Making the numbers work - Overpriced Market?

Question

I have been searching certain areas in Florida (Panhandle Beaches; Disney area; Clearwater to Sarasota Beaches) to buy something as a STR. Looking at average STR gross revenue and the related costs, particularly the mortgage carry costs given the inflated prices, I can't find anything that pencils out with a reasonable ROI.

Are others buying in this market or standing by for a correction? How long does it take for rental rates to increase to absorb the higher real estate prices?

Are others buying in this market or standing by for a correction?  How long does it take for rental rates to increase to absorb the higher real estate prices?

Collin Hays · Answer

Christopher, excellent questions.  You are to be commended for asking yourself the tough questions prior to making a substantial investment, because there is no one-size-fits-all answer to these questions. Your questions are of a macro nature, similar to "Is this a good time to invest in the stock market".

In order to gauge suitability of a real estate investment, and in fact any investment, for your portfolio, it is important to fill in the blanks on these questions first.

- What is my tolerance for risk?

- What is my time horizon?

- What is my investment goal?   Income?  Appreciation?

Specific to your questions, however: A "reasonable ROI" is going to be a different number for every investor. Are you referring just to income yield? Overall yield, including projected appreciation?

A "correction" supposes that prices are overly inflated to begin with.  But relative to what?  If the annual income return on a vacation rental was 13 percent three years ago, but is now 8 percent, is it overpriced?  Not as long as there are willing investors to accept 8 percent. What is a reasonable ROI for you?

Making decisions based on cash-on-cash is a very dangerous game, because you leveraging 80 percent of the cost.  If rents go down, you are suddenly 20 percent NEGATIVE cash on cash.  I've been there, and worse.  There have been years when I was paying out TWICE per month what I was taking in.  Was that a "reasonable" ROI?  As of today, right now, yes it was.

The future of rental rates is anyone's guess. That ultimately is a supply-and-demand issue and is impacted by new construction, traveler demand, the overall economy, etc.  Rates may rise, rates may fall.  I bought my first cabin in 2005, right before the financial crisis, for $240,000.  My annual rents the first year were around $15,000, and they rose steadily until the financial crisis.  In 2010, that cabin appraised for $120,000.  Yikes.  And I was having to rent it for $69-79 a night just to keep some $$ coming in.  It is now worth about $700,000 in my estimation, and the nightly rent is around $270 on a year-round basis.

Moral of the story:  Define what is a reasonable ROI for yourself, and make sure you factor in a 50 percent haircut on values and rents for a few years.  It happens.

Dan Maciejewski · Answer

If you want to see oversaturation, look to Orlando and surrounding areas -- they are definitely in a bit of a pickle.  They are competing on rates while occupancy is lower.

It will definitely depend on the area.  In my area, there is no room to build (without increasing density) more housing that will be good for short term rentals, so we can't run into the Orlando situation.  Price appreciation, on the other hand, will definitely start to limit returns.  All the people that wanted to wait for the market to cool 1-2 years ago are now effectively priced out of my market.

I would be interested to see what the OP is looking at because the ROI on STR in Pinellas is still shockingly high.  Some people have unrealistic expectations, though.  I see he's using CoC and looking for 20% in year one.  I would say that is impossible anywhere, but ¯\_(ツ)_/¯ YMMV.  I tend to use cap rates to compare investments (some people hate that SFR isn't traditional commercial, but IDC, it's apples to apples without worrying about debt service and credit scores and APRs, etc. . . )

Christopher Knibb · Answer

Collin - that is a great perspective and the type of information I need to hear. I'm excited to get started in this space and trying to figure out what is reasonable deal for my first one.  Hearing your story will help me as I calibrate my model and expectations.  THANK YOU

Tony R Fox · Answer

@Collin H.

Fantastic insight!!!  I am new to investing as well and I've had similar concerns.

Part of me wants to still buy as there never is a "right time" to buy and I am afraid that if I wait, I'll miss out--even in an overpriced market in CT that I am in.

Michael Plante · Answer

I am on the same area I don’t think this is a cycle

For many reasons I don’t think central FL (the area I deal with) will see a big sell off at all

We are in strange times for many reasons.  I just don’t see an end to the price increases.

A slow down is possible but I don’t see a correction coming for a long time of ever

Michael Baum · Answer

Hey @Christopher Knibb, I think 20% on your first year is too much really. With a new property, you will have to build up a reputation with 5 star reviews etc in order to meet and exceed that goal.

Now the area you are in might help with that, but I feel that is a good general rule.

Dan Maciejewski · Answer

I'm not sure about your numbers or what you're seeing for short term rentals here in Pinellas.  I wanted to take a look to see what you're looking at, though.  I usually use cap rate -- that way I can compare a STR to another STR or a long-term rental or a carwash and see where my money is better parked.  Cap rate is also very simple and not prone to misinterpretation.  It's just NOI divided by market value/sales price.  Then I take a look at the other things that will determine my cash payback period.  I did do a quick search and it looks like most investors are happy with a 8-12% cash on cash.

Average-looking purchase:

Our average sales price in Pinellas is 530,000, and median price is 400,000.  Most people that are looking to purchase a short term rental usually want a 3/2 with a pool;  that runs around 450-650 right now, depending on neighborhood, location, turnkey status, etc. . .   In that price point, with the right purchase, you should be looking at 70-75%+ occupancy and $300-$350 ADR.  That's a gross of 75,000-96,000 -- obviously that will move around in that range based on your property and how well you manage it.  I will use $300 ADR and 75% occupancy for this.

That purchase of, say, $525,000 will be about 150,000 cash out of pocket (dirty ballpark) - 110,000 down payment/closing costs and 40,000 to get furnished and fix small things.  OpEx will be about 27% without a PM and 45% with  That can vary wildly depending on a lot of factors. Debt Service looks like 25,000-30,000/year. This will also change depending on the borrower.  That makes a CoC return go from 14% with a PM to 23% self managing.  I might be wrong, since I don't usually use this metric to analyze, but that's what I got just now.

Eric Bilderback · Answer

@Christopher Knibb

Yup I think you are spot on.  My tune has changed over the past few years.  If I didn't underwrite any properties with rent bumps I would not be buying anything.  Luckily for me rents have exponentially gone up.  I would look at the places that sold in the last 3 months or so and pick the 3-5 best properties and tell yourself, "if I can find X criteria like property A and B I am going to buy it."  If nothing sold that was 20% COC you either need to adjust your criteria or cut bait.

To paraphrase a famous economist, "at some point the market will correct however at some point we will all be dead."

Christopher Knibb · Answer

Michael - I'm thinking you are correct, especially in FL.  I came close to buying a great beachside town house on Tampa Bay in 2012, but, it had Chinese Drywall and all the copper was deteriorating.  That unit is now valued over 4x (>400%) higher than 2012 and it flipped within the last 8 months at a 100% increase... So, seeing the current prices, now, when I'm ready to jump in, I've had a little sticker shock.  At some of the price points 12 to 18 months ago, the cash flow returns would have been much higher than the models I'm doing today.  All that said tho, I am going to keep looking and pull the trigger soon.

Thanks!

Making the numbers work - Overpriced Market?

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