What cap rate do you target for your STR investments?

Question

What is the lowest cap rate you will invest at in an STR-friendly market w/ good future demand outlook?

Are these targets still achievable for you in today's market?

(Asking about cap rate instead of CoC so it's apples to apples)

Erik Stenbakken · Answer

Hey, @Sean Bramble, Good on ya for looking at apples to apples type metrics.

I use 9 as cap target. Higher is better of course. Just did 2021 numbers and am hitting closer to 12 - 14. BUT that's based on purchase price a few years ago. I'm under contract on a new construction that should hit about 9 when done, and another new build finishing that should do about 10. But those are new builds. Very delayed gratification.

Outright buy today, rent (or renovate/rent) tomorrow… it's going to be hard finding cap rates at 9 or higher in the markets I know.

Yeah. I know one cannot count on appreciation, but these days, it needs to be part of the metric. I mean, you could buy a government bond at 1.5% … which makes a cap of 8 look stellar! Likewise, I don't buy everything as "cap rate today only!" I look at "can it pay for itself now? Will rents likely increase? Will property likely appreciate? And the biggie: is there anything BETTER to do with my money/time than this?"

Hope that helps!

Luke J Nelsen · Answer

Last year in the Smokies we were targeting 30% cash on cash returns. Now with inflated prices and interest rates rising the returns have dipped into the teens for on market deals. I am still seeing 30%+ returns on off market deals we're analyzing.

Jeff Stephens · Answer

Interesting post. IMO, it's up to the investor on their cap rate/CoC. Some are happy with a lower 4-6% return, while others aim for the much higher of 20%-30%. At the end of the day, I always look at what I am comfortable sacrificing. If I have a lower return initially, but the safety of a historically appreciating area, then I'll sleep a slightly better at night knowing my exit strategy isn't going to be impacted drastically. It'll be interesting to see what happens to those who have taken advantage of low rates while not truly understanding the business side of STR's. Could be a great opportunity to come in and find some deals.

Sean Bramble · Answer

@Luke J Nelsen just curious what % down you’re assuming for these deals? 10%? 20%?

Luke J Nelsen · Answer

@Sean Bramble We are putting 10-15% down. In one case we put a bit more down but that was when rates were in the 3's. Now at 5.5% and higher asset prices, the equation definitely changes.

Erik Stenbakken · Answer

@Sean Bramble I think you're seeing this VERY clearly. Not more than 10 min ago got a text from a friend. A friend of his is unloading 10 STRs. They're not performing in 2022 like they did in 20-21. Shocker? Not to me.

I still think STRs are a good gig. But ONLY if bought right and seen for what they are (as you note): a hospitality business.

Be wary. But not afraid. Time is the friend of real estate.

Sean Bramble · Answer

@Erik Stenbakken makes sense - I really appreciate you thinking out loud here

I worry a bit that investors are applying a residential lens to what is really a hospitality business. i.e., assuming STR returns will be as non-volatile as LTR returns during an economic downturn. I suppose time will tell, but I can imagine a lot of these guys buying at super low cap rates in vacation markets could find themselves in a tough situation in an economy where people cut back on discretionary spending. But I'm quite new to this ... and probably missing something :)

Erik Stenbakken · Answer

@Sean Bramble, I'll give you my OPINION. How's that?

I think you're right. So either we're both right… or maybe both wrong! Or parts of each.

I do think there will be continued and increased demand for STR. Those assumptions about higher ADR and occupancy are premised on a good economy and buyers who can afford to hold the line if it isn't. If buyers get in too deep and NEED to make say $6k/mo gross so that they can just pay their bills… then they're going to be hurting when they hit $5k if it happens and they're not well capitalized. Then what? A race to the bottom for rates? Dunno. No crystal ball.

Your point #2 about more investors wanting in… yeah. That's here. That's driving margins for new buyers WAY down. If My mortgage is $2000/mo and someone buys similar property today and has to pay $3500/mo for the same income… that's thinner margins for sure. But will that stop buyer demand? It hasn't. No idea where the hard stop is. I helped someone analyze a potential STR with them and best-case scenario, she was losing $500/mo even if she was hitting top 80th percentile in her market. She didn't buy.

But will someone else? Only if they want to feed it for ___ years till cash flow catches up or appreciation goes even higher. Personally, I'd pass on a cash-negative property. But I think there's a lot of "I sure hope" math going on in various markets right now.

Sean Bramble · Answer

Thanks @Erik Stenbakken!

Curious how you think about future appreciation in STR dominant markets ... where homes are essentially being valued as income producing hospitality assets rather than homes ...

i'm new to this - so please let me know if i'm thinking about this the right way - but it seems like in an STR dominant market appreciation would be driven by 3 things:

1) increased demand from Airbnb consumers (essentially boosts NOI through higher occupancy/ ADRs, and therefore boosts market value of homes if you hold cap rates constant)

2) increased demand from Airbnb investors willing to pay more for the same earnings (i.e., lower cap rates)

3) inflation

Am I thinking about this the right way? If so, does this imply that home values will eventually max out at cap rates that are so low most people won't want to invest? Where do you think the "floor" is?

What cap rate do you target for your STR investments?

Most Popular Reply