Many of our articles here at RentalTrader discuss how to properly run your vacation rental property while maximizing your bookings and profits. But before you can start acting as a host, you’ll have to invest in a property, and that’s what today’s article is all about.
Read on to discover a variety of vacation rental financing options and their advantages and drawbacks. We’ll also talk about pre-approval, private mortgage insurance, condo financing, buying properties sight unseen, and the choice between building new and buying existing properties. Scroll to the end of the article to see our top five tips for choosing the right vacation rental financing strategy and ultimately becoming a successful real estate investor! For a quick summary of this article, you can click through the PowerPoint slides below or just scroll down to read the rest of the article.
Don’t forget to come back to RentalTrader after you’ve made your investment to list your property on our platform for free! We’d love to help you bring more guests to your short-term vacation rental and thrive as a host.
- 1 Pre-Approval (And Why You Need It)
- 2 5 Traditional Financing Methods
- 3 The 10% Down Vacation Home Loan
- 4 Jumbo Loans
- 5 Private Mortgage Insurance: When Do You Need It?
- 6 Alternative Financing Strategies
- 7 Financing a Condo
- 8 Should You Buy Vacation Rentals Sight Unseen?
- 9 Building Vs. Buying Existing Properties
- 10 5 Financing Strategy Tips
- 11 Top Takeaways
Pre-Approval (And Why You Need It)
When investing in a vacation rental property, you’ll need to secure pre-approval from your chosen lender before making an offer. Making an offer first with the thought of figuring out the financing later just isn’t smart. Most short-term rental markets are extremely tight, and properties are sold very quickly. There’s simply no time to waste!
Sellers typically only consider offers that include a pre-approval letter or proof of funds, so if you decide to put in an offer first and deal with financing later, your chances of entering into contract on the property are very slim.
It’s as simple as this: Sellers aren’t interested in tying up their property with a buyer who can’t close, even for just a few days. So, if you’re not 100% certain that your financing is solid, don’t make an offer or get under contract.
The Pre-Approval Process
A pre-approval letter shows sellers that you’re serious about purchasing their property.
The first step you’ll need to take to get pre-approval is to consult with a lender. This gives you the opportunity to discuss various loans and figure out your options. It can help you clarify your total budget and what you can afford to pay monthly on your new vacation rental property.
Once you’ve talked through your options, you’ll fill out a mortgage application, and the lender will run a credit check. They’ll also need to see all sorts of documentation proving your job history, income tax returns, assets and liabilities, and more. If you’re self-employed, you may need to provide additional documentation as well.
After the lender has had time to review your application, they’ll either grant you pre-approval, offer you pre-approval with conditions, or deny pre-approval. Note that getting pre-approval is not a guarantee that you’ll qualify for a loan, and it doesn’t mean you’re promised a certain interest rate.
As you can probably guess, this process can take some time, which is why you want to secure pre-approval before making an offer on a vacation rental property!
What can you do to increase your odds of being approved for vacation rental financing? Well, having enough money for a large down payment can help, and a strong credit score of 720 or more greatly increases your chances of approval. A low debt-to-income ratio and reserve funds can also show the lender that you’re financially responsible enough to lend to.
Proof of Funds
Like pre-approval, proof of funds comes in the form of a letter, but these two documents are not the same.
A proof of funds letter shows evidence that you have enough cash or liquid assets to buy a property. This paperwork shows the seller proof that you can cover the down payment, other purchase costs, and closing costs. If you plan to pay in cash, you’ll have to have proof of access to sufficient funds to cover the entire cost of the home. In many cases, sellers won’t take their property off the market until they’ve confirmed that you have the necessary funding.
The difference between a pre-approval letter and a proof of funds letter is that a pre-approval letter states that a lender is willing to provide financing, while a proof of funds letter shows evidence of necessary cash or assets.
5 Traditional Financing Methods
Before we get into methods of financing that are unique to vacation rentals, we’ll cover five traditional financing methods that you can use to invest in a short-term rental property. The best choice for you depends on various factors, most importantly your personal financial situation. Learn more about paying with cash and securing various types of loans below.
|Traditional Financing Options|
|Type of Financing||Pros||Cons|
|Cash||Stable and secure approachAbility to jump on opportunities quicklyNo interestSteep discountsImmediate cash flow||Lots of disposable income requiredLimited profitsRemoving risk reduces rewardPossibility of losing money if property depreciates|
|Conventional Loan||Most common type of mortgage loanLower interest rates than private lendersCan maximize profits with larger down payment||Comes with some riskTakes time to be approvedStricter approval criteriaLimit to number of conventional loans you can have|
|Commercial Loan||Provides a cash flow boostCan take it out using business credit||More expensive than conventional loansRequires a larger down paymentHigher interest rates|
|Private Lender Loan||More flexible than conventional loansFaster and easier approval processPersonalized customer serviceCan cover investment and renovation||Takes time and effort to build up a sufficient private lender networkHigher interest rates than conventional loans|
|Hard Money Lender Loan||An option for those who can’t get approved for other loansQuicker and less rigorous approval processApproval not entirely dependent on credit historyCan close on sales faster||Additional risk for the lender means higher interest rates for youRequires a larger down paymentShort repayment periodsMay have to prove your investment track record|
Paying with cash is just as it sounds: paying the full amount for your new vacation rental property upfront in cash.
- Paying with cash is considered a more conservative and safe approach to real estate investment. It provides stability and security.
- Cash investors can quickly jump on good opportunities, rather than waiting to be pre-approved and getting proof of funds.
- Your chances of beating out other offers increase dramatically because the seller has no doubts about your ability to pay for the property.
- You may be able to purchase properties at steep discounts in exchange for the convenience added for the seller.
- Buying with cash means avoiding interest payments altogether.
- You can create immediate cash flow by purchasing a property outright.
- It’s necessary to have a huge amount of disposable income available to purchase properties with cash.
- The profit a cash investor can make on a property is less than that of a leveraged investor. Leveraged investors can invest in multiple properties, each of which can begin bringing in revenue. Meanwhile, people who pay in cash are typically limited to only purchasing one property at a time, limiting the amount of profit they can earn.
- If you have a limited amount of money to spend in the long term, tying up all of your assets in a single investment can be very risky and isn’t always the wisest strategy.
- Although the property is likely to appreciate since you’ll potentially be renovating and fixing it up for guests, homes can also depreciate. When you pay with cash, you’ll be losing money outright if the property depreciates.
- By removing risk, you also reduce the potential reward that can be earned.
2. Conventional Loan
Conventional loans are the most common form of mortgage loan. They’re provided by financial institutions based on your credit history and future ability to pay them off. The National Association of Home Builders revealed that 78.5% of new home sales in 2022’s first quarter were made up of conventional loans.
Conventional loans are backed and serviced by private lenders such as credit unions, banks, and other financial institutions. They’re not affiliated with government agencies.
To get a conventional loan, you’ll usually need a credit score of 660 or higher, although you may be able to get approved with a score as low as 620.
As far as down payments go, some conventional mortgage loans have special programs with up to 100% financing, and others have down payment requirements of only 3%. While this can be great if you don’t have a lot of funds available for a down payment, you’ll generally need to pay for private mortgage insurance anytime you’re putting less than 20% down.
You can get a conventional loan of up to $647,200 for a single-family property in 2022. In some high-cost areas, this goes up to $970,800. If you’re looking for a larger loan, then you’ll need to consider a jumbo loan (click here to jump to the jumbo loan section of this article).
Most conventional loans are repaid over a 30-year term, but you can qualify for 15- and 20-year conventional loans as well.
Interest rates for conventional loans can be fixed-rate or adjustable-rate and are primarily dependent on your credit score and history. The better your credit, the less interest you’ll pay over the loan’s lifetime.
- Conventional loans usually come with lower interest rates than private lenders. (However, interest rates for investment properties tend to be higher than those of loans for primary residences.)
- Depending on the funds you have available for your down payment, financing through a bank can maximize your profits.
- There’s some risk associated with conventional loans. For instance, if your vacation rental isn’t getting many bookings, your mortgage payment may begin to eat away at your profits.
- In comparison to private lenders, it takes longer to be approved for conventional loans. In addition, conventional loan providers often have stricter lending profiles.
- There’s a limit to how many conventional mortgages you can have open at once.
3. Commercial Loan
Commercial loans, often called Commercial Real Estate Loans or CRE loans, are mortgages on commercial property (rather than residential property). In general, CRE loans are made to investors like developers, partnerships, trusts, funds, corporations, and real estate investment trusts: business entities whose purposes are to own and operate commercial real estate.
Since vacation rentals are a form of income-producing real estate used for business purposes, they’re eligible for CRE loans.
You can find CRE loans offered by a variety of sources: private investors, banks, insurance companies, independent lenders, pension funds, and more. Lenders will typically look at the nature of the property you want to purchase as well as your credit score, credit history, and financial ratios.
Commercial loans usually have shorter terms. While conventional loans often last 30 years, commercial loans typically range from five to 20 years.
Down payments for CRE loans most often range from 20% to 30% of the property’s value, and interest rates are around 10% to 20%.
There are multiple types of commercial loans available, including permanent loans, SBA loans, and bridge loans.
- A commercial loan can boost your cash flow if your vacation rental business is struggling.
- You can take out a commercial loan using your business credit rather than your personal credit.
- Commercial loans are usually more expensive than conventional residential loans.
- CRE loans require larger down payments and have higher interest rates.
4. Private Lender Loan
While financial institutions fund most loans, private lenders are usually funded by individuals, conglomerates, and accredited high-net-worth groups. They’re often operated independently, and approval for private loans isn’t so much based on income, credit rating, and assets as on other factors. There are even some private lenders that will look beyond credit scores for explanations as to the rating. More important is proving cash in the bank or liquidity as well as income.
If you decide that a private lender loan is the best option for you, it’s vital to evaluate various private lenders and look at them almost as vacation rental business partners. Evaluate their portfolio, product, goals, and responsiveness.
- Private lender loans are typically more flexible than conventional loans.
- Private loans usually have a faster and easier approval process, meaning that you can move forward with better odds of purchasing the property you’re interested in.
- Private lender loans offer you a more personalized customer service experience and simpler funding.
- Various loan solutions are available through private lenders that aren’t available through conventional loan providers.
- Private lender loans are an excellent option for those who don’t qualify for conventional loans.
- Private loans can cover renovation costs as well as the initial property investment.
- Entities and LLCs can borrow money through private lenders for tax benefits and legal reasons.
- Private loans tend to have higher interest rates than conventional loans.
- Building a private lender network that can fund your vacation rental property investments may take time and effort.
5. Hard Money Lender Loan
Hard money loans come from private companies and individuals rather than traditional lenders. These hard money lenders accept various assets, like property, as collateral. Hard money loans are secured by the property they’re being used to purchase, and the “hard” part of a hard money loan refers to the asset you’re using to back the loan’s value. If you were to default on a hard money loan, the lender could take ownership of the asset to recoup its losses.
This type of short-term rental financing is often used by real estate investors who flip homes for profit, but short-term rental investors can also take advantage of hard money loans.
- Hard money loans are a valid option if you can’t get approved for conventional loans.
- Getting approved for a hard money loan is much quicker and less rigorous than conventional loans since hard-money lenders create their own rules for debt-to-income ratios and credit scores.
- Approval is mostly based on the property rather than your credit history.
- Hard money loans make it easier to make purchases happen quickly; in some cases, you can close on a sale in only a few days.
- Since hard money lenders take on more risk than traditional lenders, you end up with a more expensive loan with higher interest rates.
- In many cases, you’ll need to put down a larger down payment than you would with other types of loans.
- Hard money loans usually have short repayment periods of only a few years, so you have less time to repay the loan.
- Sometimes, you’ll need to prove that you have a good track record of flipping houses or investing in vacation rentals.
The 10% Down Vacation Home Loan
A financing option that’s exclusive to vacation rental opportunities is the 10% down vacation home loan. As long as you meet several specific requirements, you’ll be able to take advantage of this conventional Fannie Mae/Freddie Mac-backed loan and its smaller down payment.
When speaking to a lender about this type of vacation home financing, it’s necessary to be transparent and clear about your intentions to purchase a property and turn it into a short-term rental that will be listed on major booking sites. Being upfront and honest about your plans ensures that you’ll follow all of the guidelines for this particular loan type.
Here are the usual stipulations for the 10% down vacation home loan:
- The property you’re purchasing must be located at least 65 miles away from your primary home.
- The property must be a one-unit dwelling; duplexes and other multi-unit properties are not eligible for this loan.
- You must occupy the property for a certain portion of the year. Your lender can fill you in on the specific number of days.
- The property needs to be suitable for occupancy for the entire year.
- You can’t sign control over to someone else with a lease; instead, you must have exclusive control of the property.
- You can take out multiple 10% down vacation home loans as long as each of the properties is in a different market. However, you can only have one loan per market.
Currently, guidelines for this loan don’t prevent owners from listing and renting out their vacation home on major booking platforms like Airbnb during the parts of the year they’re not occupying it. Still, you’ll want to note that Fannie Mae and Freddie Mac place limits on the number of vacation home loans that can be carried out by lenders.
Jumbo loans are a way to finance properties that are too expensive for conventional conforming loans. The limit for conforming loans is usually $647,200, but in some markets, it’s as high as $970,800. Meanwhile, the limit for jumbo loans is different in every state and depends on the real estate values in the area.
These loans aren’t often used for long-term rental investments, but you’ll see them utilized more frequently for the purchase of short-term rentals, most often for large luxury properties. They’re not backed by Fannie Mae and Freddie Mac, so lenders take on more risk when they approve jumbo loans, as they’re not protected from losses if borrowers default.
To be approved for a jumbo loan, you’ll typically need a credit score of at least 700 and a debt-to-income ratio of 45% or lower. However, having plenty of cash reserves can help if your debt-to-income ratio isn’t ideal. Some jumbo loan lenders will want to see that you have sufficient cash reserves to cover an entire year of mortgage payments, and they may also require an appraisal for the property you plan to purchase.
- You can get larger loans and purchase luxury properties with jumbo loans.
- Some jumbo loan providers offer competitive interest rates that are close to those of conventional loans.
- Approval criteria are much stricter than they are for conventional loans since jumbo loan lenders take on more risk.
- You’ll need to provide more documentation than you would for conventional loans.
- You’ll usually have to make a larger down payment of at least 20% for a jumbo loan. However, some lenders will go as low as 10% for your down payment.
- Interest rates, closing costs, and other fees tend to be higher for jumbo loans.
Private Mortgage Insurance: When Do You Need It?
Private mortgage insurance, or PMI, is a type of mortgage insurance that’s typically required when your down payment for a conventional loan is less than 20% of the property’s purchase price. This type of insurance doesn’t protect you; instead, it protects the lender in the case that you aren’t able to continue making your loan payments.
Your lender will arrange for private mortgage insurance, and it’s provided by private insurance companies. There are a few ways you can pay for PMI, including a monthly premium added to your mortgage payment, a one-time premium paid at closing, and a setup with both an upfront payment and monthly premiums.
Removing PMI with a BPO
After a couple of years, you may be able to eliminate your PMI by getting a broker price opinion, or BPO. This is when a real estate professional familiar with the local housing market uses their expertise to give their opinion of a property’s value in dollars.
Suppose the BPO indicates that your vacation rental property has appreciated by 10%, and you have 20% (or more) equity in the property. In that case, your lender will usually be willing to remove your private mortgage insurance.
BPOs Vs. Appraisals
BPOs aren’t the same thing as appraisals. Although both are methods that determine the value of a property, they have several differences.
First, a BPO is a real estate agent’s opinion of the amount a property will sell for. In contrast, an appraisal is completed by a professional appraiser and determines the property’s current worth.
Another difference between BPOs and appraisals is that only appraisals are used in the mortgage application process. Broker price opinions are not accepted in place of appraisals.
BPOs are typically less expensive than appraisals, often running between $200 and $250, while appraisals cost nearly twice as much.
Overall, appraisals are looked at as being more accurate than BPOs when measuring a property’s worth.
Alternative Financing Strategies
Aside from the five traditional financing strategies, the 10% down vacation home loan, and jumbo loans, you may wish to consider a couple more alternative vacation rental financing strategies when investing.
Buy, Rehab, Rent, Refinance, Repeat (BRRRR)
The BRRRR strategy consists of several steps:
- Buy a property in need of repairs with cash.
- Rehab the house, completing repairs and forcing appreciation.
- Rent the property.
- Refinance the property for its new value after repairs (often called after-repair value or ARV).
- Repeat the process.
Although you’ll need a large amount of cash to start out with this strategy, in the long term, you’re basically getting your vacation rental property for free. After you complete repairs and refinance the property, you’ll earn at least the same or even more cash than what was spent on the property and repairs in the first place.
You may or may not be able to use this strategy; it doesn’t work in all markets. Whether or not you’ll be able to pull off a BRRRR mainly depends on the conditions of the market.
For example, metro markets are a much better option for this strategy than regional and national vacation markets.
As a refresher, metro markets are large metropolitan areas like NYC that have plenty of industry outside of tourism. Regional vacation markets are affordable, accessible markets that most visitors drive to, and they’re 100% financially dependent on tourism. National or “true” vacation markets are markets that most visitors fly to; they’re also totally dependent on tourism, but are more expensive and less accessible for travelers.
Metro markets are best for the BRRRR strategy because properties must be purchased for far less than their market value to be viable candidates. In order to find a property that will sell for way less than market value, it typically needs to be distressed, meaning that the owner is experiencing financial problems and needs to get the property off their hands as quickly as they can.
There are far fewer opportunities to utilize this strategy in vacation markets because most of the properties there are either existing investment properties like short-term rentals, or they’re second homes. If the owner of one of these properties runs into financial trouble, their first move will be to sell off these properties for close to market value.
Since metro markets have plenty of permanent residents, you’ll more often see distressed properties there. While it is possible for investment properties and second homes to become distressed, it’s not very common.
Something to note is that if you want to purchase a property that has the potential to be a successful short-term rental, you’re going to need a high budget. In some markets, it might be impossible to invest in a property like this, even if it needs lots of repairs, just because real estate prices are so high.
Of course, if you have plenty of money at your disposal, then BRRRR could be an option for you in any market.
If you think BRRRR might be a good choice for you, it’s important to realize that it requires quite a bit of coordination and hard work to do successfully. Still, it can be an excellent way to scale your real estate portfolio and generate fantastic results when done right.
If you’ve ever wondered how to buy a vacation rental with no money down, you’ll probably be interested in this short-term rental financing method.
While the BRRRR strategy requires plenty of cash, a partnership is an effective way to invest in a vacation rental property with very little money down.
If you want to partner on a property and have both parties on the contract, you’ll need to get either a conventional or commercial loan. Unfortunately, the 10% down vacation home loan isn’t an option for partnerships unless the partners can prove that they’re related.
There are a few ways that you can structure a partnership for a vacation rental purchase, but the most common is a money partner paired with a sweat-equity partner.
While the “money partner” is pretty self-explanatory, a sweat-equity partner is someone who provides a non-monetary contribution. In the case of short-term rental investing, the sweat-equity partner is the person who does all of the vacation rental management day-to-day. Meanwhile, the money partner acquires the loan and the contract.
The money partner essentially holds a vacation rental mortgage with the sweat-equity partner for half of the down payment. The sweat-equity partner pays this mortgage to the money partner until they’ve paid off their half of the down payment.
At that point, the vacation rental profits are split between the partners 50/50 after expenses. The profits can be paid off monthly, quarterly, or yearly; it’s up to the partners and what they agree to.
Even if you’re partnering with a friend or someone you trust quite a bit, it’s crucial to have an attorney draft a document containing all of the terms of the partnership. Having everything in writing will simplify the process and save you from conflicts in the future.
Financing a Condo
If you’re like most vacation rental investors, you probably back away anytime a condo investment is brought up. Many people associate condos with outrageous association fees and have no interest in them as a result.
But before you write off condos completely, consider looking into the fees and seeing what they cover. For example, maybe you’re looking at a two-bedroom condo that has a homeowners association fee of $500 per month. That might sound insane, but if you learn that the HOA fee includes some of the utility costs, plus cable, internet, and amenities, it becomes much more reasonable. Some condo fees even include insurance on exterior items and the building, making your insurance premiums cheaper.
You’ll find that condo financing is very challenging to obtain in some markets, especially those that are particularly tourism-driven. This is primarily because, in most vacation markets, condos are located in buildings called “condotels.” This clever combination of the words “condo” and “hotel” refers to buildings that are made up of investment properties and short-term rentals. Many condotels have in-house vacation rental management companies and check-in desks.
Condotels are non-warrantable, so they don’t satisfy the criteria for conventional loans. Many lenders view them as too risky, making financing a condo in a condotel very difficult. Still, it can be done. But you’ll likely have to make a down payment of more than 20%, and you’ll need to secure a commercial or portfolio loan.
You won’t be able to figure out whether or not a property is part of a condotel just by looking at it. Instead, you’ll need to get a condo questionnaire from your lender and have the HOA manager complete it.
To be considered warrantable, a property has to meet the following criteria, which are part of the condo questionnaire:
- The HOA isn’t involved in any lawsuits.
- The unit is a detached condo.
- The project has less than four units in total.
- At least half of the units are primary residences or second homes (not investment properties).
- No single person or entity has ownership of more than a certain percentage of the units. (This specific percentage changes yearly.)
- Commercial space makes up less than 35% of the project’s square footage.
- No more than 25% of the unit owners are delinquent on their HOA dues.
If you’re interested in a market that has quite a few condotels, you should be able to find local lenders offering excellent vacation rental financing options for condos. Take some time to call local mortgage companies and banks, and you’ll likely find one that will work with you.
Should You Buy Vacation Rentals Sight Unseen?
Depending on the market you’ve chosen, you may or may not be able to physically see the properties you’re interested in before you make an offer. While there will be plenty of time in some markets to walk through properties and analyze them before putting in an offer, the same isn’t true for more popular markets. Often, there just won’t be enough time to see all of the properties you’re interested in before they go under contract.
So, if you’ve chosen a tight seller’s market, you’ll need to be alright with making offers sight unseen, meaning that you’ll put in an offer before you ever get to view the property in person.
As you may expect, some short-term rental investors are comfortable with this concept, while others are not. If you can’t stomach the idea of potentially spending tens or even hundreds of thousands of dollars before seeing a property yourself, then buying vacation rentals sight unseen probably isn’t for you, and it would be better to look at less popular markets.
Take an Exploratory Trip
If you’re a vacation rental investing newbie interested in a hot market, and you’re undeterred by the idea of buying sight unseen, taking an exploratory trip to the area will help you quite a bit. Take a few days to drive around and see the sights, visit restaurants and tourist attractions, and identify the locations you like best. Get as familiar with the market as you can so that once properties go up for sale, you feel knowledgeable and prepared enough to make an offer.
Ask for Photos and Videos
Another thing that will help is asking your real estate agent to take several videos for you once a property is put on the market. You’ll want a 360-degree view of each of the rooms on the property so you can see their size and how the space is set up. You’ll also want a 360-degree view from the front yard to see all the surrounding properties. Finally, you’ll want a photo of the HVAC unit’s serial number to determine how old it is and whether it’ll soon need replacing. These videos will enable you to identify any problem areas or things that need to be fixed or replaced altogether.
However, even though your real estate agent can absolutely help you out by taking plenty of photos and videos, they are not a licensed contractor or home inspector. As such, you can’t expect them to identify every little thing that will need further attention through these videos.
Contingencies and Inspection Periods
If you make an offer sight unseen and get under contract, then a licensed professional will come by and complete a home inspection. However, in markets where most of the properties are already short-term rentals, nobody will be able to enter the property when it is rented. This extends to buyers, realtors, and home inspectors.
A property could go on sale on a Wednesday and be occupied by a guest until Sunday. During that time, the property could go under contract before anyone–agent, buyer, or home inspector–is able to view or take photos and videos of the property.
If you find yourself in this type of situation, there are a couple of ways to protect your investment. The first is to ask for a viewing contingency. A contingency clause allows the contract to be broken without any penalties or loss of earnest money. Earnest money, also called a good faith deposit, is usually a deposit of one to three percent of the property’s sale price that you put into escrow until the deal is done. Putting down earnest money shows the seller that you’re serious about buying their property.
With a viewing contingency, the seller will give you a specific amount of time after accepting your offer for you to view the property. If you don’t like it, you can terminate the contract, and the seller will refund your earnest money.
The problem with viewing contingencies is that they can weaken your offer and lead the seller to go with someone else’s instead. If you know that multiple offers have been made and you believe a viewing contingency would hurt your chances of getting the property, you can ask for a 14-day inspection period.
An inspection period gives you or your agent plenty of time to look at the property. You’ll still need to have an inspector complete an inspection. The worst thing that can happen in this case is that you’ll terminate the contract based on the inspection if you need to back out. While this strategy isn’t 100% airtight because the seller can push back, you’ll usually be able to leave the contract and get your earnest money back based on the inspection.
Building Vs. Buying Existing Properties
Many new investors consider building their own vacation rental property rather than buying an existing one. Since most existing short-term rentals receive multiple offers at or above market value in just a few days, the market’s competitiveness can be off-putting and discouraging. It can seem like a better idea to just build your own perfect vacation rental property and avoid the hassle of trying to beat out other investors with your offer.
Even though it may seem like a good idea at first, the reality is that completing a custom build isn’t always (or even usually) the smartest move for investors to make. For instance, what if you build a property that is absolutely perfect in your eyes, but renters and potential buyers aren’t interested? Or what if you find, after a few months of running your new vacation rental, that you don’t like the market you built it in?
Of course, the option to sell your newly-built property is always there if things don’t work out. But you won’t end up with a long-term income stream in that case, which means you wasted quite a bit of your time and your resources building the property.
Instead of undertaking a custom build project, we recommend getting some experience in your desired market first.
But if you decide that building is what you want to do, be sure to do your research. Look into all of the potential costs and methods available to go about the building process. Construction costs can vary quite a bit from market to market, so you’ll want to figure out whether there’s anything special you have to do when building a new property.
In metro markets, you have to be very careful regarding zoning and homeowners association rules. Meanwhile, if you’ve chosen a mountain market that’s very steep, you might sentence yourself to spending more than $100,000 on retaining walls and grading. And if you’re building in a beach market, you’ll need to expect lots of additional costs that come with building up the lot to protect it from floods.
It’s smart to interview other investors who have built properties in the area, as well as engineers and builders. This can help you narrow down the costs you’ll have to pay to build your own vacation rental. Sometimes, building costs can hurt your ROI, so that’s something to think about.
The Problem with Nonstandard Developer Contracts
If you decide to build new, pay special attention to your new construction contracts. Every state has a standard set of real estate contracts and forms for new and existing construction that were created by the National Association of Realtors or NAR. These standard contracts protect both the seller and the buyer during the contract period.
However, sometimes builders and developers who are building a set of properties have their own attorneys draw up nonstandard contracts. Watch out for these nonstandard developer contracts, because they typically only offer one-way protection (for the developer, not for you as the buyer), and they allow the builders plenty of leeway and liberty to do as they please. Meanwhile, they lock the buyer into a contract in which they have no real power to object or negotiate. Even if the developer decides to make changes to the property that the buyer didn’t agree to in the first place, the buyer has no protection or legal recourse.
Nonstandard developer contracts caused issues recently during the coronavirus shutdown. As many businesses went under and investors’ financial situations changed for the worse, those who entered into new-construction contracts before the pandemic were suddenly unable to qualify for the properties for which they were under contract.
While those who used the standard NAR contracts could invoke the financing contingency and get out of them, those who were bound by nonstandard developer contracts ended up losing tens of thousands of dollars in deposits.
This isn’t to say that nonstandard contracts are inherently bad; many of them do result in incredible finished products. However, this does mean that you should have your lawyer carefully review any contract that isn’t the standard NAR version.
It’s essential to have your lawyer do this and not your real estate agent. Realtors cannot be held responsible for interpreting the contract; in some places, doing this can even result in their real estate license being revoked for practicing law without a license.
The Spec Home: A Middle Ground
Maybe you’re not ready to jump in and build a vacation rental property, but you’re not too keen on buying an existing property, either. Meet the spec home, an alternative to both custom builds and existing properties.
A spec home is a house built with the goal of selling it immediately. Some spec homes are located within full neighborhoods of other spec homes, while others are one-offs. With a spec home, you get the aesthetic of a new home as you would with a custom build. You also get the usual builder’s warranty and avoid the wear and tear that comes with buying an existing property.
But you avoid some of the pitfalls of custom builds, because you don’t have to source plans or go through the extensive decision-making process that’s usually involved.
In each vacation rental market type (metro, regional, and national), you’ll see that entire developments are built for short-term rental use. These developments are becoming more and more common.
It’s often best to buy a spec home in these types of communities, rather than a one-off spec home that is part of a traditional homeowners association. With a traditional HOA, you’ll likely be dealing with many permanent residents who aren’t fans of the idea of a vacation rental being in the neighborhood. In some cases, this dislike of vacation rentals could even result in a ban on them in the future.
5 Financing Strategy Tips
If you’re stuck between all the vacation rental financing strategy options, these five tips will help you choose one and start taking action as an investor.
1. Stick to a Single Strategy
There are many ways to finance and earn money from vacation rental investments. However, it’s in your best interest to select just one strategy to use with each property purchase. Attempting to utilize several strategies at once makes the process far more difficult.
2. Select Different Strategies for Different Deals
While it’s true that it’s best to only use one strategy at a time, that doesn’t mean you should use the same strategy for every deal. A good real estate investor is highly adaptable and ready to adjust their strategy to fit the market and property they’re currently interested in. No one strategy is better than others, but some are better suited to certain markets and situations. What works perfectly in one market may not be effective in another, so be ready to switch things up as needed.
3. Accept that You Can’t Always Negotiate
Many investors go in thinking that they’ll always be able to convince the seller to come down on pricing. While you’ll be able to negotiate pricing quite a bit in some markets, there are other areas where you’ll be competing with multiple offers on every property available. When you’re competing with many other investors, you’re just not going to be able to convince the seller to lower their asking price.
4. Be Open to Compromise
Some investors pass up on amazing opportunities because they’re too rigid in their approach. For instance, they might come across a great deal, but because the property needs a few repairs, they turn it down. Or they may find an incredible property at a good price, but because the numbers are just a little bit off, they decide to hold out for that “perfect” property instead.
Instead of holding out and being uncompromising, think about cash-on-cash return, which is what matters the most at the end of the day. How much are you putting in to acquire the property, and how much are you going to get out of the property? As long as the cash-on-cash return is good, you don’t need to hold out for the ideal property with the ideal price and ideal amount of necessary repairs. You just need to ensure that the property will be worth the investment.
5. Know the Difference Between Successful and Unsuccessful Investors
What is the difference between a successful and an unsuccessful real estate investor? The successful real estate investor closes deals. So, if you want to find success, you need to resist the feeling of paralysis that comes from doing far too much analysis. Next, you need to be open and adapt to your chosen market. And finally, you need to take action and start putting in offers until you enter into a contract.
After you’ve purchased your vacation rental property and gotten it ready for guests, don’t forget to list it on RentalTrader! Here at RentalTrader, our mission is to take back the vacation rental industry and make travel affordable for everyone. It’s quick, easy, and free to list your property with us, and we don’t have high fees like some of the other booking sites–just a flat host fee of 4.5% per booking. Plus, we have a huge library of articles for hosts and travelers to check out.
If you want to know more about the vacation rental financing for hosts and investors, please watch out this video: