Short-term rental investments come with a lot of risk and variability: Seasonality in revenue, high up front furniture, unforseen risks, repair & maintenance cost. In this article, we will provide our framework for modeling investment returns for short-term rentals that every savvy investor needs to throoughly understand and compare free cash flow, Cash on Cash Returns, and IRR (Internal Rate of Return) across different investment classes. If you are curious to learn more and get our excel file, you can sign up for our course to model short term rental returns.
We will demonstrate using the below two examples to help an investor understand how to breakdown various aspects of their cost structure - and also highlight costs that are often overlooked that can drive down profitability.
We take one example of a median 3-4 Bedroom home from a sample urban market such as Seattle, and one from a rural market such as Scottsdale/Tampa to demonstrate each line in detail.
House price and mortgage: This is the full home price the investor will be purchasing the asset for. Typically, the investor will get a mortgage on the property, either a convention, DSCR or some other form of loan, which is generally of 75-80% of the home value. Urban home prices are typically more expensive than rural. In our example, we take the case of a $900K home in an urban market such as Seattle and a $700K in a rural market such as Scottsdale/Tampa.
Investor Upfront Cost: Your out of pocket cost includes the initial down payment, closing costs, and also initial furniture + remodel/maintenance the investor may have to do make the home Airbnb ready. These costs can vary widely, typically brand new furniture for a 3BR home costs $18,000-$20,000 alone - the small items such as linens, towels, toiletries etc all add up.
One can reduce their initial furniture cost through creative ways such as buying second hand furniture from Facebook marketplace or OfferUp - depending on the type of Airbnb one is targeting.
Investors often overlook the labor cost to set up the Airbnb. It takes usually 80-100 man hours to make a high end 3 bedroom ready for listing on Airbnb, and first few months of additional effort to smoothen out your listing issues.
Labor cost cost can add up, even at $30/hour for labor, this can easily add up to $3000+. We typically see this cost in the range of $5,000 as skilled labor is more expensive. Investors may be able to shave this cost - but we recommend to still factor this in as ultimately they are trading their time for money.
Rehab cost is another highly variable cost - typically homes in rural areas need more work as they are larger, and we recommend budgeting appropriately.
Gross Income: Gross Income is your projection of the revenue potential of the home. Different sites calculate this differently. For example, Airdna includes cleaning fees in their gross income, and hence the investor needs to subtract that out as cost to ensure correct modeling. We recommend level setting these numbers with your property manager (more on this later) to ensure your numbers are in the right ball park.
Expenses:
This is the biggest line item that can make or break an investor. Aside from cleaning fees, which are typically 10-15% of your gross income, investors need to count management fees, even if you are self managing.
We recommend incorporating management fees in your model even if you are self-managing as you are trading your time for extra income and it needs to be valued as a cost.
Incorporating management fees into your model also helps give you the option of later converting the home to one managed by a professional property manager in case managing short-term rentals becomes too taxing as you have already baked the cost in your profit model
Mortgage, property taxes are relatively straightforward items to model. Insurance can be another variable expense. Insurance policies for short-term rentals are typically more expensive, and if an investor is renting a home in a flood zone, or hurricane prone area such as Florida, this cost can easily be $4,000/year and eat up your profit.
Another often overlooked expense is repair and maintenance - it can be $0 for a few months, and suddenly your fridge breaks and you need to replace it. Aside from including preventative repair and maintenace such as servicing AC/furnace, cleaning ducts, dryer vents etc, we recommend investors to ammortizing the cost over the lifespan of different items: roof (25 years), kitchen appliances (5-7 years), AC interior/exterior painting (5 years), furniture (5 years), carpets (3 years) etc.
Repair and maintenance cost can vary between $4,000-$7,000 per year after factoring in the age of the home etc.
It's a good habit to budget roughly $4,000-$7,000/year and save some of the excess cash towards rainy day expenses in case something unexpectedly breaks, which it will.
Profit: After deducting all above expenses, the investor can finally realize their profit and cash on cash return. We recommend a minimum 10% cash on cash return target to compensate for the risk of owning short-term rentals, which are far more volatile asset classes than long term rentals. This target number is lower in urban markets. In highly volatile vacation rental rural markets such as Scottsdale, Nashua, Tampa etc., we recommend a target of 15%.
Tax Benefits and Principal Repayment:
Seasoned real estate investors are aware of the power of real estate investing. Aside from the cash flow returns, investors need to bake in the tax benefits such as ability to deduct interest payments, expenses; which can easily add up to $10K+ when done right. We recommend connecting with a seasoned CPA who deals with real estate investors to learn more.
Additionally, investors are also paying down their debt: by year 30, which is the most common term for mortgage, investors will have a full paid off home. The seasoned investor will bake this cost back into their return to get the final number of IRR. This IRR number is what we recommend investors use to compare their investments against different asset classes such as syndication, REIT etc.
Modeling Risks:
So far, we have only discussed modeling returns of the market. If you want to get this excel file for our own use, learn how to model risks, and practice with more examples, feel free to check out our course here.
