This is part one of a series of posts I’ll be writing about investments in vacation rentals. The vacation rental industry has rapidly evolved in recent years. What’s driven this change? And which investors are thriving in the space?
It’s an area in which I’m deeply invested (both literally and figuratively), and therefore, I’ve thought a lot about it.
The Impact of Economic Market Cycles
As markets change over time, investors are constantly looking for ways to adapt to those changes. Those with some experience know these changes tend to move in predictable patterns and often have a good idea what’s coming next.
Here’s an example. A market booms then goes through a bit of a slump after the boom. Prices of single family homes top out and begin to drop. Experienced investors know that eventually that drop will bottom out and be followed by another cycle of rising prices.
In the meantime, they’ll tend to hold on to the homes they own if they are rented out and performing while they wait for better opportunities to come around before investing in any more. In fact, chances are that many investors will have already stopped looking at single family homes as the prices began to inch up.
As prices rose, eventually it became so difficult to find ways to add value to their acquisitions, they had already begun looking elsewhere. This is supply and demand at work. When the price of anything goes up, demand for that thing goes down.
Given these cycles tend to be predictable, the next place these investors look is traditionally small multifamily properties (one to four units). Again, the cycles are predictable, and the prices of these get bid up, as well. Then, a similar thing happens with those.
Typical of this cycle is that larger multifamily development also proceeds at a fevered pace until the local or regional market tops out. After that, sometimes abetted by some other economic factor, there is a slump—maybe even a crash.
From an economic standpoint, these cycles are not limited to real estate markets—it’s how all markets work. But their broad predictability notwithstanding, there are other forces that produce changes in these cycles.
Introducing new products or categories disrupts the regular cycles to a greater or lesser degree. The change maker is almost always technology.
Related: 3 Tips to Help Keep Yourself (and Your Property) Safe on Airbnb
The Impact of Advancements in Technology
Advances in technology lead either to new developments or changes to the rules around older developments. That, in and of itself, can alter market cycles.
The most current example in real estate is vacation rentals, often called short-term rentals. (There are other kinds of rentals that are also short-term rentals, like traveling nurse housing or executive traveler housing, but I will use the terms interchangeably since the vast majority of short-term rentals today are vacation rentals.)
It’s just a decade and a half since the vacation rental market began to undergo fundamental changes as a result of new technology—in this case, the internet. For vacation rentals, the internet introduced a completely new and radically more efficient way for vacation rental properties to be marketed and made available.
The old way of marketing vacation rentals was the use of travel agencies, signage, a bit of newspaper advertising, or possibly travel magazine advertising. Previously, the supply of vacation rentals was relatively limited to a few very touristy locations. But internet listings of vacation rental properties has changed the landscape forever.
The Short History
When we started our vacation rental business in Northern Arizona, VRBO.com was very new. There were just 14 listings in the area. Now, a decade and a half later, there are 1400.
But the rise in the number of vacation rental properties in areas all over the country is only half the story. While better technology makes listing properties and communicating with travelers much easier, it doesn’t fully explain the speed of the increase in supply. The other major factor was the housing crash of 2007.
Hundreds and hundreds of second homes in markets all over the country were suddenly very much underwater. The run-up to the crash saw unwarranted exuberance and the purchase of too many second homes.
After the crash, a ton of these homes were either being fire-saled, foreclosed on, or were otherwise in distress. Many owners, in an effort either to save their homes or simply to defray the cost of owning them, put their properties in the vacation rental marketplace.
Of course, the sudden influx of single family homes in vacation areas rather than primary markets continued to depress the prices of these homes. These markets have been the slowest to recover in the years since the crash.
Related: 9 Steps to Develop Your Own Short-Term Rental Management Business
Groups of investors who picked up many of the distressed properties ALSO put them in the vacation rental market when returns on them as single family rentals turned out to be too low. So, now you had three groups of vacation rental property owners operating in markets across the country: the original group of vacation rental owners and operators, the second-home owners who needed help paying for their homes, and the investors who turned from single family rentals to vacation rentals to find good enough returns.
This activity, in turn, gets plenty of attention from the investor community. The category is new—it’s a technology-driven new opportunity in real estate that didn’t exist a decade ago.
So, today as real estate markets all over the country are approaching market highs, prices have risen to the point that both single family residential and small multifamily residential properties are no longer viable investments for just anyone. Instead they’re limited to those with the deepest pockets. As such, the vacation rental space is quickly becoming a popular place for investors to look for the returns they need.
Similar to other types of real estate, vacation rentals have their own set of rules and principles. The things that make vacation rentals unique and allow them to offer higher returns also change the dynamic of investing in single family homes, such as how long investments are held, market liquidity, different kinds of renovations, decorations, and furnishings. These things also drive changes in how properties must be managed and marketed. For these reasons and more, there’s a bit of a learning curve for investors when it comes to vacation rental investments.
The New Normal
Of those three groups of vacation rental owners, one of them already knows the ropes: the original group of vacation rental owners and operators. The other two are having to learn how everything works in the school of hard knocks.
The vacation rental marketplace has been growing—both on the demand side and on the supply side. Except for a few saturated markets, most regional markets continue to enjoy demand growing faster than supply.
Investors wishing to take advantage of this have choices similar to what they have enjoyed in the single family residential and small multifamily residential markets: direct investment, partnerships, and passive investments.
Direct investors and partnerships have the steepest learning curves. Maturing markets have begun to manifest the expected stratification of offerings, and the 80/20 rule—maybe even the 90/10 rule—applies. The majority of vacation rental properties are marketed and managed by inexperienced operators (those who needed to keep a home out of foreclosure and those looking for better returns after the crash).
It’s the original, seasoned operators and a growing set of regional branded operators who produce higher returns. Some of those regional operators have begun taking investors on to grow their businesses more quickly. This is an opportunity for both passive investors and savvy investors who want to partner their way into this new segment.
In my next article of this series, I’ll discuss how vacation rentals can provide returns far above those that can be achieved through single family rentals. Keep an eye out for it!
Do you own vacation rental property? Have you considered it?
Let me know in a comment below.
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12 Comments
Great intro discussion. Having just finished a cabin in Prescott AZ designed to be a vacation rental (my first), I will be following this topic for more guidance !!
Looking forward to the next article. I just purchased my first short term vacation rental instead of doing another long term single family home. Good stuff!
Michael, What kind of ROI are you getting on your property?
Hi Asif. I am not sure if this was directed at me as my post seems to have disappeared.
Our ROI for year one was negative. We came to market late with no reviews so we got the last minute bookers.
I just booked 2 more families. One for Memorial Day and one for a baby shower. That brings our days up to 67. So with that we are at the break even point. We still have a number of days available in August plus labor day. The fall brings bicyclists to the Trail of the Coeur d’ Alenes so I expect maybe 20 more for that time.
Having said all that we should be about 8-10% above expenses in year 2. That is on top of the 24% increase in property value since 2017.
I hope that helps!
One big mistake homeowners made in the run-up to the 2006 housing crash was believing that comparable sales at the time represented the value of their house. Those sales were at bubble prices which by definition means they were too high. Vacation home owners should beware. A lot of vacation owners in my community are having to sell because new city ordinances made their rentals illegal. You can always recognize these listings because they are way overpriced for the neighborhood, and sellers eventually have to drop their prices about 25% in order to sell or convert the unit into a common SFR rental. It is more prudent to estimate appreciation at the 100-year historical average of 3% per year. A lot of people of learned the hard way that you cannot eat paper appreciation. The only appreciation that counts is realized appreciation.
It took me a minute to understand what you were meaning to say, but I got it.
We bought this home for a long term investment and a retirement place. If it cash flows, great, but if the STR revenue just takes the edge off ownership that is also ok.
Our plan is to add to our portfolio with something more 4 seasons capable. That will be something that will cash flow, so that is why it is taking longer for us to figure it out.
I get that the current market increases are unusual, but we bought this home for an excellent price. We could never get something like this on the lake again so I feel comfortable with it.
The coolest thing about the house is also a negative. Lakefront property is often a slow mover when you go to sell. Especially something like ours which is pretty far from a larger town.
I am not worried about STR restrictions. Harrison has 260 people and is pretty much open only in the summer for tourism. There are only 4 or 5 other homes in the immediate area for STR and only one is waterfront.
Our vacation rental is located in a place that will always be okay, BUT investor beware. Because of neighborhood complaints, many communities are enacting local ordinances limiting or banning vacation rentals. In my community, a lot of “vacation rentals” have been coming on the market because of recent ordinances that outlawed their operation as vacation rentals.
Looks like a great home.
I have an interest in short term rentals… I thank you for the information and will follow the discussion as it progresses.
got my interest when you said vacation rentals have better returns than small multifamily. I’ve noticed some of the 3 & 4 star hotels adding a cleaning service charge (when it used to be free). The result is a higher ROI for them and vacation rental owners. This is copying the model of AirBnb, HomeAway, and VRBO
Cleaning service charge was never free in hotels. It used to be bundled into the room rate. However, it is almost always a separate charge in a vacation rental. So hotels are not adding the charge, but unbundling the charge in order to compete. Otherwise, prospective guests would likely anchor on the hotel’s higher room rate.
Most vacation home owners cleaning fees are a direct passthrough with no profit. That is what we do.