How to Passively Invest in the Vacation Rental Market

[Editor's Note: This guest post was submitted by Stephen Sorenson, who enjoys a double life as a tech professional and a real-estate developer. He and his wife have operated a vacation rental property development and management business since 2003 called Classy Cabins AZ. In this article, he attempts to make the case for investing passively in vacation properties. While I'm not sure I was convinced, I think it is a worthwhile conversation to have, so I've turned it into a bit of a Pro/Con post. We have no financial relationship.]

Pro: Vacation Rentals Are a Great Investment

As a busy professional, you may have little time to spend as an active investor. Whether it's doing research in the stock market or bond market or looking at real estate, there is a substantial time commitment. Even the time necessary to meet with financial advisors, then weed through their offerings to decide if they are for you is heavy. It's also a fact that you should invest as early as you can to let the magic of compounding work. And then invest regularly. It all adds up to quite a bit of time and energy.

Fortunately, now is a great time to be interested in “passive” investments as there are many more choices than there used to be. In fact, you can find ways to invest passively in nearly any asset class from stocks and bonds, to durable equipment, to various kinds of real estate. There have been big changes in many markets as technology advances. In the stock market equities field, there are now fully automated systems that allow you to place money in the system, and just let it do what it does after you indicate some basic preferences. Or, you can simply invest in index funds or ETFs. But, if the stock market just isn't your cup of tea, perhaps real estate is better. It's been said a zillion times, but it's true; more wealth has been amassed through real estate than through any other class of asset.

Recently there has been a spate of changes in nearly all real estate markets. For active investors, and for passive investors supporting those activities, are immensely popular. How many other kinds of investments have so many reality TV shows devoted to them? But popularity brings with it a lot of players. Competition always puts pressure on returns and today, that kind of investment is extremely competitive with billions of dollars of both domestic and foreign money snapping up properties and bidding up the prices as they go. So, what happens when a particular segment gets really crowded? Investors start looking for other places to do what they do.

Vacation Rental Market Trends

In just the past dozen years, vacation rental properties have undergone huge and fundamental changes, and just in the last few years have attracted the attention of investors of all stripes and sizes from Mom & Pop to Institutional investors. What's happened? What's driving the changes? And more importantly, are there great opportunities there?

Rise of the Internet

Our business started 14 years ago with our first vacation rental cabin. At the time, near the Grand Canyon, there were 14 listings on the first large vacation rental site, VRBO.com. With the advent of the internet and world wide web came the ability for the owner of a vacation property to list it online – and that was a HUGE change. Before that, if you had a vacation rental you marketed it by letting travel agents know, and by posting signs and maybe newspaper ads. But the internet changed everything in that market as in so many others. While VRBO was one of the first and the biggest site at the time, many more would appear as internet access became ubiquitous and speedy. A group of smart investors started HomeAway.com, which purchased VRBO, and several other listing sites. Flipkey started up, then was snapped up by TripAdvisor. And Airbnb, now the 800 lb gorilla of the vacation rental market is a household name all over the world. In our area, there are now 1400 vacation rental properties, a 100-fold increase, but with changes in demand, the inventory is still constrained.

Surge in Supply and Demand

With the changes making access to vacation rentals easier came expanded marketing efforts by the listing sites and by individual owners. The market for vacation rentals has surged. It's become so big that hotel marketing websites are almost all carrying vacation rental listings alongside their hotel listings. Most travelers now consider vacation rentals a viable alternative to hotels, and a large and growing segment of travelers prefer vacation rentals when they travel. During the last real estate bust, a large number of vacation homes suddenly became unaffordable for their owners. A large number of those owners chose to try renting the homes out rather than lose them to the bank. Some investors even decided to buy up houses during the downturn and re-purpose them as vacation rentals.

So the original seasoned and experienced vacation rental operators, mostly single home operations, suddenly came face to face with large numbers of newly christened owners and their rentals in the market. There was a bloodbath of sorts. So many stories of people failing at renting out their homes, despite obviously huge demand and easy listings. What's the real story behind it all? The hastily fielded vacation homes were not designed to be vacation rentals and they weren't run by experienced vacation rental professionals. Two categories of vacation rentals emerged. There are a lot of vacation rentals in the market which are cheap to rent but don't offer a good experience for the traveler. So, they don't get rented as often as their owners’ hope. On the other hand, there are professionally managed vacation rentals that have much higher occupancy and offer a much better travel experience but that have higher nightly rates. As with any product category, there are widely varying degrees of quality to be found.

Investment Returns

For an investor looking for passive returns in real estate, ownership in professionally managed rentals are what you should consider investing in. While the AVERAGE return on vacation rentals is just slightly higher than the average return on single-family rentals, the returns available from well-run vacation rental operators are above market. The average single-family rental home gross rental yields (gross rents/sales price) returns around 9%. That’s gross, not net. You might expect a secured investment in a vacation rental to return 7-14%, NET, before appreciation, depending on whether you wanted regular and predictable cash returns or were willing to simply participate in the profits on a quarterly basis including seasonal swings.

How to Look for Passive Investment Opportunities

When looking for an investment opportunity in vacation rentals, here are some things to keep in mind:

Look for operators who have an established business, with a track record of success.
They ought to have properties which enjoy higher occupancy rates and higher nightly rates than superficially similar properties.
Check out the properties they have now and see what kind of reviews they get.
You are looking for operators who understand they are providing an experience for travelers.
Talk to them, make sure they are trustworthy and will provide proper reporting to you on a quarterly basis.
You should expect to be able to view the books on a property at any time. Look for an accounting of bookings and income, all expenses, bank statements, and a quarterly narrative comparing actual performance to plan with a discussion on the factors leading to variances.
Vacation Rentals in all markets are seasonal, and even local event driven.
Verify your investment is secured by an interest in the property.
Look for quarterly premiums or profit sharing, and an annual allocation of depreciation for your taxes.
Look for proper LLC Operating Agreements and Subscriptions Agreements that set out the terms clearly.

Customer Experience

Our own experience in the market over 14 years has validated our core tenets and shown up nicely in our bottom line. What you are actually selling isn't necessarily the same as the merchandise. The more successful vacation rental operators understand they aren't just providing a larger hotel room. Travelers who want to stay in a vacation rental are very much “experience” travelers. They want a place that looks great, like a magazine spread. They also want their stay to be a happy experience enhanced by the accommodations. Properties which cater to families and groups of friends need to provide awesome gathering spaces, pleasing views, and fully equipped kitchens, excellent bedding…the list goes on. And finally, the customer experience dealing with the operator is just as important. From initial inquiries, through booking, to thoughtful communications before during and after the stay, those experiences should make the guests feel listened-to and taken care of.

It is this understanding of what the customer really wants that makes the difference between extra successful operators which command higher occupancy and nightly rates and those that make up the bulk of cheaper and non-differentiated vacation rental properties. If you think investing in the hot vacation rental market is for you, now you know what to look for–the savvy operators with a superior product and a track record are looking for investors to grow their businesses faster.

Con: Tread Carefully, Every Deal is Unique

I'm not going to pretend I'm an expert in real estate, much less in the relatively small niche of vacation rental real estate. Katie and I travel a lot and have stayed in resorts, hotels, campgrounds, vacation homes through AirBNB and VRBO, cabins, and even wilderness areas. However, we have never invested in those properties and have little interest in landlording as a profession ever again. And if I don't want to landlord, I certainly don't want to run a hotel. So, all of our real estate investments are now passive by pretty much any definition of the word. In fact, we are even moving away from selecting the individual properties and notes we invest in to just hiring a professional to do that. It kind of reduces everything to a bit of a numbers game: How likely am I to get my money back, what am I likely to make on it, and how is that return going to be taxed. Beyond that, I really don't care if I'm investing in single family homes, multi-family, commercial, storage, trailer parks, vacation homes, mortgages, or hard money loans. I really don't. I just like mailbox money. But there are a few truisms about investing that I think are worth consideration when being pitched.

# 1 Stocks aren't evil

Usually when someone wants to sell you something they point out the problems with investing in the stock market:

Stocks are volatile,
A large percentage of the return comes from price appreciation
Company management can be corrupt
You have little control over how the business is run
People lost their retirement in 2008!
More Gazillionaires got that way through real estate
Whole Life Insurance provides guarantees

The list goes on and on. But after hearing this dozens of times, maybe you ought to consider why everyone compares themselves to the stock market. Maybe there is a reason it is the gold standard, especially for those looking for a passive investment return.

# 2 Some investments are more cyclical than others

When it comes to stocks, cyclical stocks are those which do well in economic booms when people have more money to spend. Just like stocks, some real estate assets are more cyclical than others. Guess which ones are the most cyclical? That's right. Vacation homes. In a down market, guess what is the first thing you cut out to save money. Hint: it's not rent and groceries.

# 3 Diversification and fees matter

Just because you move from one asset class to another doesn't mean you should forget the basic principles of investing most learn with stocks–diversification matters. It protects you from what you don't know. So if you haven't sat down face to face and eaten a meal with those who are running a company or a property, it probably should not make up a very large percentage of your portfolio. If you have no influence over how the business is run (and it's pretty hard to consider it a passive investment if you don't), then you should probably have more than one of them in your portfolio. Fees still matter. While managers can and often do provide additional value (particularly in less efficient asset classes), every dollar you pay them is still a dollar that comes out of your return.

# 4 Location, location, location

The most important factor in real estate is location. It always has been and always will be. I don't care how fancy your property is or how well run it is if it isn't close to where I want to be. Everyone else feels the same way.

# 5 Track record

While past performance is no guarantee of future performance, if you're looking for a general partner or syndicator, a nice long, strong track record should be a requirement. How long is long enough? How strong is strong enough? It depends on the alternatives, but just like you don't want to be in a teaching hospital on July 3rd, you probably don't want to be an LP in someone's first limited partnership.

Maybe vacation rentals are the hot new asset class in real estate. Maybe they aren't. I have no idea. But tread carefully and run the numbers because every deal is unique.

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What do you think? Do you own a vacation rental individually or via a syndication? Why or why not? Do you think this is a good asset class to invest in? How much higher returns do you expect over apartment buildings during good times? How much worse in bad times? Comment below!