One of the questions asked most frequently by new investors is “Which market should I buy short term rentals in?”
It makes sense that short term rentals are a hot topic. After all, who wouldn’t want to own a beautiful property that cash flows hand over foot and comes with the bonus of free vacation at a whim?
There’s just one problem. While it’s possible to build a succesful strategy around the short term rental (STR) model, there are fundamental issues that make it both risky and difficult to scale. This post will dig into why the call of STR may in fact be a siren song and why, at the very least, the strategic investor might instead start by asking whether a short term rental strategy makes sense to begin with.
Macro Misalignment
The most glaring issue is the fact that markets in which vacation rentals would be most profitable are typically also the most difficult to operate in. This is because qualities that make cities attractive to tourists — e.g. entertainment, culture, and economy — are also qualities that make people want to live there. High demand plus low supply equals housing shortage, and a housing shortage means residents are in zero sum competition with tourists.
The result? Short term rental regulation.
Take a look at some of the regulations that are already in place across the country. In New York, a host has to be physically present for any rental under 30 days, can’t advertise, and can only have up to two paying guests. In Los Angeles and Denver, no home can be rented for more than 30 days that is not a primary residence. In Miami Beach, you can’t rent at all unless the property is in certain designated tourists zones. If you do, you’re looking at a series of fines that escalate by $20k per violation.
The list goes on. The cities that have the strictest regulations follow an obvious pattern: they are tourist hubs that are also major residential areas.That indicates that these regulations are symptoms of a deeper issue.
There’s a natural pressure for strict STR regulation in any market where residential housing is in high demand and short supply (essentially every residential market in high demand given the dearth of new construction since the Great recession).
That means even if you were to identify a market on the upswing by way of fundamentals data that does not yet have strict regulations in place, you wouldn’t get to enjoy your spoils for long. If you build (find) it, the tourists may indeed come … but the regulation will be hot on their heels.
Scaling a portfolio with regulatory risk constantly on the horizon may be acceptable to some. The rest of us are better off building over different mediums.
Capital Conundrum
As I’m sure many will be quick to point out, there are high potential STR markets that do not suffer from macro misalignment — that is, markets that attract tourists but are not at risk of ever-expanding regulation.
Ski towns in my home state of Colorado are a good example. These areas draw rampaging hordes of visitors year round for outdoor activities, and many rely on that income to sustain their economies. That plus relative remoteness and (typical) lack of a strong job market means that Colorado ski areas occupy a happy niche where profit potential is substantial and restricting short term rental activity would hurt local business owners.
So, checkmate, right? Short term rental makes you the big bucks?
Well, maybe. But only if you have them to begin with. The secret has long been out about such markets, and the predictable result is sky high prices (pun intended). We all know about Vail and Aspen home values, but take a market even like Breckinridge, CO, which is not typically associated with luxury living. The median home price in Breckinridge as of January, 2022 was $1,159,593, which represents a crazy one year increase of 40%.
Compare that now to what financing options are available. Conforming loan limits vary by county, but in Breckinridge (Summit county) it’s currently $822,375. That means that even if you put the standard 20% down, you would need around two hundred thousand dollars on hand to buy a place with a maximum purchase price of $1,027,968 — in other words, $200k down to buy a below average residence.
There are few ways around this capital conundrum for those without much capital on hand since a larger down payment isn’t an option and qualifying for private lending will be difficult, especially if it’s clear you don’t intend to operate a traditional rental.
That leaves anyone not sitting on a pile of cash with two options to pursue the short term rental strategy:
- buy one of the most affordable (and thus least attractive) options in a popular area
- buy in an area that is not yet too popular with tourists but might be later on
Either option should make anyone who was paying attention to real estate during the worst of the pandemic wary. The blow to tourism was bad for short term rentals in general, but those that found themselves in possession of rentals that weren’t in high demand to begin with were hit the hardest.
Evasion of the macro misalignment also creates another issue. Any market that relies on tourism is also a market in which it is very hard to pivot into a different rental strategy, a bad problem made worse when one considers that even ski towns are not immune to regulation.
That sort of unmitigated risk makes the underwriting of even a one-off short term rental difficult, much less a whole portfolio of them.
DTI Dilemma
Assuming you have managed to evade the macro misalignment and are lucky enough to be unconcerned about the capital conundrum, there’s another alliterative problem waiting around the corner: the DTI Dilemma.
DTI stands for Debt to Income ratio. It’s one of the major tools lenders use to qualify loan applicants. In short, DTI is the ratio of all sources of debt to all sources income. If you earn $10k a month and pay debt of $3k, your debt to income ratio is 30%. Lenders typically want to see a DTI no higher than 36% on a borrower’s profile.
Why does this matter for short term rentals? Shouldn’t the extra earning potential mean a better DTI?
In fact, it means the opposite.
Not all lenders care about DTI, but the ones that are required to (i.e. lenders offering conventional loan products) are strict about what qualifies as income. Short term rental income is uncertain compared to traditional rental income guaranteed by a lease, so lenders typically require two years of operating history before they offset any debt with that income in their calculations.
All the debt you take on to buy a short term rental will thus be offset by zero income for the first two years as far as many major lenders are concerned. Maybe your income is high enough to keep your DTI healthy anyway — good for you, if so. Can it survive two STRs though? Three? Four?
Missing out on new loans opportunities can add up to a lot of opportunity cost. Instead of chasing higher returns for each individual investment, investors would be better off targeting cumulative return from a portfolio that can grow without such financing difficulties.
Business or Pleasure?
A final question the aspiring STR investor might ask themselves: am I including any variables in my analysis that aren’t purely business related?
If the answer is yes, you’re not alone. Thinking qualitatively instead of quantitatively is a problem for new and experienced investors alike, and the idea at hand here is a particularly sexy one. Owning a short term rental is often translated to owning a vacation home that earns income. Time share gurus have been successfully making that pitch for decades: Why pay for a vacation when you could get paid to vacation (cue toothy smile and wink)?
Having secondary residences you can jet off to on a whim is a status symbol. It is understandable that those that can afford such things are tempted to hastily acquire them.
For those that subscribe to the Rich Dad, Poor Dad mentality, however, it should be clear that there is probably a better way to go about collecting luxury things.
Instead of buying whatever you want with whatever money you have as soon as you have enough of it, the Rich Dad Poor Dad prescription is to invest your money in assets that produce income, and then use the yields from those assets to buy luxuries.
This applies readily to most people’s desires for a fancy vacation home. Instead of buying one out of the gates and calling it an investment, why not buy actual investments that maximize return at scale? That return can then be used to buy a vacation home that doesn’t have to compromise between earning potential and personal preference. If that residence can earn income too, great. That’s then just a cherry on top of your vacation home cake.
In the meantime, instead of having to return to the same spot every year, you could vacation, I don’t know, anywhere you want while your investment strategy creates wealth in the background. I hear there’s even a pretty good market of affordable rental homes for those looking to visit areas as tourists.
Conclusion
The siren song of short term rentals will always seem a beautiful warble to many. If you still count yourself among that group despite the issues discussed in this post, you’ve probably thought deeply about your strategy. Good job and good luck.
For me, direct investment in short term rentals is not a great way to build an investment portfolio. Alternatives like traveling nurses housing and corporate rentals offer much of the cash flow upside without the regulatory risk, and traditional residential housing is still king in terms of potential for scale.
Whichever direction you go, however, the best advice anyone can give is simple: get clear on what you want and begin with the end in mind. Here’s to hoping this post helps kick off the right kind of analysis when choosing your rental strategy.
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