How to value a vacation rental property​

Last updated: December 31, 2024

Valuing a vacation rental property can be both an art and a science. Whether you’re an experienced real estate investor or just starting your journey, understanding how to accurately determine the value of a vacation rental is critical to your success. This guide will provide you with a step-by-step approach to valuation, dispel common misconceptions, and highlight pitfalls to avoid when investing in short-term rentals.

The Basics of Valuing a Vacation Rental Property

When determining the value of a vacation rental property, investors typically consider three approaches:

1. Sales Comparison Approach: This method evaluates the property based on comparable sales ("comps") in the area. While the sales comparison approach is widely used in real estate transactions, it can be misleading for vacation rentals since it does not directly account for the income potential of the property. Vacation rentals also tend to be unique and therefore there not be accurate comps in the local market.
2. Income Approach: Often used for commercial properties, this method determines value based on the property’s income-generating potential. For vacation rentals, this involves calculating the Net Operating Income (NOI) and applying a capitalization rate ("cap rate").
3. Cost Approach: This method calculates value based on the cost to rebuild the property, factoring in land value and depreciation. While less relevant to vacation rentals, it can sometimes be used for unique or newly constructed properties.

Common Misconceptions About Vacation Rental Valuation

Misconception 1: The Sales Comparison Approach Is the Most Accurate

Many new investors assume that vacation rental properties should be valued solely based on comparable sales. While comps provide a starting point, they don’t account for the unique income-generating potential of a vacation rental. A property’s proximity to attractions, seasonal demand, and amenities can dramatically impact its revenue. Ignoring these factors can lead to overpaying for a property or undervaluing its potential.

Misconception 2: Vacation Rentals Are Always High-Income Investments

The income potential of vacation rentals varies widely depending on location, market demand, and management. Overestimating occupancy rates and nightly rates can lead to unrealistic projections and financial strain. Always perform conservative income and expense projections when valuing a vacation rental.

Misconception 3: You Can Ignore Local Regulations

Some investors overlook local short-term rental regulations, assuming they’ll have little impact on property value. In reality, stringent rules or outright bans on short-term rentals can significantly reduce the value of a property intended for vacation rental use. Research zoning laws, permitting requirements, and homeowner association (HOA) rules before purchasing.

Key Metrics for Vacation Rental Valuation

To value a vacation rental accurately, consider the following metrics:

1. Gross Rental Income: Calculate the total income the property is expected to generate annually based on average occupancy rates and nightly rates. Use data from platforms like Airbnb, VRBO, and AirDNA to estimate market trends.
2. Net Operating Income (NOI): Subtract operating expenses (e.g., property management fees, utilities, maintenance) from the GRI. The NOI provides a clearer picture of the property’s profitability.
3. Cap Rate: Divide the NOI by the purchase price to determine the cap rate. Compare the cap rate to other investment opportunities to assess whether the property offers a competitive return.
4. Cash-on-Cash Return: Evaluate your cash investment’s return by dividing the annual cash flow by the total cash invested. This metric is especially useful for financing scenarios.
5. Occupancy Rate: Analyze the average occupancy rate for comparable properties in the area. Adjust projections for seasonal fluctuations and local events.

Step-by-Step Process to Value a Vacation Rental Property

1. Research Local Market Conditions:
   • Use tools like AirDNA rentalizer to analyze occupancy rates, average nightly rates, and market trends.
   • Study local competition to identify comparable properties and pricing strategies.
2. Estimate Revenue Potential:
   • Calculate the property’s annual revenue based on realistic occupancy and nightly rate assumptions.
   • Consider peak and off-peak seasons and adjust projections accordingly.
3. Assess Operating Expenses:
   • Property management fees (typically 20-30% of gross income for vacation rentals).
   • Cleaning and turnover costs.
   • Maintenance and repairs (higher than long-term rentals due to wear and tear).
   • Utilities (water, electricity, internet, etc.).
   • Marketing and booking platform fees (Airbnb charges approximately 3% per booking).
4. Determine NOI and Cap Rate:
   • Subtract estimated expenses from gross revenue to calculate NOI.
   • Divide NOI by the purchase price to determine the cap rate and compare it to similar properties in the market.
5. Account for Financing Costs:
   • Include mortgage payments, insurance, and property taxes in your cash flow analysis.
   • Calculate cash-on-cash return to understand the profitability of your investment.
6. Evaluate Market Risks:
   • Research local short-term rental regulations and compliance costs.
   • Assess market saturation and potential competition.
   • Factor in the impact of economic downturns or travel restrictions.

Financing Vacation Rental Properties

Financing a vacation rental property can be more challenging than financing a traditional long-term rental. One common option is the DSCR loan, which bases lending decisions on the property’s debt service coverage ratio (a cash flow metric that divides gross rent by monthly mortgage payment) rather than the borrower’s personal income.

Key Considerations for STR DSCR Loans

• Lower Loan-to-Value (LTV) Ratios: DSCR loans for vacation rentals often come with lower LTV limits, requiring larger down payments compared to traditional mortgages.
• Higher Interest Rates: Given the higher risk and uncertainty associated with short-term rentals, DSCR lenders typically charge higher interest rates than they would for long-term rental properties.
• Income Uncertainty: Lenders may scrutinize the income projections more closely, especially in markets with seasonal demand or regulatory risks. Ensure your income estimates are well-supported by market data.

Other financing options include conventional loans, portfolio loans, and home equity loans, but each comes with its own set of requirements and limitations. Work with a lender experienced in vacation rental financing to understand the best option for your investment goals.

Vacation Rentals vs. Long-Term Rentals: Hospitality Business vs. Passive Income

Investing in vacation rentals is fundamentally different from investing in unfurnished long-term rentals. While long-term rentals are relatively passive, vacation rentals operate more like a hospitality business, requiring active management and marketing to succeed.

Key Differences:

1. Operational Execution:
   • Vacation rentals demand higher levels of operational involvement, including guest communication, cleaning coordination, and resolving issues promptly.
   • Long-term rentals typically involve minimal interaction with tenants once leases are signed, and property management needs are limited to occasional maintenance requests.
2. Marketing Risk:
   • Vacation rentals rely heavily on effective marketing to maintain high occupancy rates. Poor reviews or inadequate marketing can significantly impact revenue.
   • Long-term rentals, on the other hand, have consistent demand, with tenants often committing to year-long leases.
3. Seasonality:
   • Vacation rentals face fluctuating demand based on the time of year, local events, and economic conditions.
   • Long-term rentals provide steady, predictable income with less exposure to seasonal changes.
4. Wear and Tear:
   • Frequent guest turnover in vacation rentals leads to higher wear and tear, requiring more frequent maintenance and updates.
   • Long-term rentals experience less wear and tear as tenants typically stay longer and take greater care of the property.

For investors, the decision between vacation rentals and long-term rentals depends on their risk tolerance, availability to manage the property actively, and investment goals. While vacation rentals can offer higher revenue potential, they require a higher level of effort and carry more risk compared to the relatively passive nature of long-term rentals.

Common Vacation Rental Mistakes to Avoid

1. Overpaying for a Property: Don’t base your purchase decision solely on comps or income approach and cap rate. Vacation rentals are unique and there are two types of prospective buyers should you need to sell the property: primary residence/vacation residence buyers or business purpose buyers. Consider the marketability (attractiveness) of the property to each of these personas. How much would someone pay for the property if they want to live in the property and not rent it out? How much would someone pay for the property if they want to continue operating it as a vacation rental? In an elevated interest rate environment, the cap rate needs to be sufficiently high enough to justify the elevated financing costs which means the valuation will face downward pressure.
2. Ignoring Local Market Saturation: An oversaturated market can drive down nightly rates and occupancy. Analyze supply and demand before buying.
3. Underestimating Management Costs: Managing a vacation rental is time-intensive. If you’re outsourcing, budget for property management fees and additional expenses.
4. Neglecting Maintenance and Wear and Tear: Vacation rentals experience higher wear and tear due to frequent guest turnover. Budget for regular updates, cleaning, and unexpected repairs.
5. Failing to Plan for Slow Seasons: Many markets experience seasonal fluctuations. Ensure you have a financial buffer to cover mortgage and expenses during low-occupancy months.
6. Purchasing or rehabbing a vacation rental that will be difficult to sell: We've all seen the MLS listings of failed vacation rental properties that are so unique few people are even interested in purchasing them.
7. Purchasing or rehabbing a vacation rental that will be difficult to pivot to a long-term rental It's important to underwrite your rental property to make sure it will still pencil in as a long-term rental (i.e. unfurnished 12+ month lease) in the event your vacation rental market becomes oversaturated, faces difficult local regulations, or you realize that running a hospitality business is not for you and you want to pivot to a more passive real estate investment.

Tools and Resources for Vacation Rental Valuation

• AirDNA: Provides data on occupancy rates, revenue projections, and market trends for vacation rentals.
• Mashvisor: Offers property analytics and rental income estimates for short-term and long-term rentals.
• PriceLabs: Helps optimize pricing based on demand, seasonality, and local events.
• Local Realtors: Partner with agents who specialize in vacation rental markets to gain insights into market conditions and comparable sales.

Conclusion

Valuing a vacation rental property requires a comprehensive approach that balances traditional real estate valuation methods with an understanding of income potential and market-specific factors. By avoiding common misconceptions, conducting thorough market research, and using reliable tools, and underwriting using conservative assumptions (i.e. occupancy rate, per-night pricing), you can make informed decisions and maximize the profitability of your investment.

Remember, the true value of a vacation rental property lies not just in its purchase price but in its ability to generate sustainable income while minimizing risks. Investing in real estate using the STR strategy requires discipline, commitment, and a passion for hospitality. Approach each investment with diligence and a clear strategy to ensure long-term success.

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