Opening the Door to Short-Term Rental Investing

6 min read

Anthony Connell of Matthews on how, despite a number of challenges, this segment of the market is growing quickly.

Anthony Connell

Short-term rentals are one of the fastest-growing commercial real estate sectors, valued at $1.8 trillion. As investors look for more stable and secure assets after the global pandemic, short-term rentals offer significant upsides. This is particularly true in high-demand tourism markets like Southern California and other coastal regions. Now, some of the biggest names in commercial real estate, are chasing the alternative asset to increase cash flow and diversify their portfolio, turning short-term rentals into long-term investments.

READ ALSO: Short-Term Rental Survivors Positioned for Expansion

Introducing Short-Term Rentals

A short-term rental is a furnished property that is available for patrons to rent for a limited amount of time, oftentimes used as vacation rentals. The niche asset class rose in popularity with the inception of Airbnb, a world-wide STR facilitator that reported $1.5B in revenue in Q4 2021. Airbnb catapulted short-term rentals into the real estate spotlight, offering high daily rents and low operating fees. The sector grew wildly popular after the onset of COVID-19, as employees started working remotely and travelers began visiting destinations for longer periods.

As local and private investors entered the market to take advantage of home-sharing services, institutional investors took notice of the perks. Short-term rentals can be scaled and expanded to create diverse portfolios with higher-than-average yields. Depending on the market, an STR property can generate up to three times the amount of monthly rent. The asset class allows for turnkey property management, producing a higher profit margin and incentivizing investors to buy large STR portfolios over a single multifamily building.

The market is facing its fair share of challenges. Regulations are slow due to the sector’s infancy. Many local governments are feeling the pressure from citizens to limit the number of STRs a city or neighborhood can have, as citizens hope to keep their neighborhoods free of never-ending droves of tourists. Many politicians and activists are also pointing out that STRs are contributing to the housing shortage, as home buyers are being priced out of the market due to out-of-state investors buying up inventory to rent out. In turn, increased housing prices are hindering cities’ goals to improve their affordable housing supply, pitting operators, cities and community leaders against each other.

Despite these challenges, the short-term rental sector is here to stay. While regulations may sound worrisome, they are also indicative of a maturing market. STRs provide significant benefits to local economies, as cities reap additional tax revenue and local businesses and restaurants benefit from increased tourist spending. Therefore, it is vital that cities incorporate a balanced approach to address community concerns while adapting to meet the shifting accommodation demands of its visitors.

Producing Profitability

Property prices for long-term rentals are experiencing high inflation, due to low interest rates, which has crowded the purchasing and borrowing space for multifamily investors. Despite the recent rise in rates, this challenge has caused cap rates to compress, specifically in high-demand regions like Southern California. Short-term rentals are a viable solution for formulating a strong multifamily deal in a compressed cap rate environment, as they offer increased yields.

Newport Beach, a high-priced coastal market and popular tourist destination attracting over 7 million people annually, is a great example of this benefit. The average market rent for a one-bedroom apartment in Newport Beach is $3,000 per month, but a short-term rental market average daily rate is $275 per night at 80 percent occupancy, totaling $6,600 per month. Considering typical cap rates in this high-price market hover below 3 percent for traditional multifamily, positioning an asset as a short-term rental can in many circumstances double an owner’s return and make deals pencil that otherwise would not.

Where to Invest in STRs

Lodify, an STR software company, reported the cities with the best cap rates in the U.S. Although high cap rates can produce high yields, it’s important to remember high cap rates equals higher risk. Experts suggest investing in properties with a cap rate between 4 percent and 6 percent.

Private and Institutional Interest

Institutional investing is still new to the short-term rental space, but as institutions look to diversify their portfolios with pandemic-resistant assets in business-friendly states, short-term rentals will continue to grow in popularity.

Several prominent players have partnered with rental property management companies or short-term rental developers to enter the expanding market. As inflation continues to rise, short-term rentals are expected to thrive as more consumers are priced out of the home buying process and look to STRs as the solution. Private equity firms and institutional investors have shown their interest in the sector over the last few quarters by investing in stocks of rental property companies. Skift reported Level Equity and TPG Capital have notable holdings in Vacasa, a branded vacation rental property manager.

Along with increased opportunities, short-term rentals come with their own set of investment challenges. Institutional buyers are investing in STRs due to their pandemic-resistant nature, but some properties are less resilient than others. High-quality rentals perform the best, but are hard to come by, as many luxury homeowners do not want to dispose of their property. Premium properties may have more security in a cyclical downturn.

Investing in short-term rentals also requires capital firms to enter the property management market, a rare occurrence when investing in traditional multifamily units. Short-term rentals run the risk of funds dissolving at a faster rate than long-term rentals. Funds for STRs tend to last for a decade, which may not be enough time to benefit from the long-term management fees and property appreciation. Investors also face the ever-evolving obstacles of local government restrictions and community pushback. It’s likely that as short-term rentals continue their rapid growth, more policies will be put in place to protect community members and restrict market pricing.

Will STR Replace Multifamily?

The elevated interest in short-term rentals has yet to replace traditional multifamily investing. Short-term rentals provide renters with more flexibility since the leases are much shorter than the typical 12-to-18-month lease periods apartments provide. The benefit of shorter leases for landlords is that they can capitalize on increased market rent and adjust their pricing more frequently. The downside for landlords is the risk of high turnover and vacancy. Long-term multifamily investments provide a stable, profitable income and are often financed much more easily than short-term rentals. The STR market is fresh and will take time to provide the reliability and security traditional multifamily offers. Large institutional and private investors aren’t pulling capital from multifamily investing, they are adding STR to an already established portfolio.

Overall, short-term rentals offer opportunity, profitability and security for investors. The unique asset class offers higher cash flow at relatively affordable pricing in growing markets throughout the U.S. Although new to the sector, institutional investors are predicted to increase their funding and activity in the short-term rental environment, cultivating new developments and capital.

Anthony Connell is a premier client adviser for Matthews Real Estate Investment Services.

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