Have you ever wished that you owned a vacation house or condo in a highly desirable location that you could use yourself, possibly retire in it one day, and have it pay for itself? One way to do this is to purchase a second home and rent it out as a short-term rental.

Pros and cons of investing in a vacation rental home

Having owned two such properties myself, I can speak from experience that there are pros and cons of this type of investment. Short-term rentals can generate higher income than a long-term monthly rental, but there are plenty of issues to consider. This article will talk about the advantages and disadvantages of these sizable real estate investments.

Know the landscape before making your purchasing decision!

When purchasing a short-term rental home, there are several things to consider and that should not be overlooked:

• Is the area you are looking to purchase a home zoned for short-term rentals, meaning can you even rent day to day or week to week? Many areas in the country do not allow this; be sure you understand the playing field before stepping on it!
• What is the draw of the home, are other properties in the area getting rented on a regular basis, and are there seasonal droughts that could adversely affect your cash flow? Many times, you can check Airbnb or VRBO listings in that area and see what “the competition” is doing, what they are charging, the features they offer, and how regularly they are occupied.
• Are you planning to manage the rental yourself? If so, you may save fees and rental percentages, but you will need to market, maintain, and tend to the renters when something comes up that is unexpected, as you are essentially on call 24-7 when you have a tenant in your rental. You will also need to secure the government permits needed to make your venture a legal enterprise. I can tell you from experience that this can be time-consuming but can also be rewarding for a hands-on type of owner.
• Are you going to hire a property manager? The burden of management can be shifted to them, which frees up time and lowers the anxiety of having to deal with the day-to-day operations of your rental home. Many times, a property manager will charge 10-20% of the gross rental income, and there may be other fees that they charge or pass along to you. It is crucial that you properly vet the property manager, as a good one is worth their weight in gold, while a bad one can bring huge financial loss due to poor rental income or deficient maintenance of your property. Ask for references from other clients of the property manager, and make sure you interview the manager thoroughly so there are no surprises.

Understand the finances—it is not likely you will get rich with a short-term rental!

There are many financial considerations people don’t think about when thy buy a short-term rental:

• When you use it yourself, you are limited to 14 days, or 10% of the number of days that the rental is occupied in a year if you want to maintain the property as an exclusive vacation investment property in the eyes of the IRS. This means that certain deductions from rental income may have to be pro-rated if you use the property yourself more than these limits.
• A net operating loss ($25,000 max/year) is usually not deductible from your other non-passive earnings if your modified adjusted gross income (MAGI) is $150,000 or greater, and these losses are phased out starting at a MAGI of $100,000.
• Beware of all the hidden fees! Airbnb and VRBO will charge you and/or your renters a variety of fees which can eat into your bottom line and/or discourage renters from choosing your property.
• In addition to marketing costs, what does a cleaning service cost? Who will perform the repairs or maintenance on your property? Is there a HOA fee associated with the property? What are the tax and insurance costs?
• I would highly recommend that whatever emergency fund you have for your own household is doubled for the addition of the new property. Now you have two homes that can have an air conditioner fail, have a plumbing leak, need a new roof, or need a remodel. Remember that if your second home is down for repairs, it also leads to lost rental income, and you need to be ready to cover these expenses.
• From a purely investment-return perspective, it is likely that you can get a higher return on your investment (ROI) from real estate investment trusts or other real estate investment vehicles. Most short-term rentals generate a ROI of 5% or less on income each year.

There are many moving parts, but short-term rentals can be rewarding for the right people!

Despite all these concerns, by holding a second home that pays for itself, you can experience significant capital gains in a positive real-estate market. It might be that you couldn’t otherwise afford a second home, but the short-term rental allows you to build additional real estate equity and can be available for your own use for things like an annual family vacation. To some people, having a beautiful vacation home that they might one day retire in is a much better second home than a monthly rental that they wouldn’t necessarily live in themselves.

Understand all the financial ramifications

It is important to understand the various financial ramifications and whether a short-term rental can help you achieve your goals. A financial advisor can help map this out for you! For more information on how we can assist you please visit us at our website, or schedule a free consultation.

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Photo credits: Bob Anderberg (F5 Financial)