Vacation Rentals Are Popular But Are They Profitable? (Hint: Yes! Very.)

This is part two of a series of posts I’ll be writing about investments in vacation rentals. As I mentioned before, the vacation rental industry has rapidly evolved in recent years—largely due to advances in technology.

These changes have affected market cycles in investments in single family residential homes (SFRs). And, as it turns out, vacation rentals (VRs) can return multiples of SFRs!

Why Vacation Rentals Are Generating Large Returns

Previously I described three groups of vacation rental owners, one of which already knows the ropes—the original group of VR owners and operators. These are folks who were up and running before the crash and ensuing entry of new groups of VR owners.

The other two groups—distressed homeowners and opportunistic investors—are having to learn about owning and operating VRs on the fly. Meanwhile, the vacation rental marketplace is continuing its boom, both on the demand side and the supply side.

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The Current Vacation Rental Market

In my company’s market, when we started in 2004, there were just 14 properties listed on VRBO.com. Now the area has approximately 1,400 listings across all the VR marketing sites—the largest of which is Airbnb.

A few statistics from just the past five to 10 years are illustrative of the growth rates here. According to VRMA.org, in 2010, only one out of 10 travelers had utilized a peer-to-peer marketed accommodation (i.e., a vacation rental). But by 2015, one in four had.

Statistics from VRMB.com are equally impressive, showing that in a similar timeframe, VRs went from being almost exclusively beachfront properties to a nearly 50/50 mix of beachfront and urban properties. And this is a trend that continues.

Needless to say, this market is really taking a bite out of the hotel business. VRMB.com data also show half of the people who have tried vacation rentals now prefer them to hotels.

Yet, as of now, only 11 percent of travelers have tried vacation rentals—so there’s A LOT of growth coming. In fact, Hostfully.com reported an 8.5 percent compound annual growth rate over the past five years.

Except for a few saturated markets, most regional markets continue to enjoy demand growing faster than supply. Investors who hope 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.

But direct investors and those entering partnerships indeed have a lot to learn. As such, it’s the original, seasoned operators, and a growing set of regional branded operators who are producing higher returns.

Related: 6 Steps for Successfully Investing in Vacation Rentals

Why Veteran Vacation Rental Owners Are Earning Even More

Despite the predominance of online travel agencies (such as HomeAway, Airbnb, and TripAdvisor) that make it easier for the average VR owner to list and rent their properties, it’s the experienced operators and regional brands that are leading the way with higher per-night revenues and higher occupancy.

This is largely thanks to what they’ve learned along the way about travelers and the hospitality industry that they can now apply to the VR niche. Let’s analyze some results, and examine how returns compare between regular full-time rentals and short-term rentals.

While the average return on VRs is just slightly higher than the average return on SFRs, the returns available from well-run vacation rental operators are above market. Attom Data Solutions found that the average SFR gross rental yields (gross rents/sales price) returns around 9 percent.

Compare that to your market! And keep in mind, that’s gross—not net.

Returns on SFRs are being squeezed hard in most markets today. While Attom data show that yields on rentals vary significantly from market to market, many markets are experiencing negative returns. Meanwhile, well-run VRs easily return over 20 percent cash on cash—net—before taxes.

As a passive investor, expect a secured investment in a VR to return 7 to 14 percent net before taxes, plus the tax benefits of depreciation—and not counting appreciation over time. Actual returns in a passive scenario will depend 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).

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Related: 13 Mistakes New Vacation Rental Owners Always Make

The Math Behind the Returns

Here’s an example to illustrate how vacation rentals can produce better returns.

An SFR property might cost $250,000 to purchase and provide monthly rentals in the range of $900 to $1,200 per month.

A VR property might cost as much as $325,000 but produce rents in the range of $250 to $400 per night.

Our operating model calls for our properties to cover the entire cost of operation with four- to six-nights occupied per month—and more occupancy obviously produces greater profits. Even for highly seasonal locations, which produce 13 to 15 nights’ occupancy on average, monthly revenue sits around $4,000 to $6,000 per month.

It’s this dynamic that can produce much higher returns for similar properties. Of course, there’s a catch though. And it’s something you may have already suspected.

Managing VRs is NOT the same as managing full-time rentals. Operating a vacation rental such that occupancy and nightly rates are kept high to enable high returns requires experience and a team. While this isn’t different than investing in SFRs or fix and flips, the skill sets and the players on the team do differ.

Today, you see some SFR investors trying a new dodge. They find a property the same as they always did, but now they analyze it as if it were a VR, looking for what they need and analyzing for cap rate or cash on cash return. This is a formula for overpaying for a property. It’s also a formula for purchasing properties in the wrong locations or properties that just aren’t suited to be vacation rentals.

Think about it. Imagine you are wanting to go on vacation and want the extra space of a vacation rental or a full kitchen. Will any house in any neighborhood be what you are looking for? Nope.

You wouldn’t throw a dart at a map to pick where you were going to stay while on vacation, but that’s essentially what happens when somebody looks for houses the wrong way.

If you’ve been successful with flips, full-time rentals, or small multifamily properties, you had to learn a lot along the way. Expect to have to do that again if you want the superior returns you can get with vacation rentals.

Therefore, if you are looking to invest passively, seek out an experienced operator to invest with, one who knows how to source and operate the right kinds of properties.

What other questions do you have about vacation rentals and their potential returns? Are you currently participating in the VR niche or are you hesitant to dive in?

Let’s discuss in the comments.