How to Evaluate Vacation Rental Potential Before Buying

Airbnb has become an increasingly popular strategy, but to make money with it, you need to know how to evaluate vacation rental potential. Online platforms like Airbnb, Vrbo, Booking.com, and Expedia have made booking short term rentals simple enough to motivate travelers to choose them over hotels.

From an investor’s point of view, this translates into a profitable real estate business opportunity that was not available a few short years ago. But just like investing in long term rentals, this strategy has to be applied after careful evaluation.

Table of Contents

1. Are Vacation Rentals a Smart Investment?
2. The Advantages and Disadvantages of Owning a Vacation Rental
3. How to Estimate Vacation Rental Potential

A major indicator of the resilience of the short term rental industry is how quickly it recovered after the initial shock of the Coronavirus pandemic. At first, the vacation rental market took a serious hit amid closures and restrictions. However, as soon as the first limitations were lifted, the industry was back on its growth trajectory.

Revenue in the US is expected to increase from $19.39 billion in 2023 to $20.57 billion in 2027. For comparison, the value was $16.58 billion in 2017. Despite the potential in this market, buying just any property and listing it for rent does not guarantee success.

Real estate investors need to conduct careful analysis and valuation of the potential of a vacation rental before purchasing it. It includes both the market and the property itself. In the rest of this article, we’ll show you how to do that and how Mashvisor can help you along.

Are Vacation Rentals a Smart Investment?

Before getting into how to evaluate vacation rental property, it’s important to discuss if this investment strategy is worth it at all. The fact that US Airbnb hosts are expected to make a total of $20.57 billion in 2027 doesn’t tell us much about the profitability of individual properties and investors.

We’ve resorted to Mashvisor nationwide Airbnb data from 28 June 2023 to answer this question. We’ve focused on US cities with median property prices below the $1,000,000 benchmark (for affordability) and with 100+ listings on Airbnb (for major markets).

Our analysis shows that the average rental income across the 1,300+ locations that fit these criteria is $2,958. This results in an average ROI of 3.08% for cash on cash return and 3.11% for cap rate. These numbers make it look like short term rentals are not a very good investment as usually a cap rate of 8-12% is recommended, while a good cash on cash return is 10%+.

But the truth of the matter is that these are just averages, so it is normal for them to be relatively low. After all, not all vacation rentals in the US market are strategically placed and carefully chosen. Indeed, many individual hosts can generate thousands of dollars in double-digit returns and monthly rental income. To do that, you need to know how to analyze a property and how to price your vacation rental, which we’ll cover here.

The Advantages and Disadvantages of Owning a Vacation Rental

Like any other investment strategy, vacation rental homes come with their own pros and cons. What are they? And are the pros or the cons more significant? Let’s take a look.

Advantages of Investing in Vacation Rental Properties

Before we jump into how to estimate vacation rental income and other important variables, let’s consider the main benefits of owning a vacation rental investment:

• Extra income: According to Mashvisor data, Airbnb hosts make about $2,958 per month. Income can vary greatly depending on the quality of your rental, how often you rent it out, its location, and your services. Nevertheless, short term rentals generally offer robust revenue opportunities.
• Tax deductions: Owning a vacation rental home means that you can deduct many of the costs you incur while running your Airbnb business. Some expenses you can write off include cleaning costs, taxes, utilities, supplies, insurance premiums, and mortgage rates. If you’re working with vacation rental management companies, you must also factor in their fees.
• Appreciation: Real estate assets always increase in value over time. You are basically guaranteed to make a profit when you decide to sell your investment property. In this way, your rental property also acts as your hedge against inflation.
• Free holiday spot: Besides renting it out and making money, you can enjoy free accommodation whenever you want to take a vacation by yourself or with friends and family. For this reason, buying a vacation rental in an area you enjoy and can easily get to is advisable. But you shouldn’t ignore the investment analysis either.
• A nest egg for retirement: A vacation rental can be a great source of passive income during retirement. You could even choose to sell it and use the cash for your costs of healthcare, travel, and more. Alternatively, if it’s in a warm area with favorable climate, you can move there and sell your primary residence once you are no longer bound by work and family obligations.

Disadvantages of Buying a Vacation Rental Home

Amid these important benefits, there are also some drawbacks that you need to consider, including:

• Startup costs: Starting a vacation rental business requires more money than becoming a landlord. In addition to buying a property, you have to get certain licenses, furnish the rental, and market it actively. But this is compensated for by the strong ROI potential.
• Active management: Being an Airbnb host is different from being a landlord. Many daily tasks can take all your time and energy when renting out to short term guests. However, this problem can be solved by hiring a professional property manager.
• Legal regulations and restrictions: Many US cities have strict Airbnb laws prohibiting or at least limiting vacation rental activities. Nevertheless, there are still hundreds of markets where this strategy is feasible and profitable. It’s a matter of evaluating the situation before investing.

As you can see, the pros of owning a vacation rental outweigh the cons significantly.

How to Estimate Vacation Rental Potential

Now that we know that buying a short term rental can be a great investment strategy, it’s time to look at how to value vacation rentals to make smart and profitable decisions. The valuation of a vacation rental has two parts: 1) Analyzing the market and 2) Analyzing the property itself.

How to Evaluate the Potential of a Market

Location is one of the main factors in analyzing and evaluating an Airbnb property. All factors that affect the performance of a short term rental are impacted by its location in one way or another. Here are the main indicators to keep an eye on when checking the feasibility of a city for vacation rental investments:

Affordability

Some real estate markets are more expensive than others because of higher housing or investment demand and higher costs of living. Meanwhile, prices directly affect profitability in real estate investing. Moreover, depending on their budget, they determine whether a vacation rental market is affordable for an investor or not.

So, when evaluating a potential market, it’s important to look at the median property price level. It will help you answer the question, “Can I afford a vacation home in this market?” It will also help you decide how to price vacation rental properties compared to the general real estate price level.

Visitor Attractions

Another factor to look at in your vacation rental market potential evaluation is the city itself. How many people visit it per year? What do they come to see? What are the main attraction points, and where are they located? Are these mostly business centers or tourist places? Is there a peak season and a low season?

The answers to these questions will allow you to estimate how many and what kind of guests you can expect to stay at your rental. If only a few thousand people visit a place per year, then it’s probably not worth owning a vacation rental there. If the city brings in millions of tourists, it could be one of the best short term rental markets.

Airbnb Daily Rates

The location of an investment property also dictates the rental rates. In the case of short term rentals, that’s the average daily rate. It is affected by the demand for vacation rentals, the supply, and the general standard of living in the city. In turn, it impacts the rental income and the return on investment.

So, when evaluating a market, check out what existing hosts charge and estimate if this will be enough to make the initial investment worth it.

Airbnb Occupancy Rate

Another major vacation rental data point determined by the market is the occupancy rate. Ideally, investors need to look for a city that attracts a lot of visitors year-round but is not oversaturated with Airbnb properties. Doing this will lead to higher occupancy rates in the future.

Taxes and Fees

Vacation rentals face various property, business, and hotel taxes in different markets. Moreover, there are many fees related to starting a business, registering with local authorities, getting a license, etc. All these vary by location and impact cash flow and profitability majorly. So, part of your rental market analysis should focus on these.

Vacation Rental Management Costs

Other Airbnb expenses to take into consideration are the costs associated with managing your property and renting it out. It can be the money you need to operate your Airbnb business on your own or the fees paid to professional managers. The size depends on the prevailing rates in a market.

How to Find a Good Vacation Rental Market

Now the question is, how do you find a suitable market for short term rentals? With the help of Mashvisor. The Mashvisor real estate investing platform has a number of tools that help investors locate the best places for this strategy.

First of all, investors can refer to the Mashvisor real estate blog, in particular the Top Locations section, to find the most profitable vacation rental markets. Whether you want to focus on income, occupancy, cash on cash return, or cap rate, you’ll see up-to-date rankings using our proprietary data.

Second, investors can use the Mashvisor Market Finder to search for the top areas for short term rentals in line with their own criteria. You can use several filters to narrow down your search based on your budget, expected revenue, occupancy, and cap rate.

Third, the Mashvisor neighborhood analysis pages provide all the data you need to decide whether a certain area makes sense for investing or not. You can know the average occupancy rate, cash on cash return, and the best property types for Airbnb.

To start evaluating vacation rental market potential, sign up for a 7-day free trial of Mashvisor.

How to Evaluate the Potential of a Vacation Rental Property

The second part of the evaluation that goes into knowing how to own a vacation rental with strong potential is analyzing the property itself. Here are the most important numbers that will help you estimate a short term rental potential:

Occupancy Rate

Merely listing your vacation home on Airbnb does not guarantee you will generate profits. To make money from your vacation rental property, you need to get bookings and maintain a good occupancy rate. Doing this is important to measure the vacation rental occupancy rate before buying. The formula for the Airbnb occupancy rate is as follows:

Airbnb Occupancy Rate = Number of Booked Nights/Number of Total Available Nights x 100%

While most beginner investors have heard about the occupancy rate, they are not really sure what is a good value. There is no golden number for this metric, but generally speaking, a profitable rental should have more than 50% occupancy.

Average Daily Rate

How to price your vacation rental for booking is at the core of making money with this strategy. Experienced hosts know you have to apply dynamic pricing to boost your income. If your daily rate is too high on a particular day, guests will prefer other rentals. If your rate is too low, they will book with you, but you’ll be leaving money on the table.

Although nightly rates change all the time, it’s important to evaluate the average daily rate of a property before investing in it. Together with the occupancy, the average daily rate determines the revenue a host generates from their property.

Rental Income

The monthly or annual rental income is the money an investor gets from their guests over a month or a year. It is the product of the average daily rate and the number of days the rental was booked. This value is very important when analyzing a vacation rental potential as it shows you how much money you will have at your disposal in order to cover all operating expenses and then pocket the difference.

The rental income calculation means that to optimize this value, you have to hit the right balance between daily rates and occupancy. If one of these is optimized at the expense of the other, the rental income will suffer.

Cash Flow

Cash flow is another popular metric for evaluating the potential of a vacation rental. Here is the formula for calculating cash flow:

Cash Flow = Rental Income – Rental Expenses

The rental income is the amount of money an Airbnb host generates per month (or year). It is calculated based on the average daily and Airbnb occupancy rates. Expenses, on the other hand,  include things like property tax, mortgage payments, property insurance, HOA fees, rental income tax, property management fees, utilities, and cleaning fees.

Positive cash flow happens when rental income is higher than rental property expenses. When the opposite occurs, it is referred to as a negative cash flow property that no real estate investor ever wants. As a smart investor, you need to make sure that you will be able to have positive cash flow right away. Otherwise, you’ll be simply losing money.

Cap Rate

The capitalization rate, or cap rate for short, shows how much income the rental property generates compared to its value. The cap rate formula is easy and straightforward:

Cap Rate = Annual Net Operating Income (NOI)/Vacation Rental Price x 100%

The net operating income is the difference between the gross rental income and the operating expenses (cleaning, management, maintenance costs, etc.). Most real estate experts are in consensus that a good cap rate for vacation rental properties should range between 8% and 12%.

The reason for the upper limit is that the cap rate also measures the risk of investing in a particular property. And naturally, the risk should not be too high for an investment to be good.

Cash on Cash Return

The cash on cash return measures the percentage of profit you can anticipate based on the actual out-of-pocket money you’ve invested when buying a vacation rental property. Here is the cash on cash return formula:

Cash on Cash Return = Annual Pre-Tax Cash Flow/Total Cash Invested x 100%

Understanding the pre-tax cash flow is straightforward. What’s important is to note that the denominator has the invested cash amount, not the property price. It includes the down payment, closing costs, repairs, furnishing, etc.

So, how you finance the purchase of your income property affects its cash on cash return, while it doesn’t impact the cap rate. Vacation rental analysis requires a lot of numbers and metrics, which makes one wonder:

How to Find a Good Vacation Rental Investment Property

Once again – with the Mashvisor tools. The Mashvisor Property Finder is an AI-based real estate tool that allows investors to look for top-performing vacation rentals for sale in any US city. All you need to do is to enter your market, budget, and preferred property type. Then, you’ll get a list of available listings for sale that meet your requirements and promise to bring good ROI when rented out on a short term basis.

Next, you can use the Mashvisor vacation rental calculator to evaluate the potential of the properties that you like. This tool provides in-depth rental property analysis, including all data and information an investor needs before buying a property.

All the measures and values that we discussed above are incorporated.

The metrics for determining the potential of a vacation rental provided by the Mashvisor rental property calculator comprise:

• Rental income
• Rental expenses
• Cash flow
• Cap rate
• Cash on cash return
• Occupancy rate

Another great thing about this tool is that it not only estimates the valuation of a short term rental property. It also works with long term rentals. So, if you ever decide to convert your Airbnb into a long term rental, you can use the same calculator to conduct all the necessary analysis.

Boosting Your Vacation Rental Valuation Strategy: Final Words

Investing in a vacation rental property can be a lucrative real estate business. However, before buying a property, it is important to analyze the market and the listing to estimate its expected performance. After reading this article, you should know the steps and metrics that go into evaluating a vacation rental potential.

Conducting vacation rental market and property analysis manually can be a very time-consuming and frustrating process. The good news is that you can use the Mashvisor tools to assess the potential of any location and property. The platform will provide you with a detailed report containing all the vital metrics that will help you evaluate the profitability of any deal.

To learn more about how the Mashvisor vacation rental calculator can boost your results, sign up for a 7-day free trial now, followed by 15% off for life.