The patient isn't dead, but he's in a coma

In 2005, I bought my very first vacation rental in the Smokies. Yes, VRBO was a thing even back then. I thought I made a good deal. $240,000 for a 3-bedroom cabin right on Cosby Creek. In comes the financial crisis of 2008, and things went very south, very quickly. My cabin was now, at least on paper, worth about half of what I had paid. Ouch!

I had friends just up the road that had paid between $700,000 and $900,000 for luxury cabins with indoor pools. The developer went bankrupt, and left that development without a permanent sewer/septic system. Within a few years, those same cabins were being sold by the bank for as little as $250,000.

This is the business cycle of vacation rentals. Right now, we are staring at the likelihood of a collapse in prices, and here is why:

1. Properties were way overvalued in 2021 and 2022. Money was cheap – 3 and 4 percent mortgages, which made investors insensitive to the actual price and fully focused on the payment.
2. Demand was at all-time highs in 2021 and 2022. Post COVID “revenge” vacations. Not enough supply of rentals combined with a seemingly endless supply of guests meant that nightly rates skyrocketed.
3. As nightly rates skyrocketed, home sellers were able to price – and sell – their homes based upon a multiple of the artificially high rents coming in. Properties were even further overvalued.

In 2023, we find ourselves in precisely the opposite situation:

1. Supply now exceeds demand, and by a whole bunch. Not only are the revenge vacations over, but many more properties have been built. That means lots of inventory chasing after fewer guests. And that translates into price cuts, often dramatically so.
2. As rents decrease, the property isn’t as valuable, as the price-to-earnings multiple has contracted.
3. Borrowing costs have doubled and quite possibly tripled, meaning a substantial chunk of the property’s income has to be dedicated to paying interest.

In closing, the patient isn’t dead, but he’s in a long-term coma. In my next entry, I will be further analyzing how we got here, and what we as investors need to do going forward.