INVESTING IN VACATION RENTALS
Comparing Property Investment Options – Long-Term Rental vs. Short-Term Rental
When considering property investments, two common strategies often come up: traditional long-term rentals and short-term rentals (like those listed on Airbnb and VRBO). Each investment model has its unique advantages and challenges, from rental income potential to operational costs. In this blog post, we’ll compare two property purchase options: one focusing on a long-term rental and the other on a short-term rental. Both properties are priced at $500,000 with a 75% Loan-to-Value (LTV) ratio at 7.5% interest. We’ll break down the rental income, expenses, and overall investment potential to help you understand the financial differences between these two types of properties.
Scenario 1: Long-Term Rental Property
Let’s start with the long-term rental scenario, where the property is purchased for $500,000, and you expect to earn $36,000 annually in rental income.
Key Assumptions:
Purchase Price: $500,000
Loan-to-Value (LTV): 75% ($375,000 loan, $125,000 down payment)
Interest Rate: 7.5% on the loan
Annual Rental Income: $36,000
Annual Property Tax: $8,000
Annual Insurance: $3,000
Loan Breakdown:
To calculate the monthly mortgage payment for this loan, we’ll use the formula for a fixed-rate mortgage. For a $375,000 loan at 7.5% interest over 30 years, the monthly mortgage payment can be calculated using the formula for monthly mortgage payments:
M=P×r(1+r)n(1+r)n−1M = P \times \frac{r(1+r)^n}{(1+r)^n - 1}M=P×(1+r)n−1r(1+r)n
Where:
PPP is the loan principal ($375,000)
rrr is the monthly interest rate (7.5% / 12 = 0.00625)
nnn is the number of payments (30 years * 12 months = 360 months)
Substituting the values:
M=375,000×0.00625(1+0.00625)360(1+0.00625)360−1≈2,613.73M = 375,000 \times \frac{0.00625(1+0.00625)^{360}}{(1+0.00625)^{360} - 1} \approx 2,613.73M=375,000×(1+0.00625)360−10.00625(1+0.00625)360≈2,613.73
So, the monthly mortgage payment is $2,613.73.
Annual Costs:
Mortgage Payments: $2,613.73 * 12 = $31,364.76 per year
Property Tax: $8,000 per year
Insurance: $3,000 per year
Total Annual Expenses:
Total Expenses (Mortgage + Taxes + Insurance):
31,364.76+8,000+3,000=42,364.7631,364.76 + 8,000 + 3,000 = 42,364.7631,364.76+8,000+3,000=42,364.76
Net Operating Income (NOI):
Rental Income: $36,000 per year
Total Expenses: $42,364.76 per year
To calculate the Net Operating Income (NOI), we subtract the total annual expenses from the rental income:
NOI=36,000−42,364.76=−6,364.76NOI = 36,000 - 42,364.76 = -6,364.76NOI=36,000−42,364.76=−6,364.76
So, the Net Operating Income for the long-term rental is negative, meaning the property would result in a loss of $6,364.76 annually before considering any potential appreciation or tax deductions.
Scenario 2: Short-Term Rental Property
Next, let’s consider the short-term rental option, where the same $500,000 property is expected to generate $100,000 annually in short-term rental income.
Key Assumptions:
Purchase Price: $500,000
Loan-to-Value (LTV): 75% ($375,000 loan, $125,000 down payment)
Interest Rate: 7.5% on the loan
Annual Short-Term Rental Income: $100,000
Annual Property Tax: $8,000
Annual Insurance: $3,000
Annual Management Fees: $7,000
Annual Utilities: $5,000
Loan Breakdown:
Since the loan terms are the same as in Scenario 1, the monthly mortgage payment remains $2,613.73.
Annual Costs:
Mortgage Payments: $2,613.73 * 12 = $31,364.76 per year
Property Tax: $8,000 per year
Insurance: $3,000 per year
Management Fees: $7,000 per year (typically 7-10% of rental income for property management)
Utilities: $5,000 per year (costs associated with maintaining the property for short-term guests)
Total Annual Expenses:
31,364.76+8,000+3,000+7,000+5,000=54,364.7631,364.76 + 8,000 + 3,000 + 7,000 + 5,000 = 54,364.7631,364.76+8,000+3,000+7,000+5,000=54,364.76
Net Operating Income (NOI):
Short-Term Rental Income: $100,000 per year
Total Expenses: $54,364.76 per year
To calculate the Net Operating Income (NOI) for the short-term rental:
NOI=100,000−54,364.76=45,635.24NOI = 100,000 - 54,364.76 = 45,635.24NOI=100,000−54,364.76=45,635.24
So, the Net Operating Income for the short-term rental is $45,635.24 annually. This is a positive cash flow, meaning the property generates substantial income after covering expenses.
Comparing the Two Investment Options
1. Income Generation:
Long-Term Rental (Scenario 1): The property generates $36,000 annually in rental income, but due to the higher expenses (mortgage, property taxes, insurance), it results in a negative NOI of -$6,364.76.
Short-Term Rental (Scenario 2): The property generates $100,000 annually in rental income. After expenses, including mortgage payments, property taxes, insurance, management fees, and utilities, the NOI is $45,635.24, resulting in a positive cash flow.
2. Upfront Costs and Loan Terms:
Both scenarios involve purchasing the same $500,000 property with a 75% LTV loan at 7.5% interest. This results in the same loan amount and monthly mortgage payment for both scenarios:
Loan Amount: $375,000
Monthly Mortgage Payment: $2,613.73
Down Payment: $125,000
3. Operational Expenses:
While both properties share similar property tax and insurance costs, the short-term rental incurs additional costs like management fees and utilities:
Long-Term Rental (Scenario 1): The total annual operating expenses (including mortgage, property tax, and insurance) come to $42,364.76.
Short-Term Rental (Scenario 2): The total annual operating expenses (including mortgage, property tax, insurance, management fees, and utilities) come to $54,364.76.
4. Risk Considerations:
Long-Term Rental (Scenario 1): Long-term rentals tend to be more stable, with fewer fluctuations in income, and the tenant is typically responsible for utilities. However, it’s not uncommon to encounter periods of vacancy.
Short-Term Rental (Scenario 2): Short-term rentals can be highly profitable, but they also come with risks such as seasonality, occupancy rates, property wear-and-tear, and the management of guests. Additionally, short-term rental regulations and market conditions can change.
5. Potential Appreciation:
Both properties have the potential to appreciate over time. However, appreciation may be affected by the neighborhood, demand for rental units, and overall market conditions. The short-term rental may see more volatility due to its reliance on vacationers and transient guests, while a long-term rental might experience steadier appreciation trends.
Conclusion: Which Investment is Better?
Long-Term Rental (Scenario 1): While the long-term rental might seem more stable, it generates negative cash flow, resulting in a loss of $6,364.76 annually. This could be acceptable if you’re counting on the property’s appreciation over time or using it as a long-term investment for wealth building.
Short-Term Rental (Scenario 2): The short-term rental, while having higher operating expenses, results in a positive NOI of $45,635.24 annually. This property appears to be a much more profitable option, but with greater operational risks and management responsibilities. However, the higher income can help absorb these risks and provide greater returns in the short term.
Ultimately, your choice depends on your risk tolerance, investment goals, and ability to manage the property. If you are looking for stability and less involvement, a long-term rental may suit you better. If you're willing to take on the responsibility of managing a short-term rental and want higher cash flow, then the short-term rental might be the more lucrative choice.
Happy investing!
