STR ROI
How to Calculate the ROI of a Short Term Rental (STR)
STRs are becoming a more popular investment option in Real Estate, but it's important to do your research before you invest. STRs come with more operational complexity and regulatory risk than a traditional Long Term Rental (LTR) so it is important to make sure you have a strong Return on Investment (ROI) to compensate.
ROI is a measure of how much profit you can expect to make from an investment, and then when you are operating how much your actual ROI is. It is calculated by dividing the profit by the investment amount. For example, if you invest $100,000 in an STR and make $20,000 in profit, your ROI would be 20%. Sometimes this is also referred to as a Capital Rate (CapRate). But what goes into those numbers? Well discuss more!
What goes into an ROI Calculation
There are a few things you need to know in order to calculate the ROI of an STR:
The purchase price of the property including closing expenses
The cost of repairs and renovations
The cost of furnishings and other amenities
The cost of property management (Management commissions and contractor expenses)
Permitting
Property Taxes
Utilities
Insurance
The cost of marketing and advertising
Software Subscriptions
Rental income
Fee Income
When calculating your CapRate or ROI it is important to think through all the costs. The last thing you want to do when entering an investment is underestimate the expense side of the equation if you are relying on the cash flow.
Property Acquisition Cost Side
On the property cost side it is important to get this dialed in so you know all the costs associated with acquiring the property and setting it up. This side of the equation are the expenses you will face before you start earning revenue. Incorrectly estimating this side and running out of cash may mean the revenue wont be there to offset. It is important to understand renovations required with a good inspection to avoid costly mistakes.
With the acquisition side it is important to know with very strong confidence that your property can operate as a legal STR and the regulatory landscape is safe. The last thing you want to do is buy a property that cannot be rented as a STR, is held up in permitting or becomes illegal.
Operational Cost Side
On the operational side of running your STR it is very important to have your game plan set up. Are you going to self manage, if so how much time and do you have your contractors lined up to support you. It is important to get a true sense of these costs and the work involved. Running a STR is not a passive endeavor there will be issues that pop up, late night phone calls and sprints to get things dialed in between guests.
If you are going with a professional manager, it is a great idea to get commission proposals from them as well as estimates on typical costs of managing a STR. If they are a reputable manager they have a good idea of what repairs, utilities or other surprise expenses might cost you. A professional STR manager will be your best ally in knowing your unknowns.
A good manager will also help you to understand technology and marketing costs, though if you sign up with a STR manager they will likely be covering these costs for you as part of their management fee.
Carrying Cost Side
This is probably one of the more easier sides to calculate since taxes, HOA payments, insurance etc are easy to quote up front and do not change as often.
Revenue Side
Until you start operating your property you will have to forecast your revenue. A good STR manager will be able to help you refine your estimates. Using scraped data is a great way to build a strong CompSet to see what rates, occupancy and level of effort each Comp was putting in. You will want to evaluate homes that are giving it a professional try by filtering to those giving the same level of effort you plan to with an open calendar. From there you can put together ADR and Occupancy assumptions for as granular as you want to build out your forecasting model.
Once your property is up and running you will want to make sure you are tracking pacing against your expectations to make sure your property will devlier. With a strong revenue management strategy you might even be able to out perform.
Ofcourse, make sure you pay attention to every guest revenue early. These will be full of gems of information on how to make your property better, stand out and perform. If guests wish there were more chairs at the dining table, had more privacy or the home was a little too drafty take these all in to consideration to drive a better and better product.
The Math
Once you have all of this information, you can use the following formula to calculate your ROI or CapRate:
ROI = (Profit / Investment Amount) x 100
For example, if you invest $100,000 in an STR and make $20,000 in profit, your ROI would be 20%.
It's important to note that the ROI of an STR can vary depending on a number of factors, including the location of the property, the type of property, and global economic factors. However, by following the steps above, you can get a good estimate of the ROI of an STR before you invest.
Here are some additional tips for calculating the ROI of an STR:
Be realistic about your costs. Don't forget to factor in things like property taxes, insurance, and maintenance costs.
Use historical data to get an idea of the ADR and occupancy rate for your target market.
Consider the seasonality of your market. Some markets are more popular during certain times of the year than others.
Build in a buffer for unexpected expenses. Things like unexpected repairs and vacancies can cut into your profits.
By following these tips, you can calculate the ROI of an STR and make an informed investment decision.
What is a Good ROI or CapRate?
A good CapRate or ROI will vary by market, property type and year as well as what your goal is for the property.
If you are buying your first STR you may have the goal of using the property for your family in which case you may want to measure against a 3% CapRate so your family gets a free vacation home while you earn enough ROI to cover maintenance and repairs.
If you are building a portfolio of STRs and your goal is financial freedom you might be targeting an 8% - 12% CapRate. It is very important to be realistic about your expectations. If someone is showing you a CapRate of 25% dig deeper into their revenue and cost assumptions, these typically do not exist on the open market and if they did there is either a reason (regulatory) or data issue--otherwise the person showing you would buy it.
Building a CapRate, if you find a 3% property but you want a 10% or more you can still get there. Look at the property itself, can you add an ADU or additional bedroom conversions to the property? For example if you find a 4,000 square foot 3 Bedroom house could you add 2 more Bedrooms to drive occupancy? Or are there amenities that would appeal to your target demographic? Another example might be a home on large acreage that could be used for camping, new units, timber or RVs etc. Great returns are reserved for those we are delivering great value, keep that in mind on how to improve the property beyond what is at face value.
The Impact of Financing
Of course CapRates and ROI are only one part of the equation. You are most likely going to use some form of debt or leverage for the property you are evaluating. This form of return measurement is called a Cash on Cash return. Meaning if you bought a property for $100K but had 80% leverage or Loan to Value (LTV) that means you only put $20K down. So if your property was a 5% ROI or 5 Cap you are earning $5,000 on $20,000 a 25% Cash on Cash return! You will want to make sure you take in to account your debt servicing on the net income portion of the math of course.
Interested in building your own deal finding platform or tool? Hungry Robots can help with the largest coverage of STR scraped data to help you model forecasts and property returns.