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STR to Primary Game
The STR to Primary Game
On the subject of where profit accrues, one of the biggest potential wins, especially for higher income folks is what I call the STR to Primary.
There still is a way to win at the STR game but it’s not really being an STR operator. It’s leveraging the tax code to obtain a property you want as a primary or secondary residence, reducing the overall cost during your time of ownership. Here is how you do it.
Find the property you want and purchase it.
Conduct a cost seg study, setting up shorter depreciation lives for a portion of the property. This allows you to accelerate considerable depreciation into Y1.
Outfit and furnish it, down to the art, exactly how you want it. This is subject to bonus depreciation in Y1. If you were doing it for your own house, you would get no possibility of deduction.
Generate STR bookings. Feel free to set the price on the high side and keep the bookings on the low side, but you do want some activity, ideally, somewhat decent and regular activity.
Maintain this for about 18 months. After which, you shut down the STR operation and occupy the house. It’s your only choice for such a money losing proposition, right?
When you go to sell the property, you are required to recapture this depreciation so technically, it is a deferral, not a total write off. However, if you hold the house for 10 or 15 or more years, this is a significant benefit.
This allows you to buy the property you want, get a good size tax break in Y1, do some work for 18 months and then have your property. Don’t forget to thank me.
So you want to buy an existing STR? What should you look out for?
I see a lot of properties for sale that are currently operated as STRs (Short Term Rentals). These usually come with revenue numbers (unless the revenue numbers are bad) and some expense detail. Invariably, the net income always looks great relative to the list price. This is true for all businesses for sale but we will break apart STRs only right now and save business brokers for another day.
The first thing to do after assessing the value of the property in your own eyes and with your own comps is to decide if there is a business premium. Often, these properties are sold (or attempted to be sold) at a higher price because of their income abilities. So, how much more is the property listed at than it is worth?
Next, break up the revenue number. How solid is this? Is there a multi year history supporting this number? Is there booking data supporting it? A tax return? What I often see here are excuses. Oh…the owner used it more last year so revenue wasn’t all that good. Really? Or, did they use it more because it wasn’t booked? Remember, you are paying for what exists, not what the owner thinks can be. If it could BE easily, it already would be.
After that, are the costs legit? I routinely see properties in which the owner does a lot of the work..the maid service, the maintenance, etc. Those are jobs. You don’t pay a premium to get a job anyone can get. It’s good if you want to do that work and have the time, but don’t pay for it. You should see the following costs on any P&L you receive.
Cleaning
Maintenance
Insurance
Property Tax
Supplies
Hotel Tax (possibly, depending upon how they are accounting for it)
If you don’t see these items, you need to add them in when calculating your expected return.
You can make money with an STR just as with long term rentals and other investments. But, there are more variables at play than with a long term rental demanding a higher rate of return and make sure you understand the time and cost it will take to operate it successfully. If you are completely hands off and outsource everything, there likely will not be much left unless you purchase at a bargain price.
Additionally, keep in mind that if the income from the STR activity is supporting a price in excess of market price for a residence, if your income declines, so too will your value. Your downside risk is greater in this case, just as theoretically, your upside possibilities are greater too. However, often what I see is a downside risk that is greater than the upside from increased bookings and asset appreciation.
Do you understand your business model? A VRBO example.
In every business in every industry, there are a variety of actors and participants. A business model is simply an outline and clarification of how you make money offering the product that you offer. When diving into any business, though, it is important to understand where the money is flowing and who the elephants in the industry and supply chain are. Often times, where you think the money is is not actually where it is.
Let’s look at VRBO activity today as an example. These take many forms but the two basic models are I have an extra house I don’t use all the time and I want to rent it out and make a little money. I don't really care about the profit and the returns because I don’t have to worry about the cash flow and my main goal is to use it. The other form is I am going to buy this house and rent it out ad hoc, make a profit and maybe even get to use it for free too. The latter is a business intent. Before you get into it, understand who is making the money where you are.
Central to any real estate purchase, from a financial view, is cap rate. I’ve written a previous brief on cap rate. Be sure to read that. With a VRBO, you have new tenants every few days. The risk level is higher than with a straight long term rental. As such, your returns should be higher for accommodating that risk. So, the first question is can it generate enough revenue to generate enough net income to hit the cap rate required?
Many people purchase a property without actually calculating likely, max and min potential revenue based on logical occupancy rates for the area. $200 a night sounds good but if reasonable occupancy is 20% of available room nights, it might not be that good. So, understand your revenue potential and likely numbers. Understand what it will take to get that revenue and who the intermediaries are that you may have to go through. Stress test your model at varying occupancy rates. If you are being told the occupancy rates are high (75% for example), test out why that is. Don’t take it as fact. Are there any demand drivers in your area during the week? Consistently during the week. Two festivals a year does not a profitable rental make.
Next, what are your costs. This gets into understanding who makes money. To generate your revenue, you are going to almost certainly have to use a booking site like vrbo.com or airbnb.com. They take their cut. It’s large. Yes, you can put that on to the customer but it does add heft to your bill. It’s not an invisible cost any more than real estate broker fees are invisible.
After that, what do you have? Electricity, gas, water, cable, internet, maintenance on the hot tub, supplies. But, what supplies? Towels, pillows, toiletries, etc. These wear out much faster than the ones at home do, particularly if you want to maintain a good guest experience.
What else? CLEANING. You have to clean the property. You can hire people or a service or you can be the maid yourself. But, did you buy a VRBO property so you could be a maid? You can get that job for free and people will pay YOU to do it. That’s a hard job. But, be careful. Here is where the business model gets fun. This can get very expensive. Particularly if the service is charging a percent of the revenue. Particularly if you are in an area that sells this dream to people who don’t live in that town. The locals will fleece you so, you have to understand this component well.
In my experience, the biggest determinants to your profit outside of Revenue are as follows
Booking costs
Cleaning costs
Property tax
Maintenance
To generate max returns, you have to bring as much of this internal as you can. For example, in the cleaning service fee, why would you pay a percent of revenue? A three night stay becomes 3x as expensive as a 1 night stay but with the same work for the cleaning team. Break their costs down to the hour and make it a checklist. Make sure they earn enough to justify their travel time to your place. Make sure they earn enough from you each month to make it interesting. Hire individuals and not a service. Regardless, break down their costs and control them or it will eat you. If too many people are taking their cut, there won’t be anything left for you to eat.
The same is true for maintenance and booking, to an extent.
You may not be able to control all but if you don’t control a majority, you’ll be in sad shape with your financials and there will be no profit left. And, that’s sad. It makes me sad when there is no profit.