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There are a ton of benefits to buying a vacation rental property. Still, many owners will view their rental as a passive income source first and foremost. In real estate, we call this an investment property.
Investment properties can earn you a considerable amount of money and be part of a robust investment portfolio. For this to work, though, you’ll need to conduct a lot of due diligence research on your end. In this article, we’ll look at a few things to keep in mind when viewing your rental as an investment property.
Demand For Nearby Destinations And Minimizing Operating Costs
Let’s start with the basics. To earn money from your vacation rental property, many visitors need to be interested in nearby destinations. You’ll want to choose a property with easy access to these can’t-miss stops. Your rental also needs amenities that make sense for this particular group of travelers. For example, tourists looking for a beach getaway in Destin, Florida, will appreciate a pool or hot tub for extra fun in the sun.
Maximize your investment by looking for areas where there’s a discrepancy between operating costs and demand for rentals. For example, while Castroville, California, may not be on your travel bucket list, it’ll make a lot more sense for a vacation rental than nearby San Francisco. The “Artichoke Center of the World,” Castroville was recently named one of America’s up-and-coming rental markets by AirDNA. Meanwhile, San Francisco has some of the most expensive real estate in the country and very strict laws on renting out a property, another important factor.
Most destinations will have a high and low season for travel. As a rental owner looking to turn your property into a passive income source, the low season can cut into your bottom line.
Before investing in a rental, use resources like AllTheRooms and AirDNA to understand how long (and severe) low season is in the area. Some destinations rely heavily on seasonal attractions, like the ski resorts of Angel Fire, New Mexico. Unless you have a plan in place to maximize income during a handful of months and minimize costs for the rest of the year, these may be areas to avoid.
Calculating Cap Rate
Cap rate gives you a ballpark figure of how much return on investment you can expect each year from your property. Here’s AirDNA’s formula for cap rate, although there are other examples:
Net operating income ÷ Property asset value × 100 = Cap rate.
Anything between 8% and 12% is a solid cap rate, according to AirDNA. Still, many factors can impact your rate. Learn more about these variables in our article on the acquisition phase.
Hosting travelers isn’t the only way to turn your rental into an investment property. When the time comes to sell, your rental’s increased value, also known as “appreciation,” can lead to a big payday.
There are two types of appreciation: natural and forced. Natural appreciation is the market-driven increase over time of your property’s value. This could be because of a supply shortage, a new attraction heightening interest (ex: the opening of a theme park), or inflation.
Natural appreciation is mostly out of your control. However, there are a few things you can do during your due diligence period to put yourself in a good position. Look for strong signals that your property will be in demand for the foreseeable future. That includes nearby recreation options and tourist destinations. If you want to pitch this property as a primary residence to some buyers, you can also be on the lookout for an area with good schools.
Forced appreciation is when you add something that increases the market’s valuation of your property. You’ll have more control over this than natural appreciation.
For example, adding amenities that benefit your visitors will also boost the value of your property. So if you add that pool or hot tub to your Florida property, that will cause forced appreciation.
You can also increase the value of your property by adding new rooms or expanding the current spaces. A new bedroom or a larger living space will cause forced appreciation. Plus, while you still own the property, this extra elbow room will entice more guests (such as large families) to stay at your rental.