Cap Rates on Vacation Rental Properties?

Question

This might be a dumb question (I'm a new to this).  Do vacation rentals use cap rates for valuation?  I'm looking at a property in Destin, FL and I'm trying to determine an average cap rate for a condo located on the beach.  The agent I'm using there gave me a confusing answer making me think that it was a dumb question.  If not a dumb question, does anyone have a good answer for me?  Thanks in advance for your assistance.

Kristina Heimstaedt · Answer

Hi @Philip Arthurs. It's a challenging question to answer for agents because it fluctuates significantly from month to month and even year to year. You also ought to confirm/consider to what extent do/does each condo association allow for vacation rental. Knowing what your city wants that way is very important and can significantly impact your bottom line. I often refer people to Bill McBride's blog Calculated Risk Blog because he's got a lot of excellent data and macro numbers. I mention his blog because he shows that the occupancy rate for hotels over the last 3 years have either set records, and/or have been some of the best in history.

Vacation rentals are probably one of the areas where it would be nice to have a healthy cap rate because you need the buffer for fluctuations in the market on top of the fact that they are typically in secondary housing markets and those are what we see have some of the largest swings in appreciation and depreciation. If the infrastructure is based on tourism and the tourism decreases/disappears, that dramatically impacts the housing market. I like to think of secondary housing markets as the cherry on top in "keeping up with the jones's". Lots of money to be made, but arguably higher risk as well.

Andrew Johnson · Answer

@Peter Mohylsky Some good advice there.  I was looking at Gulf Shores because it looked like (at the time, not sure about now) that prices hadn't recovered since the 2006 crash.  However, it was still busy as heck during the summer.  So I figured that I could get some solid cash-flow and have the potential for appreciation as the "dirt" (sand) regained value.  It wasn't going to be assured, but hey, I'd have some cash-flow in case things remained flat.  Then I started to learn about wind insurance (one quote was $7K per year!), PM fees of 25%, what happens to SFRs in the winter with occupancy (arguably, you'd rather own a condo then!), etc.  If I was living in the south I probably would have bought a place (there were two "finalists").  But it would be for the "soft" reasons like I could visit "free" and so could family, we could invite friends, blah...blah...blah.  All of those things have tangible (but hard to quantify) value but if you're sitting in San Diego, Colorado, Michigan, etc. that tangible value drops to a big ol' fat zero.  Now for @Philip Arthurs that tangible value could be there and it could be great and it could be huge.

Andrew Johnson · Answer

@Philip Arthurs Short answer, no, cap-rates don't apply.  Especially when you're looking at condo developments.  It's all based on comps when it comes to valuation.  So taking the whole side of "you need 5+ units to use cap-rate" (which is true) vacation rentals are just different.  Usually the buyer has some emotional connection the the area (Destin vs. Gulf Shores vs. Orange Beach) and they also want to be able to use the property from time to time.  When you look at commercial properties or apartments, I've yet to find someone that's looking to live in of the units of their 20 unit apartment building.  There's less emotion, less emotional value to fit-and-finish, etc. and if the husband really wants an indoor pool in their Destin vacation rental, what's that worth in terms of an ROI trade-off?  In larger complexes there might be a units with ocean views and units with bay views.  So even if you did find an "average cap-rate" it's going to blend both of those units, you'll want the ocean view unit, and you'll think it's overpriced.  Or you get your average, you want the condo with the gym and indoor pool, and you'll think it's overpriced.

So, all of that rambling aside, here's where I would start.  Just figure out if a few of the units that you like cash-flow after you pay for property management, association fees, take out whatever weeks of rent you won't collect because you want to visit, all on a 75/25 LTV mortgage.  That's a starting point.  At that point you'll know if you are truly looking at an investment or talking yourself into an investment because you really want an ocean front condo.  By the way, there's nothing wrong with wanting an ocean front condo but it's best to be honest with yourself.

I know I look at vacation rentals in Gulf Shores and even though I never intended to visit the property I couldn't get most of the SFRs to pencil out (and that's with no condo association fee).  And the ones that did pencil out were barely cash-flow positive and couldn't match returns from apartments.  So if I would have purchase the property it would have been partly for the vanity of having a "beach front vacation rental" instead of the practicality of an ROI driven investment.  Just food for thought :-)

Craig Curelop · Answer

@Philip Arthurs - The short term rental strategy is so new that most investors do not have confidence in the cash flow volatility that comes with short term rentals. Cap rates are typically only used for properties that are 4+ units.

If your goal is cash flow through short term rentals, you can absolutely use cap rates in your own analysis. If you can turn a traditional 8 cap into a short term rental 11 cap, you are doing pretty good. I don't think that increases the value of the property to most buyers. However, if you find someone who is looking to purchase a property to use as a short term rental, then you may be able to get a premium when it comes time to sell.

As a conservative bet, I would not use income from a short term rental when determining your cap rate. I would stick to traditional comps.

Hope this helps!

Dave Van Horn · Answer

@Philip Arthurs

Usually no. Cap rates are mostly only done for multi-units or large commercial properties.

Dave Homyak · Answer

Here is a link that has data about the best places to buy property if the goal is making money from a purchase and then STR.  They also have a rental arbitrage slide.  These charts show where the easiest money was to be made last summer.

http://blog.airdna.co/buy-vacation-home-properties...

Peter Mohylsky · Answer

@Andrew Johnson has a great addition to this thread.  Spot on.  When buying a vacation home,  ROI is balanced on the emotions of owning a place at the beach.  It is a great time to buy because prices/values are still relatively low but real estate is only part of a balanced portfolio with the associated risks.

Thomas S. · Answer

The value is base solely on what the market, buyers, will pay. Since the use does not impact value cap rates do not apply.

Tyler Work · Answer

@Craig Curelop you might have some valuable insight for @Philip Arthurs on this one?

Immanuel Sibero · Answer

@Philip Arthurs

For valuation purposes the answer is simple, residential properties ranging from 1 to 4 units (i.e. Single Family Residence to Fourplex) are normally valued using sales amount of recently sold comparables. Cap rate is irrelevant.

For residential properties valuation cap rate is simply irrelevant because as a buyer you are also competing with owner occupants when looking at buying residential properties. As an investor you are looking to buy the income (i.e. NOI) of the property so the higher the NOI the more you are willing to pay for the property.  On the other hand owner occupants are looking to buy and live in the properties so their calculus in determining value is very different; they don't care about NOI, they care more about other qualities like the distance to the beach, or the the school district, etc. A beach condo in Destin would likely have very low cap rate (especially in a hot market) to the point where the numbers just don't work as an investment and this is because owner occupants have bid up the price so high.

As far as cap rate goes, if you insist on using them you can use cap rates to analyze (i.e. compare) various properties to determine which one best satisfies your criteria given your risk preference and tolerance. But why use cap rates when you can use CoC or IRR just as easily? Cap rate will never measure up to them.

Cheers... Immanuel

Cap Rates on Vacation Rental Properties?

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