Summary: If you’re looking to invest in vacation rentals, you’d better know the difference between a good investment and bad investment. We’d venture to guess that most casual vacation rental owners either lose money or barely cashflow on their properties. Why? Because most vacation rental owners don’t know how to buy an investment property OR run a vacation rental profitably. The first step to buying an investment is to know the difference between a good return, an average return and a bad return. That’s what we’ll cover in this article
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
Vacation rentals, also known as short-term rentals, can be a great investment vehicle, especially for someone who is just getting started in real estate.
What makes it so attractive?
It’s a combination of high cashflow (assuming you buy it right!), the incredible tax benefits, debt paydown and forced appreciation.
Let’s dive into each component one-by-one and read until the end to understand the target for each. It’s not enough to know the different components of return, you also need to know what to expect for each.
If you learn how to buy it right, you can make life-changing cashflow. Some in our community make as much as six figures with just one vacation rental!
But the reality is, most vacation rental owners are likely losing money on their vacation rental or barely cashflowing.
The reason is simple, in most cases, they either didn’t buy it right (they overpaid) or they don’t know how to run their vacation rental profitably.
Overpaying could mean you paid too much to buy the property. Overpaying can also mean that you paid too much for the renovation and furnishings.
So how do you avoid overpaying?
You need to learn how to buy it right. Buying it right means you diligently do the numbers ahead of time and ensure that the property cashflows. This is not only about the price you pay but also taking into account how much you pay to fix it up and furnish it. If you want to learn how to analyze deals for cashflow, be sure to read THIS ARTICLE and download our FREE short-term rental cash-on-cash calculator below.
You can easily tell the difference between someone who is buying for cashflow and someone who is buying for themselves. The ones who are buying for themselves break the bank and make the property “perfect” for them and their family.
What they don’t realize yet is that 3-6 months from now, their perfect getaway is going to not look so perfect. That favorite couch of yours? Imagine what it’ll look like after a kid spills a plate of spaghetti on it or use it as a trampoline.
In addition to overpaying, most vacation rental owners don’t know how to run their business profitably. The owners take some pictures and throw it up on Airbnb and wait for customers to book their stay. They just don’t know what they don’t know.
Vacation rental owners don’t know that there is an entire course worth of things they need to know to run their business profitably. Everything from setting up the property so that it stands out, self managing, automating, keeping costs low, setting up a direct booking website, pursuing additional income streams, and etc.
This can mean the difference between losing money and making tens of thousands of dollars each year.
In addition to the cashflow, vacation rentals also come with a tremendous tax benefit. Using a vacation rental, you can shelter active income like the salary you get from your job. You can read more about the tax benefit by CLICKING HERE.
We look at tax savings as a guaranteed return. In other words, as long as you know what you’re doing, you’re going to get the tax benefit and it represents real dollars in your pocket.
What do the tax savings look like?
We illustrated this in detail in another article, but in brief, imagine paying zero income taxes this year. This means that when you file your taxes in April next year, you’ll get everything you withheld, back in the form of a tax refund.
For example, if you make $300,000 per year and you have an effective tax rate of 30%, you will get a tax refund of $90,000.
This is money you can live on, but ideally you reinvest back into your portfolio.
So as you can see, this is a huge component of return to add to your five or six figures of cashflow!
Similar to other rental properties, whenever you pay your mortgage (assuming it’s not an interest only loan), you pay down the debt or mortgage a little bit with each monthly payment. When you pay the debt down, you accumulate equity in the property.
The great thing about rental properties is that your renter is paying your mortgage for you.
You can easily see just how much your debt goes down each year or another way to look at it, how much equity you gain each year, by putting the numbers into a mortgage calculator (there are many free ones online).
For example, let’s say you buy a $700,000 property and you put down 10% or $70,000. Let’s also assume an interest rate of 4.5% and a 30 year loan. In the first year, you pay down the debt by $11,282.82!
So add this to the cashflow and tax savings when you think about the return on investment.
If you’re new to our site, you may not know about forced appreciation.
Forced appreciation is something we talk a lot about with long-term rentals, and we get excited about it because it’s the key to growing your wealth quickly.
So what is forced appreciation?
It’s when you increase the value of your property by increasing the income that it generates.
For example, I owned an 8 unit apartment building and raised the rents of each unit by $50 from $750/month to $800/month. This resulted in a nearly $200,000 increase in property value.
How do I know? Because I bought the property for $740,000 and sold it a year later for $920,000. I know market appreciation didn’t play a role because this was in the middle of the 2008 recession, where property prices actually went down.
Forced appreciation is different from market appreciation because it’s something you can control. You can’t count on market appreciation so we don’t factor in market appreciation when thinking about the return on investment.
But you can count on forced appreciation, making it one of the biggest and most important components of return.
But can you count on force appreciation for vacation rentals?
Yes you can! However, it’s important to point out that it’s going to be somewhat different than what you do for your long-term rentals. How you estimate the amount of forced appreciation is also going to be different.
We’ll go into depth on this topic in a future article, but for now, just know that forced appreciation is an important component of return for vacation rentals that is neglected in our opinion. The focus tends to be on cashflow, which is important, but the way to grow your wealth quickly lies in forced appreciation.
So What Exactly is a Good Return on Investment For a Vacation Rental?
Why do we keep track of Olympic world records or all of the records in the Guinness Book of World Records?
The reason is, we need to be able to distinguish between good and bad.
The same is true for vacation rentals.
If your goal is to make money with a vacation rental, then it helps to know what investors consider to be a good investment.
The best return on investment in our opinion is when you maximize all four components of return above.
This means getting a high cashflow, maximizing your tax savings, using leverage and paying down debt, and forcing a ton of appreciation.
While the threshold for each is subjective, we’ll try to come up with some objective targets using examples from our community.
First, in terms of cashflow, what is a good cash-on-cash (COC) return? Many in our community aim for 20% COC return with property management. They do their calculations assuming a 20-30% property management fee whether they use a property manager or not. This just means that if they self-manage, their COC return can jump up to 35 to 50%. This is how some members of our community are making six figures in cashflow per year on one property!
Next up is the tax savings. The members of our community often aim for completely sheltering their income. So if they make $300,000 as a hospitalist, they aim to offset all of it and pay zero taxes. Also, they aim to do this every year, which means they are buying a new vacation rental every year.
Third is the debt paydown. Now you might be thinking, how do you influence debt paydown? Well some people don’t use leverage. They buy their properties in cash or they pay off the mortgage quickly. This means they don’t get the debt paydown. Also they run into the problem of lazy equity or inefficient use of their money. The money tied up in their properties isn’t making money for them. So if you want to maximize your return, get a loan. If you use a 10% down loan, you’re even more leveraged and your debt paydown will be even greater.
Last is forced appreciation. What is a good target for forced appreciation? This one is all over the map. I think the best way to illustrate this is with examples. We bought a short-term rental for $660,000 and put in $50,0000 to renovate it. Our agent told us recently that the property is worth $900,000 to $950,000. Another student of ours bought a property for $248,000 and forced appreciation to $440,000. It’s important to point out that some of this increase is due to market appreciation, however, we are confident that in both cases, the value has gone up at least six figures.
So if you’re thinking about venturing into vacation rentals, you now know what to expect. If you fall below the standards above, you know you’ve got some work to do as an investor.
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