By Simon J. Lau, CFA
Updated June 2024
Financial model: Please feel free to make a copy of this model by clicking on the hyperlink and selecting “File” => “Make a Copy.” You can then customize it to suit your specific needs.
Investing in Real Estate: Short-Term vs. Long-Term Rentals
Purchasing physical real estate is a way for retail investors to gain exposure to the real estate market, benefit from generous tax breaks provided by the government, and access leverage offered by banks that are generally reserved for sophisticated investors. For most retail investors, the most accessible physical real estate investment has been residential property. Traditionally, an investor would buy an investment property and rent it to a long-term tenant. Now, with companies such as Airbnb, Vrbo, and HomeAway, there are options to rent these same units as short-term rentals. Below are several benefits and drawbacks associated with short-term rentals compared to traditional long-term rentals, along with a case example to illustrate these points.
Benefits
- Higher Margins: Companies like Airbnb have enabled fractional ownership (as opposed to wholesale or retail purchase), which has created higher margins for asset owners. An example of a wholesale purchase is when Ford sells a fleet of Fusions to a local dealership at a significant discount to the Manufacturer Suggested Retail Price (MSRP). An example of a retail purchase is when you go to that local Ford dealership to purchase a Fusion at or near MSRP. Finally, an example of fractional ownership is when you rent a Ford Fusion from a Hertz car rental company at a daily rate that, when annualized, is significantly higher than if you had purchased and financed the car. In the case of Airbnb and other short-term rentals, one can expect greater margins because moving from retail purchase (e.g., homeowner) to fractional ownership (e.g., short-term rental) translates into higher average daily rates.
- Reduced Guest and Tenant Risk: Compared to traditional tenants who sign a lease and pay rent, short-term rental guests are not tenants and generally do not have the same legal status. In left-leaning states like California, it can take as long as six months to evict a delinquent tenant. For many independent and small-scale investors, this loss of income is very real and can significantly impair returns or even destroy financial livelihood. Additionally, Airbnb offers Host Protection Insurance, which protects against liability claims brought by third parties—up to $1 million USD—that arise from a listing during a stay. By moving away from long-term rentals to short-term rentals, homeowners can reduce their risk exposure to both tenants and guests.
- Vacation Home Optionality: Ideally, a short-term rental investment should be located in a travel destination. In this case, the homeowner can temporarily remove the unit from the market and vacation there any time of the year, returning it to the market at the flip of a switch. However, this optionality is a double-edged sword: the more often a homeowner vacations in their short-term rental, the less income they generate, and vice versa.
Drawbacks
- Greater Operational and Logistical Risk: Short-term rentals require more effort and upkeep compared to long-term rentals. A homeowner could have up to 30 different guest parties visiting their short-term rental per month, compared to one leaseholder and associated household members with a long-term rental. This creates far more wear and tear on the home. Additionally, a homeowner would need to invest time and/or money into efforts that are otherwise not required for a longer-term rental, such as furnishing the property and routine house cleaning.
- Few Viable Short-Term Rental Platforms: Although Airbnb, Vrbo, and HomeAway are among the largest short-term rental platforms, Airbnb is easily the largest within this space. However, relying on a single platform poses a risk. For example, if a platform like Airbnb were to face regulatory or operational challenges, it could severely impact your investment. To use a high-profile example, Huawei relied exclusively on Android, only to discover one day that it had been blacklisted by the US government and could no longer rely on Google technology to power its core products. If this can happen to large enterprises, it can happen to individual investors as well.
- Friends and Family Asking for Free Stays: Unless you’re good at keeping secrets, your friends and family will eventually learn about your investment property and ask to stay for free. The more desirable the location, the more important it will be to set limits. Failing to manage expectations can result in a poor financial investment, strained personal relationships, or both.
Case Example
Now that we’ve listed the high-level benefits and drawbacks of short-term rentals compared to long-term rentals, we can move forward with an example that illustrates the financial distinctions between these two business models.
235 Market St. #409, our target investment, is located in Downtown San Diego and adjacent to the Gaslamp Quarter, a central entertainment and nightlife venue. This unit is a 2-bedroom, 2-bathroom condo with 982 sq. ft., which sold for $579K in April 2019.
Long-Term Rental Comparison
As a long-term rental comparison, I used a unit at 1025 Island Ave. that I found on Craigslist (May 2019). This rental is located in East Village, a neighborhood adjacent to the Gaslamp Quarter. The unit is a 2-bedroom, 2-bathroom condo with 1,044 sq. ft. The rental is listed for $2.85K/month, which I’ve adjusted down to $2.8K/month to reflect the modest difference in square footage (1,044 sq. ft. for this long-term rental compared to 982 sq. ft. for the target unit).
Short-Term Rental Comparison
As a short-term rental comparison, I used this 2-bedroom, 2-bathroom Airbnb listing in East Village. I tested different dates up to a year from today and found that the average daily rate ranged from $269 to $275. For this example, I’ve assumed the lower range of $269 per night as the average rate.
Financial Analysis
When creating the financial model, I focused on the Income Statement and Cash Flow Statement. Both the Income Statement and the Cash Flow Statement have been standardized across the long-term rental and the short-term rental (e.g., Airbnb) to allow for an apples-to-apples comparison. Below are some important points to note.
General Assumptions
- Depreciable Assets – % of Assessed Value / Useful Life Used for Depreciation (Years): For most, if not all, real estate investments, landlords are required to depreciate the asset over a finite period per IRS guidelines (IRS Publication 946). This depreciation expense is a non-cash charge, meaning it can be a significant financial benefit by reducing the current tax burden. However, upon selling the unit, landlords often have to pay taxes on this depreciation, known as depreciation recapture. Given the time value of money, it’s better to pay these expenses later rather than sooner. Note that only the physical assets (additions) are depreciated, not the underlying land, which typically appreciates. In this example, the additions for the target unit were ~45% of total assets in 2017, which I used for this calculation. The useful life defined by the IRS is 27.5 years for residential rental property. These expenses and associated tax savings are allocated on a monthly pro-rata basis.
- Max Mortgage Interest Deduction (MID) Loan Amount: With recent tax changes, the current deductible amount is $750K. For those who purchased before 2019, the deductible amount is $1M. Changes in MID over time may significantly impact the total cost of homeownership. This benefit is applied on a monthly pro-rata basis.
- Annual Property Insurance (% of Market Value): This expense is applied on a monthly pro-rata basis.
Rental Assumptions
- Vacancy and Credit Losses (% of Monthly Rental Rate): I estimated these figures using the most recent 2017 data from Department of Numbers. Adjust these figures based on the unit’s location, the listed price relative to the market, etc. Note that an extremely low vacancy rate may indicate underpricing relative to the market.
- Management Fee (% of Gross Operating Income): To make an apples-to-apples comparison with the Airbnb example, I assumed no property management. Professional property managers are generally not worthwhile for short-term rentals due to the unique operational and logistical demands that cannot be easily outsourced.
- Monthly Utilities (% of Gross Operating Income): For simplicity, I assumed these expenses are borne by the renter.
- Maintenance (% of Monthly Gross Operating Income): Condos generally have lower maintenance expenses because the HOA covers some responsibilities (e.g., roof maintenance, exterior painting). However, landlords are responsible for most interior maintenance, so a reasonable amount should be assumed.
Short-Term Rental Assumptions
- Daily Rental Rate ($): Use the average daily rate extrapolated from Airbnb, Vrbo, HomeAway, etc.
- Vacancy and Credit Losses (% of Monthly Rental Rate): Due to the short-term nature of these rentals, expect a higher vacancy rate compared to long-term rentals. A basic Google search can provide a starting point for vacancy rates. I assumed a 35% vacancy rate based on feedback from Mashvisor.
- Management Fee (% of Gross Operating Income): I assumed no property manager for short-term rentals because managing these involves small-scale logistical tasks like house cleaning and guest inquiries, which are not suitable for traditional property managers. High vacancy rates also necessitate active management to prevent unauthorized listings and potential losses.
- Maintenance (% of Monthly Gross Operating Income): Short-term rentals experience more foot traffic, leading to higher maintenance expenses compared to long-term rentals.
- Cleaning Fee (Not Part of Assumptions): I compared the market rate cleaning cost in San Diego with that of the listed Airbnb, and the costs were the same ($80). My assumption is that an investor could leverage services such as Amazon Home Services to clean this home on an on-demand basis with no additional cost to the host.
The main takeaway from this analysis is that, when done right, a short-term rental such as an Airbnb can be far more lucrative than an equivalent long-term rental. In this example, an investor could make $400+ in monthly free cash flow from a short-term rental compared to -$800 in monthly free cash flow from a long-term rental. These higher margins are mostly due to the higher average daily rates that can be achieved in a short-term rental business compared to a long-term rental business. However, this requires the landlord to play a much more active role in managing the day-to-day operations.
Given these risks, a real estate investor would be well-served to assess the viability of the investment as a traditional long-term rental as a fallback in case the effort needed to manage a short-term rental business outstrips the financial gains.
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