At first blush, many prospective buyers see a vacation rental purchase as a potential win-win: They pick up a new source of income and have a cost-effective vacation destination whenever they have the urge to get away. It’s easy to understand why vacationers prefer to rent their own property instead of staying in a hotel or condominium, particularly if the property comes at a manageable price for potential buyers. Many potential buyers are very intrigued by the potential income opportunity of a vacation home.
While it’s true that many vacation rental owners can earn an income through year-round rentals while still enjoying the property themselves, the most successful cases come about when the buyer takes time to evaluate the situation and make a purchase that makes good financial sense. Balancing the potential income alongside the inherent risks of a given property are critical to properly assess its true rental potential. Here are some guidelines to making a well-informed property decision.
Assessing Your Rent-to-Value Ratio
Perhaps the most important measurement of a property’s income-generating potential is the rent-to-value ratio offered by the property. This ratio basically weighs the annual rental income you can generate against the overall value of the home. For example, if you make $25,000 annually off a vacation home valued at $500,000, the property has a rent-to-value ratio of five percent.
The rent-to-value ratios of vacation properties can vary widely, with the majority falling between three and 10 percent. Higher potential returns are highly sought after so these higher returns often make it tougher to buy a property due to market competition. Additionally, sellers might raise the price on a home that’s performing particularly well in the rental market, which will cut into your long-term rent-to-value ratios.
Some of the main factors that affect the potential rental earnings off a property include the condition of the property, its square footage and hosting capacity, and the “view” afforded by that location. If you’re located on a lake or beach, the distance between the rental and the water also plays a large role in rental pricing.
Buyers should be on the hunt for properties with current rent-to-value ratios of five percent or more. If you go below this ratio, your margin for error is particularly thin, and you’re likely to face a tight financial squeeze if the market for rental property dips.
Adding Up Additional Expenses
Vacation rentals can be profitable, but there are additional expenses that some buyers don’t think of before they make their purchase. One option to strongly consider is having a property management company handle the day-to-day management and maintenance of the property itself. Utilizing a property management will come at a price though with management fees running anywhere between 10-30% of the monthly rental price. Another option to consider is managing the rental duties yourself. Managing the property is a big job and would entail things such as day-to-day residential communications, rent payments, lease drafting, furnishing and maintaining the property, managing the grounds and cleaning up after guests leave. Handling all of these matters can be time-consuming, and if you’re not locally based, can be very difficult to effectively manage.
You’ll also need a special insurance policy to cover your property as a rental unit. It’s entirely possible to generate strong profits even after all of these expenses are accounted for, but you’ll need to factor all of this in to get a clear picture of the kinds of costs you will be facing.
Forecasting Demand–And Bracing For Downswings
When considering the purchase of a rental property, each type has its peaks and valleys. Not only can occupancy rates fluctuate but economic recessions tend to hit the vacation industry hard. Vacations are among the first things consumers cut out when they’re facing a tight financial squeeze. You need to look at worst-case scenarios and gauge how much of a downswing you can handle. Again, this is where rent-to-value ratios are important: How much margin for error do you have? How many days out of the year do you need your property rented to break even?
Planning for the Future
If you’re looking to purchase a future retirement home, a vacation rental can be a great financial move that offers tax breaks when things go wrong. Meanwhile, you’re investing in a future home, not just a income-generator, which makes the bottom-line more attractive.
Many buyers see a vacation home as two things: extra income and their own personal getaway. Both of these scenarios are entirely possible, and the rewards can be great. Just make sure you’ve done your homework to avoid a tough financial situation in the near future.