How to Analyze the Profit of a Short-Term Rental in 5 Simple Steps
Many buyers dream of owning a picture perfect short-term rental property (STR) in a scenic destination, meticulously curated with local goods, and a long list of five-star reviews from satisfied guests who can’t wait to book another stay. Beyond being a stellar host, when done right, a successful vacation rental can be a lucrative investment property capable of bringing in a steady cash flow to savvy property owners with a solid investment strategy that starts with these five simple steps.
Step #1: Determine Your Budget for a Short-Term Rental
Before we begin talking numbers and throwing around jargon like cash on cash return or the ever-alluring passive income, let’s start with step one: how do you conduct a short-term rental analysis to make sure this is the right type of property for you? According to Chris Davis, a Maine-based realtor, owner of multiple single-family homes, and host of a short-term rental himself, the first step is to determine the budget. “Find out how much cash you have available for a short-term rental property” says Davis. “Typically, you’ll have a 20% down payment on an investment property, and from there, you’ll know what else you can spend.”
Step #2: Choose a Profitable Location
Once you’ve nailed down this number, Davis recommends using a simple formula to use when analyzing a short-term rental that starts with doing market research on the local STR market to get acquainted with the area’s rental rates. “You want to know what the average nightly rates are, which you can do easily through your own research on Airbnb, or utilize another platform that aggregates this information,” says Davis. Websites like Airdna’s rentalizer, Rabbu’s free Airbnb calculator, or PriceLab’s market dashboards are great tools to help you do your own market analysis (heads up that some of these come at a cost, while others offer a snippet of information for free and require you to pay a premium price for more), however, these can really only give you an overall snapshot of the metrics as they are relative to your vacation rental property. There are a lot more variables that an online tool can’t take into consideration that you can!
The Enemy Method
Despite its menacing name, this strategy is an invaluable tool to have in your back pocket when scoping out the competition in a short-term rental market. This method is used by many other short-term rental owners and property investors to suss out the intangible factors that a database can’t tell you about how your future vacation home will perform on the local STR market. The approach is simple and requires you to take a close look at any nearby short-term rental properties via VRBO, Airbnb, and local property management companies in comparison to yours. It might sound tedious, but as Davis says about building wealth through a successful short-term rental investment “everything is a measure of time and effort”. Putting in the time to analyze the market through multiple platforms and from many different angles — including that of a renter — allows you to make the best investment decisions for a high-performing rental business with a steady cash flow down the line.
Step #3: Calculate Your Expenses (All of Them!)
After you’ve established the average nightly rate (a term that’s interchangeable with “average daily rate” also known as ADR), calculate the approximate costs of your expenses, which Davis advises doing a deep dive into. “You will have cleaning fees, booking fees to the platform you advertise on like Airbnb or VRBO, insurance, utility costs and property taxes,” says Davis. “You’ll also need to have a renovation budget because your bed sheets are only going to last for six months if you have people in there every weekend. You’re going to need to budget for the soaps, the pillows, the trash bags, the comforters,” advises Davis. “You’re probably changing your floors every two years because of the impact renting has on a house.” In short, it’s best not to underestimate the potential expenses and give yourself a wide margin to keep your short-term rental in great shape.
Step #4: Estimate the Average Occupancy Rate
The biggest difference in rental income between long-term rentals and short-term rentals is that STRs won’t be booked every day of the month, so the average occupancy rate will vary. It depends largely on the location which can include things like seasonality, and whether or not you plan to use it yourself and make it unavailable to renters. For those reasons, the average occupancy rate will be unique to you and how you plan to rent out the property, but it’s still a key player in analyzing what kind of return of investment you’ll get on your rental. To calculate that, simply subtract the amount of days you plan to rent it out from the total number of days in each month to get the average occupancy rate.
Step #5: Calculate Your Short-Term Rental Profit
To estimate your monthly income, multiply the average daily rate by the occupancy rate and the number of days in the month. This simple math will give you a good idea of how much revenue you could potentially make each month off a short-term rental property.
To find out the potential cash on cash return (your annual property income before tax), Davis shares a simple formula. “Take the estimated yearly rent, subtract your estimated yearly expenses, and you’ll get a number,” says Davis. “You’re gonna take that number and divide it by your investment in the property.” That number will paint a picture of how profitable this vacation rental could be, with the understanding that it takes some time (about a year or more!) to get a good return on investment and establish a steady cash flow.
So, what is a good return on investment? If you’re a hobbyist host and not a group of professional real estate investors, is something as small as 5% a good return on investment? “If it’s your first year, that’s great, you’re profitable,” says Davis. “Use what you learn in year one to try to get above 10% return on investment and even more so in year three to maximize profit on a short-term rental.” Ultimately, the goal is to keep scaling your rental business and make improvements as you go to solidify a business model. “People’s lives are being accounted for while they’re under your roof,” says Davis. It can’t be a set-it-and-forget-it; it takes a lot of attention and focus and care to get there.”