My Criteria for a Vacation Rental Investments and Airbnb

Everyone wants a second home in a sweet paradise, so I get a lot of emails from friends that go something like this. “Hey i’m thinking about buying a house in [vacation rental market], how do I know if it’s a good investment.”

Generally when people ask for real estate investment questions, the answer is “it’s complicated.” However, I hate it when people give that as a response because the person asking typically has no knowledge and you have at least a little bit to share. That said, here’s a legal disclaimer that nothing on this site is investment advice and please just use it as information, yada yada yada and consult professionals.

But it’s not that complicated. Here’s how I think through what would make a great vacation rental or Airbnb investment. Below i’m going to list out the criteria is roughly their order of importance.

1. Legality. Is it legal to do short term rentals in the location you are considering.

For our home in Sonoma, it’s in the unincorporated part of Sonoma so we were able to get a vacation rental permit. If it were a few blocks closer to to the town of Sonoma, it would be zoned in the town where short term vacation rentals are no permitted. For our home in Kauai, we bought the place primarily because it had a grandfathered in permit for short term rentals that transferred over from the prior owner.

So that’s the most important point you need to understand. If you want to make money from short term rentals, you need to make sure short term rentals are legal. That may seem obvious, but i”d say most people who ask for advice haven’t considered this point and most of the homes they are considering aren’t going to but legally suitable for vacation rentals.

I’d go so far as to suggest you invest in locations only where there is a clear and fair framework for getting a permit and the city has already put it’s rules in place. If you’re in a location where the town hasn’t made its rules yet, it’s likely that when they do make their rules, it put your property out of business.

As related point, that’s why I like vacation rentals in vacation areas, as opposed to short term rentals in cities. Cities generally don’t want apartment buildings turned into hotels, so you’re skating on thin ice. Vacation areas generally do want vacationers there, though they don’t always want vacation rentals.

2. Rental Demand. Target places with strong year round demand and high overall occupancy.

It’s tough to cover your costs if people only want to visit your place in the summer. Its tough if people only want to stay at your place during the weekends. It’s not tough to cover your costs or even turn a profit if people want to stay year round and even during the weekdays. That’s why I like Hawaii, it’s amazing year round and people aren’t coming from just a weekend so it’s easy to fill weekday spots.

As a general rule of thumb, I like for places that have high season of at least 6 months, and where you still cover your costs on the off season.

In Sonoma, we’re generally booked from May till October pretty much non-stop. The off reason is still pretty good in November (because of Thanksgiving and the tail end of October’s harvest season. December is pretty good because of Christmas and New Years break. Sometimes randomly March will be completely full, especially after we’ve gotten more reviews on all the sites. January and February are generally pretty slow, but even still the weekends get booked up by people coming up to wine country from San Francisco. Or we’ll use the house then.

In Hawaii, the person we bought our home from had it booked at about 95% occupancy rate. He’d been running it for 21 years so had a built up clientele and high search rankings on Vrbo, so it will be though for us to replicate that in the short term, but in the long run, high occupancy is the goal. There is no offseason in Hawaii.

In San Francisco, the most popular market for second homes is Tahoe. We love Tahoe. We got married in Tahoe. Tahoe is amazing place to ski in the winter and a gorges place to go in the summer.

But it’s a very tough market to turn a profit in. Even people who love Tahoe don’t go up there in the Spring or Fall. You’ll literally have zero bookings for April, May, September, October. You’ll mostly be unbooked in November  and things will be spotty in June and sometimes even March. And during snow season, people mostly just want to rent the house on the weekend, and that’s when you might want to use it. And in the summer, unless you’re really near the lake, it’s hard to get bookings.

The other issue with Tahoe is there is a huge supply homes, that are mostly unbooked most of the year. As a result, in Tahoe it’s also very hard to stand out in the sea of homes, which brings me to my next point.

3. Differentiated Property. How does your property standout and not be a commodity?

A lot of people buy condos in vacation areas. I’m not 100% averse to condos per say, but if there are a hundred other units in a building that are identical to you, how are you supposed to standout? Your condo is essentially easily substitutable for any other condo in the building and that makes it a commodity. 

In general, the vacation rental market and Airbnb has gotten a lot more competitive. Your house needs to deliver some unique experience as well as standout in it’s pictures and reviews.

You know what’s not a commodity, spending the night in a water tower in Mendocino that’s been converted into a designer Airbnb. A decade ago, our friends Rob and Elsa moved to woods of Mendocino county. On their property was an old water tower, which they converted into the most stylish and unique Airbnb you will ever see. They have over 500 reviews of the place and just added a second cabin to their property. 

I’d go so far as to say they’ve created an amazing property out of thin air. It’s not even necessarily in a location that’s historically popular (Mendocino the town is popular tourist location, but this isn’t there it’s much more remote).

An emerging thesis of mine is that with insanely great design and guest experience, you can create the demand for a rental anywhere, even the middle of no where. I haven’t necessarily tested this (nor do I have world class design skills), but my thesis if you make someplace cool, people will come, even if it’s not a high demand tourist area. 

A related point to this, is perhaps think how will the pictures of your home play on Instagram? While I don’t necessarily think it would be easily to use Instagram to promote your property, I think the kinds of places that would be popular on Instagram (and Pinterest) would likely be popular on Airbnb. No image of IKEA furniture in a regular condo is going to go viral on Instagram, but water tower house sure will.

4. Do the numbers work? There needs to need to be a “margin of safety” in the financial model.

The fourth critical criteria i look at are if the financial numbers work. If it’s legal to to do short term rentals, if the market is high demand, and if the property is unique then I build a simple financial model.

I”ll share that model in a future posts, but the three components are revenue, ongoing costs, and initial costs.

Revenue is a projection of price times occupancy for each month. I look at the exiting calendars of Airbnb hosts to make a best guess of their occupancy by month and typically nightly price in each season. I’ve also used Airdna analytics service to get this, though can’t yet vouch for it’s accuracy either way. I ignore revenue you take in for the cleaning fees and taxes and assume that gets netted out as a cost.

On going costs are mortgage, utilities, service providers costs. I don’t put big expenses like replacing the HVAC system here (though you could), but rather i look to see if i’m going to be creating enough profit to cover these expenses. Other people may explicitely reserve for those costs.

For the course of the year, I added up the profit and that’s the “ cash return.” I compare that to my initial “cash investment” (downpayment plus renovation costs). I divided the two numbers to yield my “Cash on Cash Return.” Put differently, how much cash are you generating from your initial investment. I target a 18% cash on cash return for something to be interesting. This is your return before considering equity price appreciation (or depreciation if the value of your home falls). I don’t bank of equity appreciation as part of considering the deal, though if the home appreciates that’s great.

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So that’s how I quickly screen properties. Is it legal? Is it a high demand location? Could the property stand out? Do the numbers have some margin of safety with your cash returns? If it fits those criteria, then I’d suggest exploring further.