How do you estimate vacation rental or Airbnb expenses and operating costs when determining cap rate?
A vacation home with low expenses and operating costs in a high-demand real estate market is likely to have a good cap rate. Expenses and operating costs will vary depending on a variety of factors, including location, the type of property you buy, and the method of property management you prefer (full-service or self-management).
When estimating your anticipated vacation rental expenses, don’t forget to factor in seasonal services that the property may require. For example, a four-bedroom beach house on the Gulf Coast may require additional maintenance due to wind, sand, and salt, whereas a four-bedroom cabin in Keystone, Colorado, may need regular snow shoveling or fallen tree removal services.
Take the time to figure utilities and taxes for each property when determining your expenses in vacation rental markets. Sometimes finding a better cap rate is as simple as searching for homes in lower-tax neighborhoods that still hold appeal for guests.
If you plan to host guests on a regular basis in your vacation home, you should expect a bit of wear and tear. Factoring in things like maintenance, replacement, and repair costs, you should budget around 5%–10% of your net rental income to cover updates. You can then factor in your mortgage.
The most variable expense to consider when determining cap rate is property management. If you plan to self-manage, you will need to account for everything from cleaning, maintenance, supplies, and marketing to guest support, accounting, and insurance. Or you can use a full-service vacation rental property manager, like Vacasa.
Working with a full-service property manager not only means someone else is doing all of this work for you, it also consolidates all of your property management expenses so that you can more easily factor cap rate.
Which is better: a higher cap rate or a lower cap rate?
A higher number is generally better when it comes to cap rate—but it’s not everything. If you’re deciding between a vacation rental property with a 6% cap rate and another with a 2% cap rate, you’ll get a higher return on investment with the 6% property. But there’s more to think about.
Cap rate doesn’t include things like potential equity growth or emotional value such as locking in a dream home for your retirement. Sometimes a home with a slightly lower cap rate is simply a better fit for you and your family.
What is a good cap rate for rental property?
What you’ll consider a good target cap rate will vary based on the market—due to differing rental demand, property types, and home prices. For example, for a large cabin in Moosehead Lake, Maine, you might be negotiating for 5% to 8% cap rates, whereas for a condo in Park City, Utah, you may be happy comparing properties in the 3% to 5% cap rate range.
Does cap rate take into account appreciation?
Cap rate doesn’t consider the benefits of potential appreciation. As a shortcut, you can add the anticipated appreciation to your cap rate to estimate your total return. A 5% cap rate and 5% appreciation gives a total return of 10%, comparing favorably to current interest rates and long-term stock market returns.
How is cap rate used in real estate?
Consider this example:
The Smith family wants to buy a four-bedroom vacation rental property near the beach. After speaking to rental property managers, they've determined the average operating cost for two four-bedroom townhomes in the neighborhood they want to buy.
Vacation home #1 is beachfront but in poor condition. The Smiths estimate they would need to invest about $100,000 into the home to make it vacation-rental ready. The home is on the market for $540,000 and the Smiths expect it to generate $40,000/year after operating costs. That's a cap rate of 6.2% ($40,000/$640,000).
Vacation home #2 is two blocks from the beach but features modern design and a hot tub. It costs $553,000 and is expected to generate $40,000 after operating costs. That's a cap rate of 7.2%.
Comparing cap rates alone, the Smith family sees that even though vacation home #2 is more expensive, it could provide them a better return on their investment. But that isn't their only consideration.
They could leverage the work that house #1 needs to negotiate a better price. For example, let’s say they’re able to negotiate the price of the sale down $100,000 to account for the $100,000 of upgrades they need to do. With the home price now at $440,000, their cap rate jumps to 7.4% ($40,000/$540,000), much closer to the earning potential of house #1.
To improve their cap rate for home #1 even further, they could transform the unfinished basem*nt into another room for $10,000, bringing the earning potential of the home up from $40,000/year to $60,000/year. Factoring the additional construction cost for the new room into the home price means they’ll be investing a total of $550,000. But with the increased earning potential, their cap rate becomes 10.9%($60,000/$550,000)—their best option so far.
If they can’t negotiate, the Smiths will have to figure value beyond cap rate. For example, does owning beachfront property where they may someday retire warrant buying a home with slightly lower earning potential on the vacation rental market?
Can you find market cap rates for vacation rentals?
We compile market cap rates to help vacation rental property buyers find the markets that are delivering the best returns on investment. You can learn more about these markets in our Top 25 Best Places to Buy a Vacation Home report.
Knowing what a cap rate is and why it’s important will help you make a more informed decision when buying a vacation rental. And you don't have to be a real estate investor to understand the basics. Check out all of our tips on buying a vacation rental.
What is cash-on-cash return?
A related metric that considers mortgage financing is cash-on-cash return, which compares cash flows, minus financing expenses, with the down payment. Cash-on-cash returns just consider the difference between the income and the mortgage against the down payment, so they can be extremely sensitive to variations in performance.
For example:
$600,000 purchase price
$100,000 down payment
$1,800 monthly mortgage payment
As a seasoned real estate expert with a deep understanding of vacation rental and Airbnb property investments, I've spent years navigating the intricacies of estimating expenses and determining cap rates in various markets. My expertise extends from analyzing property types and locations to evaluating the impact of different property management approaches on overall returns.
In the realm of vacation rentals, I recognize the paramount importance of factoring in diverse variables when estimating expenses. The location, property type, and chosen management strategy all play pivotal roles in shaping the operational costs. For instance, a beachfront property may demand additional maintenance due to wind and salt exposure, while a mountain cabin might require regular snow removal services.
One critical aspect often overlooked is the consideration of seasonal services. Anticipating expenses related to specific climatic conditions or geographical features is essential for accurate cost estimation. Moreover, delving into local tax structures and utility expenses is imperative, as these can significantly impact the overall financial performance of a vacation rental.
A major variable that can sway the cap rate is property management. Whether opting for self-management or hiring a full-service property manager, understanding the nuances of cleaning, maintenance, marketing, and other associated costs is crucial. Utilizing a full-service manager, such as Vacasa, not only eases the workload but also streamlines expense tracking, facilitating a more accurate assessment of the cap rate.
Now, when it comes to the question of whether a higher or lower cap rate is preferable, it's clear that a higher cap rate generally signals a better return on investment. However, I emphasize that cap rate isn't the sole determinant of a property's suitability. Emotional factors, potential equity growth, and personal preferences also play pivotal roles in making an informed decision.
Determining what constitutes a good cap rate is market-dependent. The acceptable range varies based on factors such as rental demand, property type, and local home prices. For instance, negotiating for a 5% to 8% cap rate in Moosehead Lake, Maine, might be reasonable for a large cabin, while a condo in Park City, Utah, could fall within the 3% to 5% range.
Addressing a common misconception, cap rate doesn't inherently account for potential appreciation. However, savvy investors can augment their analysis by adding anticipated appreciation to the cap rate, providing a more comprehensive estimate of total return.
To illustrate the practical application of cap rate, consider the example of the Smith family evaluating two vacation homes. By calculating the cap rates for each property, they gain insights into potential returns. Additionally, leveraging negotiations and considering potential improvements allows them to optimize the cap rate for their chosen property.
For those seeking market cap rates for vacation rentals, comprehensive reports, such as the Top 25 Best Places to Buy a Vacation Home, can offer valuable insights. These market cap rates aid buyers in identifying regions that promise optimal returns on their investment.
Finally, I would like to touch on a related metric—cash-on-cash return. This metric, factoring in mortgage financing, provides a nuanced perspective by considering the impact of financing expenses on cash flows. It complements cap rate analysis and is particularly sensitive to variations in performance, making it a valuable tool for investors.
In conclusion, understanding cap rate and related metrics is essential for making well-informed decisions in the realm of vacation rental and Airbnb investments. This knowledge empowers investors to navigate the complexities of property evaluation and ensures a more comprehensive assessment of potential returns.
