Short-Term Rental Financing: Q&A with Host Financial
Like many businesses, Host Financial started as a solution to a growing problem. Many owners and investors were jumping into the short-term vacation rental market, taking advantage of the growing segment of travelers who utilize platforms like Airbnb and VRBO.com. Founders Adam and Daniel saw that the demand was there, the properties were available, but main-stream financing had not really jumped on board, making it hard to obtain a loan for these kinds of investment properties. This is the space where Host Financial was born.
Why should someone invest in short-term rentals?
Investing in short-term rentals has one of the best risk-adjusted returns for similar investment options; while long-term rentals may, arguably, be less of a headache, the upsides and benefits of short-term rentals outweigh those of long-term rentals.
When it comes to cash-flow, short-term rentals typically have anywhere from twenty-to-forty percent higher cash-flows then their long-term rental counterparts, with top-performing properties– and the companies that manage them– easily two-to-three times those numbers.
"Risk can be significantly mitigated by working with short-term rental and hospitality experts, as well as highly-competent property management operators."
Another benefit is responsive pricing flexibility. With short-term rentals comes the ability to dynamically adjust pricing based on changes in the market. From our perspective, this is one of the biggest opportunities– as well as one of the least-understood risks– with this asset class. Risk can be significantly mitigated by working with short-term rental and hospitality experts, as well as highly-competent property management operators.
Short-term rentals allow an investor to quickly adjust pricing to take advantage of the rapid shift of supply and demand in their market to generate more revenue. With long-term rentals, you have a tenant typically for one year– at a fixed price–, and are unable to increase the rent until lease renewal.
Additionally, depending on the specific property and its market, you have the option to pivot to a long-term or medium-term tenant. The converse is not true for a traditional long-term rental property, as you are committed to your tenant who is likely signed on to a one- or two-year lease.
"Short-term rentals allow an investor to quickly adjust pricing to take advantage of the rapid shift of supply and demand in their market to generate more revenue. With long-term rentals, you have a tenant typically for one year– at a fixed price–, and are unable to increase the rent until lease renewal."
What are the financing options for someone looking to purchase a short-term rental?
There are a number of different options for investors looking to financing their short term rental properties:
Private loan: A loan from any private source, such as a private investor, family, or friends.
Hard money loan: Similar to a private loan– usually a company that is loaning their own balance sheet capital which allows them to be more flexible in their underwriting and approval guidelines. However, this type of loan typically has some of the highest interest rates in the market, and generally has a term of 1-3 years.
Conventional bank loan: The same as a mortgage for your primary home, but for a second or third property. These are typically underwritten based on your personal debt to income ratio (determined by your W2s and/or tax returns). This type of loan can have some of the lowest rates in the market, but they require the investor’s income to be high enough to support the new mortgage payments, positioning them as not always the best option when trying to scale a portfolio of multiple properties.
Commercial rental-specific loan: Also commonly referred to as a Debt Service Coverage Ratio, or DSCR loan, this type of loan is underwritten based on the actual or projected income of the property. These loans are great for scalability since there is really no cap on the number of loans a borrower can secure (so long as the property cash flow is meeting the mortgage payments of the loan).
"A savvy investor always makes sure he or she has enough cash reserves to furnish the property and cover the mortgage for at least 6 months while the property ramps up in bookings."
What’s the most common mistake you see people make when it comes to investing in real estate?
One of the most common mistakes investors make is not having enough in cash reserves to cover furnishing and the cost of ownership (mortgage payment and expenses) within the first 6 months. An investor should never underestimate the timeline and cost to get their property rent ready. Specifically when it comes to short-term rentals, investors sometimes make the mistake of factoring in only the down-payment and closing costs of a new property. A savvy investor always makes sure he or she has enough cash reserves to furnish the property and cover the mortgage for at least 6 months while the property ramps up in bookings.
Does the current macro-environment change how you think about investing in vacation properties?
Absolutely. With aggressive rate hikes, inflation running rampant, layoffs– there is a lot to consider:
Increased Interest Rates: Per design, increased mortgage rates are intended to slow down home purchases to balance out the supply-and-demand. As a result, home values will see a compression moving forward. It’s less of an ‘if’– and more of a how much, and for how long. Home value compression will be regional, making research important when it comes to gauging how ‘recession-proof’ the market is in which you’re considering investing. With that said, make sure to not be over-leveraged. You may be able to qualify for a low down payment loan, but what happens should the home lose 20% of value over the next 6 months to a year, and you’re struggling to make payments? In a worst-case scenario, the home is worth less than the loan you owe on the home, and you now have to sell at a loss that you have to make up out of pocket or foreclose. Again, 5% down payment loans are great in a bull market; in today’s market, I’d consider a 20% to 30% down payment.
"Home value compression will be regional, making research important when it comes to gauging how ‘recession-proof’ the market is in which you’re considering investing."
Inflation: As of writing this, the most recent CPI (consumer price index), published on October 13th, 2022, reflected an 8.3%. As defined by The Bureau of Labor Statistics, CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The higher the CPI, the more a consumer's discretionary income is eroded, meaning the less likely they are to spend hard-earned dollars on luxuries– such as travel– than on the everyday basic necessities.
What key metrics would you advise people to consider when looking for an investment property?
This is probably a little biased, but we think the debt-service coverage ratio of a property is a very important data point to consider. The DSCR ratio is basically the gross income of the property divided by the mortgage expenses (principal and interest) and the major property expenses (taxes, insurance and HOA fees, if there are any). That is how DSCR loans are underwritten, approved, and able to give you an idea of how much your cash flow is above your major fixed-expense of a property. Obviously there are other variable expenses that need to be considered– such as repair/maintenance reserves, potential property management fees, and more–, but making sure you have a strong debt-service coverage ratio means you’re likely in a good position for those other factors as well.
For example, if we see a property with a 1.50 or 1.75x DSCR, that means the property is grossing 50% to 75% above the cost of the major property expenses. Even if you are conservative on the other factors mentioned above, it still is likely a very profitable property/investment.
What’s a dream market where you’d personally love to own a vacation home?
[Adam]: I’ve always been very interested in the coastal and inland Carolinas. Something about Charleston has an appeal to mean even though I’ve never been there myself. I also love anything in a ski town market, as long as that market also has a strong summer draw, such as Tahoe, Breckinridge, Big Sky, etc. Some other big up-and-comers are the southern mountain and coast markets like Blue Ridge, GA and Gulf Shore, AL.
"For me, it’s never where I’d personally like to vacation; I invest where the numbers make the most sense for me."
[Daniel]: For me, it’s never where I’d personally like to vacation; I invest where the numbers make the most sense for me. Think about it this way: I can purchase a vacation home in a destination I like to vacation without consideration to the numbers, but then it becomes an emotional purchase in which I may be sacrificing cashflow. If I focus on the cashflow with my STR investments, then I can afford to vacation in any market I want. I can use the cashflow to vacation with my family in Tahoe one Thanksgiving and then in Costa Rica the next. However, if none of that mattered, I’d personally love to own a vacation home in Tahoe to bring the family together in the winter and another overseas somewhere by the beach that offers relaxation and exploration such as Bacalar, Mexico or Tamarindo, Costa Rica.
Have more questions for our financing partners or the team? Drop us a line anytime at email@example.com.