Summary: Short-term rentals have long been popular with families looking to make a little side income from a second home. But until recently, with the advent of VRBO and AirBNB, people have started to look at short-term rentals as a primary investment strategy. In this article, we look at the pros and cons of investing in short-term rentals.
Have you thought about investing in a short-term rental?
Who wouldn’t want a weekend getaway? How about having the ability to rent it out when you’re not using it for some extra income?
I think most of us would.
But what about buying not just one but multiple properties? Would this make for a good investment strategy?
In this article, we cover some of the pros and cons of investing in short-term rentals as a primary investing strategy.
What are the Pros?
Cashflow
Short term rentals have the potential to generate a significant amount of cashflow. Of course, the caveat is that you need to buy the right property, in the right area, and have great ratings.
Assuming you bought the right property and manage it well, there is definitely the potential to generate six figures of cashflow per property!
Tax benefits
Short-term rentals operate as a business so like all businesses, you only pay taxes on the profit. This means that you can deduct expenses, including furnishing your rental, paying for those Netflix and Disney Plus subscriptions, utilities, etc.
Like other rentals, you can also claim depreciation as an additional expense. And as we’ve described in other articles, depreciation lowers your taxable income and therefore your taxes.
If more and more of your income comes from short term rentals, you can lower your effective tax rate because the tax rate on the short-term rental income is lower than the taxes on your earned income.
Shelter income
The ability to shelter income is also a tax benefit. I separated it out because the benefit is significant and very few people know about it.
Whenever you buy a new short term rental, you can do something called a cost segregation study to generate a large loss on your tax return. You can read about how this works HERE.
If you do it right, you could set up a situation where you shelter your entire earned income (W2 or 1099). This means you can cashflow from your short term rental and at the same time, pay zero income taxes.
What are the Cons?
Difficult to scale
If you want to achieve financial freedom, you are going to have to grow your portfolio. Now it’s possible to do that with a few highly performing short term rentals but it’s more likely that you’ll have to continue to grow your portfolio in order to grow your cashflow.
You can buy your one or two short term rentals with a highly leveraged loan (i.e., small down payment). At some point, however, you’re going to have to start putting down sizable down payments. This means you’ll need more and more cash if you are going to continue to grow your portfolio.
Cashflowing rentals in contrast can be purchased using the BRRRR strategy with little or no money down. This enables you to scale up without needing a significant amount of money for a down payment.
Unclear appreciation potential
One of the benefits of cashflowing rentals is the ability to predictably “force appreciation.” This means that if you increase the net income of the property by a certain amount, you can determine the amount of appreciation you’ve forced.
With short term rentals, the ability to force appreciation seems less reliable. It seems with smaller properties that have lots of comparable properties, the value is going to be based on market appreciation as opposed to the income it generates.
Limits to tax benefits
One of the benefits of investing in cashflowing rentals is the ability to generate large losses. Use these to shelter W2 or 1099 income (if you’re a real estate professional as described above).
However, bonus depreciation, which is one of the best way to generate these losses, can only claimed once per property. So in order to be able to claim bonus depreciation again, you need to buy a new property.
How do we do this? We sell our properties and exchange them for larger properties. This allows us to claim bonus depreciation on the new properties.
This can be done with a short-term rental as well but the question is, after investing in furnishing the property and getting the property operating just the way you want it, do you want to just trade it in and buy a new one that you’ll have to outfit again?
Also, you’ll be trading up for more expensive properties and the question is, how high can you go with a short term rental? Do you want to own a $3 million property in a resort town and then have to trade up for a $5 million property in a couple of years? It seems there’s a limit to how expensive you want to go before it no longer makes economic sense because a) there’s a limit to how much someone is going to pay for a stay and b) there’s a limit to how many people are in the market who can afford an expensive stay.
With multifamily rentals, there really isn’t a limit or downside to going bigger. You can keep trading up to more and more expensive properties. Your rental income can continue to go up as you get bigger and you add more and more units.
The Verdict
There are clearly many benefits to investing in short term rentals but there are also some downsides to consider.
Given the cons described above, we like to think of short-term rentals as a nice addition to a portfolio of cashflowing rentals but not as a primary strategy for investing.
We are investing in a short-term rental as well and project that it will generate significant cashflow. We are building it on a strong foundation of cashflowing rentals, which allows us to fund the purchase and furnish it too!
