with if your property happens to be in the target path. International vacation rental properties add a layer of complexity as well dealing with foreign govts, taxes, etc.
Caution about what happens in downturns is wise. In the last downturn, people invested in single-family homes took a bath, then, as investors came into clean up, those homes which were purchased at a steep discount became good investments again. During that downturn, vacation rental activity actually increased. The demographics of the travelers changed, small parties became large parties; but the overall spend on our vacation rental properties rose.
Steve
Oh come on, people don’t forgo a primary residence voluntarily. They do put off renting a vacation home for a year or two until the economy and their personal finances recover.
I had the similar experience in 2008-2010. Rental income was about flat or a bit up but the value of the properties tanked big time. Still not recovered value wise or even close. Luckily I had sold most before the recession and bought back in in 2009-2012.
I have had many vacation rental properties as well as long term rentals.
Even a well managed vacation rental is not passive. Unless you have a management company that is really a financial partner with a long term equity stake in your property, they are just not going to do what is needed to keep your property looking fresh and upscale year after year. That part comes to you with multiple visits a year to determine and do what is needed (or tell your management company what is needed). They aren’t going to pick out new rugs and throw pillows, but they will arrange for needed repairs.
Candidly, even though I use a professional marketing, management, and maintenance company to take care of my vacation rentals, I would surmise that they are 10x the amount of work each that my long term rentals are.
While there are exceptions, I think it is much harder to find vacation rentals that generate the inflated returns stated after examining the true cost of running a vacation rental. Also, VRBO and the like are looking to take a larger and larger share of your rental income each year. If you plan to not make this a part time job, you need to have a management company on top of VRBO. This means overall fees are going up not down for a vacation rental. VRBO used to cost $200 a year when I started. Now between the renter fee and the owner fee they are taking $10K+ on many properties.
Here are some hard truths about costs for a vacation rental that is high end as the author describes:
— Your carpet won’t last more than 7 years, plan on 5.
— Your paint won’t last longer than 7 years either
— If your vacation rental is near the beach the AC might last 5-7 years in some areas.
— Your bed spreads will need to be replaced every few years, and your linens every year roughly.
— Upholstered goods like sofa’s last 5-7 years tops in heavy use areas like the great room
— Your tenants will wear out EVERYTHING in your home quicker than in an owner occupied home. So you will end up replacing just about everything twice as often as you would in your own home.
The authors calculator is nice, but I would say to plan on expenses of 50%+ of gross rents BEFORE your mortgage. The author doesn’t mention it, but this is called your “CAP Rate”. Hotels and vacation rentals should have a higher CAP rate.
I would not touch one without a 10% CAP rate these days and that is hard to find. I say 10% because inevitably those rug, furniture and AC replacements are never included in the expense profile of any marketed vacation rental.
So if you find that $1M vacation rental property, let’s hope it can GROSS $200K. If it can, you can comfortably pay to keep it running as a high end rental and not have your profits disappear. You can also pay to have people do the tough work of keeping it high end, and not break the returns on it as well. You can also leverage (finance) it modestly and really supercharge your returns. Finding a rental like this is possible, but difficult. Long term rentals are frankly easier.
I echo the above comments. My parents own a beach rental house. They are constantly working on replacing broken things/upgrades/etc as everything wears out more quickly with renters, especially at the beach (hint: sand is not friendly to your flooring, decks, etc). They have a management company who hands out the keys and does the weekly cleaning between renters and a few urgent maintenance things. The rest is now essentially my mom’s job (SAHM now empty-nester). They purchased in 2003 and it turns out the market has taken much longer to recover after 08 than the rest of the housing market, so they are hoping the value can rise a little more before they get rid of it. I think one of the appeals was being able to go there whenever we want, however it still has to be planned so it’s not rented out when we’re going, plus after it’s sold we can still do a family beach vacation by renting, with much less headache!
Wow Dave. Thanks for the really detailed information from your experience with rental vacation properties and the management headaches (like the increased wear and tear which makes perfect sense).
Did not realize that VRBO cut got that large with some properties. Certainly makes me want to shy away from this asset subset even more
(I know there are some cool perks of having a 2nd vacation home but for me it was not my cup of tea and I just didn’t get the draw for doing so. I would feel like I was forced to make use of it when I was free and thus would not vacation at other locales).
Thanks for sharing your valuable experience and insights.
I’m skeptical of vacation rentals from a moral/ethical position. With the explosion of airbnb this has only made things worse. There are some areas where there’s a housing shortage or housing issues for residents. There is certainly the potential for an “investor” to pluck a house from the local market, affecting availability , prices and the rental market, introduce tourist activity in areas not meant for that and just overall having a negative effect on local residents. Overtourism has become a problem in many parts of the world. I think there’s a time and place for vacation rentals, and just because you can doesn’t mean you should.
Interesting. Never thought about it from that perspective. Doubt it applies to the guest poster’s cabins, but it could in Manhattan.
There was a podcast on Planet Money that got me thinking about this:
https://www.npr.org/sections/money/2019/02/28/698763891/episode-897-new-orleans-vs-airbnb
I know folks in Hawaii who talk about this issue as well, though technically illegal rentals, still vacation rentals nonetheless. I think barcelona has issues with this, though again most of them illegal. Not that what the post was referring too, but certainly folks out there for whom legality won’t necessarily stop them if ‘everyone is doing it.’
I have to disagree with this position. It’s nice to be able to rent a house for a weekend or for a week or more. If you can make more money renting out a home to vacationers over a shorter term (while not imposing significant negative externalities on the neighbors), then you are putting that home to its best and highest use.
The issue of affordability is first and foremost an issue of limited land and significant limits (from NIMBYs and government) on new development. If a location truly is desirable, folks will build more housing stock there unless artificially prevented from doing so.
{Not everyone is going to live in Malibu or the Hamptons. If you have the skills and education to make ~$14 per hour, you might be better served by getting a roommate, going to school to improve your skills, or moving to Omaha or Mississippi where that same $14 per hours goes much further. Maybe all of the above.}
I like the option to rent a room or a whole house somewhere nice while vacationing. I think it makes sense to pay a bit to rent a house in one location then visit a completely different location on your next vacation. Compare this with buying a timeshare or vacation home, paying property taxes, maintenance, and upkeep, and then having to go to that same location weekend after weekend and year after year for vacation. No thanks.
Stephen,
Thanks for the post. I am confused though. You mention “passive investment” in this area. You mention that you and your wife don’t want to be landlords. But you offer no specifics. Are you doing this through a syndicated group or are you buying something like a vacation condo that you then pay a fee for all of the work and upkeep including the renting out of said property? More details would be useful as to how this is passive and not a secondary job. Thanks,
Thanks for your question. For US it isn’t passive. We are managing the investments. For our investors, it is. As with any product and any field, there is a wide variation in quality and location with vacation rentals. Another post above mentioned a property ought to have a CAP rate at 10%. I agree. But I think the cap rate ought to be higher that. If you are actively managing your own vacation rental, you need to consider your time and effort when looking at the return. If the return is truly passive, then the rates i’m providing are quite good. The total return needs to be split to cover all of the management and upkeep, as well as paying the principals if it’s partially funded by investors. Our properties have CAP rates ranging from 12% to 20%, with cash on cash rates high enough to split and provide an attractive rate for a truly passive investment. We get these because we acquire the land in the right place, and then design, build, decorate, market and manage the properties from the ground up to be excellent as vacation rentals.
Steve S. Are you sure you are calculating a CAP rate correctly? If you are and you can deliver 20% CAP rates to investors then please confirm and I as well as a hoard of people will be in touch to invest.
(I think you might be confusing gross income as a percent of acquisition price with CAP rate?)
Agreed. A capitalization rate of 20% is awfully attractive when apartment buildings are 6 these days.
Good point/question. Since we build these from the ground up, the CAP rate is calculated as Net Income divided by the cost of the property. That cost includes what we paid for the land and the construction costs. So, it’s analogous to the purchase price of a property. The reason CAP rates on single-family homes and even small multi-family properties are so low today is because prices are quite high today. Given an income number, the CAP rate varies directly with the price of the property. We have an advantage in the cost department because we are essentially buying at wholesale by developing our own properties. While decent cap rates can be had on homes purchased and renovated as vacation rentals, it’s much tougher to put together the right location, condition, price, etc., in that way.
That’s an odd way to calculate a CAP rate. It’s normally net income divided by the VALUE of the property. If you can now sell it for more than you built it for, then you have to adjust the cap rate. Otherwise, you get an artificially high cap rate if you use the price you bought it for or built it for 30 years ago.
The debate over the utility of CAP rate in investing decisions is both longstanding, and legendary. If you use it, then it’s utility lies in analyzing an investment you are going to make. Now, if I’m going to sell a property, there is going to be a CAP rate imputed by the Net Income and the Price of the property. Unless rents have increased with the value of the property, the CAP rate will be lower than the CAP rate I enjoyed while I owned the property. So, CAP rate is of use when evaluating an investment when you purchase it. After that, until there is a sale, the CAP rate might not be as useful as, say, cash-on-cash return, ROI, ROE, or even an IRR if the investment includes a sale or buyout at the end.
That’s probably true.
Stephen,
Thanks for the clarification. I can now see following your link to Classy Cabins that it is definitely an active investment for you. Based on your comment I assume that you have investors in your project? I have looked to invest with other friends who have done very well in the same space (different location). So far I have not had takers, but having looked at the financials from a couple friends I have seen good things over a small time frame. As mentioned in your article, the “internets” has really created this as an investment opportunity compared to the past. That being said, we have an extremely small sample size when you consider the time frame really being about 10-15 years of data thus far.
Thanks!
I too am very skeptical of the vacation rental market. Yes, there are probably some good returns to be had out there, but make no mistake that you’ll have to work for them in a very real sense. And the cyclical nature of vacation rentals, combined with the illiquidity of the investment, make 7-14% potential returns not worth it for me. I am far more interested in something like FundThatFlip, where my money isn’t tied up for many years and the risk, in my estimation, is much lower.
A patient recently was telling me about all the opportunities in real estate investing. He wasn’t a shoeshine but…
My wife and I bought 3 condos in a popular vacation area in Door County Wisconsin with the intent to rent them out as an investment. I thought we would net 10% each year, but it ended up being more like 6%. They were rented out pretty much full time throughout the summer vacation season with spotty rental throughout the rest of the year. There are so many things we didn’t consider when buying into this type of thing. Stuff needed to be fixed or replaced frequently. The manager of the units was way over worked due to being unable to find people to work doing maid service, which is a real problem with all the vacation properties in this area. It wasn’t a huge hassle, but paying the bills monthly and quarterly was another thing that needed to be done. We ended up selling all of them since I can do better investment wise just buying into Broadmark investments with no hassle. It wasn’t for us and I don’t intend to get into that type of investment in the future but some people may enjoy it.
Yes, 6% isn’t enough to keep, and doesn’t justify the hassle. It can be hard to buy vacation rentals at retail and get the kind of return you’ll want. We are seeing a similar issue right now in SFRs, where prices are too high, and cap rates too low. If you can’t develop from scratch, you have to look for really great deals – low enough that your after repair rental rates will give you the returns you need.