When buying a vacation home rental, you are buying yourself and your family leisure and indulgence, while receiving paychecks for renting it. The costs may be daunting to own a primary home and an additional vacation home. However, if planned right, the revenue generated from renting your vacation home rental will offset a lot of the costs.
Sure, renting your vacation home might sound like such a good idea. The vacation rentals market today, if you are wondering, is booming at a fast pace. Vacation home rentals are being rented more than ever in the United States today.
Renters come from the United States and from all over the world. Particularly, after the Brexit, many have resorted to the United States for their vacation getaway.
How would you assess the profitability of a vacation home rental? You can do so using many metrics such as cap rate, cash on cash return, and return on investment (ROI). Today we will divert our focus to explain the most commonly used metric, ROI. What is ROI? What is a good ROI? How do I measure it?
Related: What Is a Good ROI for Investing in Income Properties?
What Is ROI?
Before we determine what is a good ROI for your vacation home rental, let’s first explain what an ROI is. It is important that you know the term very well and understand the variables that this rate takes into account which include rental income, property price, and all expenses associated with the investment property.
ROI is a financial metric used to assess the returns on any investment. Typically, real estate investors use this metric more often as compared to other metrics so as to evaluate the profitability of a real estate investment property. The ROI measures the average annual rental income an investment property generates and expresses it as a percentage of purchase costs.
Related: Become an Expert on Real Estate Investing: What Is a Good ROI for Rental Property?
The formula for ROI is:
(Annual Rental Income – Expenses and Costs) / Property Price
Let’s explain the aforementioned variables and how to inclusively cover them in your assessment.
Annual Rental Income: This is simply the gross rental income an investment property generates in a year. You can find your annual rental income by multiplying the monthly rental income by 12 or weekly rental income by 52.
Expenses and Costs: Such include recurring and non-recurring costs associated with the investment property. Common costs include property taxes, insurance, repair costs, and utility costs.
Now that you have learned of the term return on investment, you would want to know what is a good ROI. Well, before we talk about what is a good ROI, let’s put this metric into practice.
Let’s take an example.
Using Cash Only
Let’s assume you are financially comfortable to pay for your investment property fully in cash. You pay $275,000 for it and generate an annual income of $45,300. Your annual expenses, which include taxes, insurance, and repair costs, add up to $2,000. What would your ROI be?
So Annual Income of $45,000 – Expenses of $2,000 would be $43,000. Divide $43,000 by the property price to get .156 or 15.6%.
Now, going back to the question “What is a good ROI?” To determine if an ROI is good enough, you ought to compare it to other investments that you otherwise could have channeled your funds into and assess their profitability in accordance. So, for the cash that you have invested ($275,000), would an ROI of 15.6% make a profitable investment if you were to invest in another vehicle? Would it generate you the same ROI or higher? Keep this question in mind when assessing an investment property.
You can also use Mashvisor’s ROI calculator to do the calculations for you. As you use Mashvisor’s calculator, you eliminate any errors made in your calculation. To start out your 7-day free trial with Mashvisor, click here.
Using a Mortgage
Now let’s take another example. Let’s assume that you will be using a mortgage as your investment property financing for the rental property. To purchase an investment property, you have decided to take out a mortgage that requires you to pay a 20% down payment.
Here, assessing the ROI on such an investment is slightly different than if you were to pay fully in cash. In this scenario, we will be using the cash on cash return, a similar formula to the ROI. Why? Because the cash on cash return formula uses the annual cash flow instead of the difference between gross income and expenses, as it also takes into account mortgage payments.
Related: What Return on Investment Property Should You Expect in the US Real Estate Market?
Let’s say you are buying the same property from the example above but you are now using a mortgage to purchase it. You are paying 20% in down payment for a total of $55,000. You incur on average $2,000 expenses per year. Your annual mortgage payments add up to $13,332.
So your annual cash flow would be = annual rental income of $45,300 – expenses of $2,000 – annual mortgage payments of $13,332 = $29,968.
Take the annual cash flow of $29,968 and divide it by the total cash investment of $64,625 (down payment of $55,000 + closing fees of $9,625) to get 46.3%.
This is still a very strong indicator. Remember to compare this number to other investments within the same class so as to efficiently assess and evaluate the profitability of such an investment.
It is important to note that the ROI differs from one class of investment to another. While using a mortgage, the ROI could be higher or lower, but remember to always make such an assessment in regard to other comparable investments.
What Is a Good ROI for Your Vacation Home Rental?
Now let’s go back to your vacation home rental. What is a good ROI for your vacation home rental? To derive the highest return on investment for your vacation home rental property, there are factors that you should consider. Below we explain them:
- Obtain the Right Financing: Loans to buy vacation home rentals have been more available as the short-term rentals market has grown. We recommend that you seek out more than one lender. Inquire about mortgage rates, payment terms, any grace period if offered, and other benefits. Get their rates, compare them, and select a lender that will assure you generate a positive cash flow.
- Choose an Ideal Location: Location is the secret to a high return on investment. Scan the market and select an investment property in a location where tourists are always coming in. Be wary of neighboring attractions and amenities as they will add value to your vacation home rental.
- Get your Legal Papers in Order: Since many argue that the vacation home rental market burdens the hotel industry. Many regulations have been put in order to regulate the market further. Contact your local city council to inquire about the legality of renting your vacation home rental.
- Dealing with Vacancies: Occupancy rates for vacation home rentals can greatly influence the return on investment for your investment property. You should always aim for a high occupancy rate for your vacation home rental. To help reduce vacancies, keep your vacation home rental occupied during high season, with as little downtime as possible. To do so, you want to be on top of your management game. If you are finding it difficult to manage your vacation home rental, then resort to property management companies.
A good ROI for your vacation home rental depends on various factors of which the most important are explained above. In order to get a high ROI, you must carefully assess your investment, costs that may accompany it, legal issues, and of course financing.
A good business takes plenty of planning and when you do it right, you are set for growth. We hope to have answered your question, “What is a good ROI for vacation home rentals.” To learn more about the vacation home rentals market, visit Mashvisor.