By Douglas Katz – 12/13/2022
The short-term rental market has exploded over the past few years. According to AirDNA, an increase in listings of over 60% since 2020. A simple internet search on short-term rentals will undoubtedly provide article after article about averages Joes who have made it big with giant portfolios of rental properties. Like anything with uncommon growth and huge revenue numbers like this space, some have begun to ring alarm bells over the risk. Everything from non-standard loans and lending practices to questions on the continues ability for especially luxury hosts to cover the expenses have some analysts and industry experts worried that we could see some challenges.
First off, investment properties, any investment properties, are a riskier proposition because the success or failure of the property’s owner to cover the expenses depends on low vacancy, good business practices and sufficient rent. The same analysis from AirDNA that showed the colossal increase in listings has shown a decrease in bookings of about 1.2%. When these numbers are out of alignment there is either too much supply or too much demand. All signs point to the former and that is not good for the property owners and the lenders are taking note. Long-term rentals lock in revenue with leases covering longer periods of time. This provides less uncertainty and less risk. While short-term rentals do on the whole generate significantly more revenue than long-term rentals, the risks are also much greater.
Unlike long-term rentals, the short-term rental market depends on people using disposable income for vacations where they need a place to stay. If demand drops, many hosts will find it harder to rent their properties or they will need lower their rates to get more bookings. This is a double whammy as not only will the number of renters decrease but the boom in new hosts has created significant competition in the most desirable areas. Some owner operators have built solid businesses with sufficient reserves, but many have not and lower vacancies could stress some owners to the point of failure.
The loans have also come under scrutiny. Most of the criticism has stemmed from the lender’s income analysis and other safeguards. Critics of the non-conventional rental loan market cite models that disregard other components of a borrowers income and employment picture. Most of these loans do in fact use the income from the property as the sole source of approval, but this is usually balanced either by considering other compensating factors or establishing a debt service coverage ratio at the appropriate level to support the property even if some assumptions change. Additionally, extensive requirements for reserves to insulate against shocks to an host/owners business.
Competency and desire to be a landlord/host are also beginning to impact the market. It is very common, especially in industries like real estate, for neophytes to act on the siren’s call of easy money and to chase an “easy” fortune. The reality that many find are late night calls, bad guests who trash the property, difficulties finding decent help with cleaning and maintenance as well as everything else that comes with running a business. I would expect that more and more current hosts will reduce their footprint or completely exit the market, especially if the renting becomes harder.
Finally, the big regulatory question. Municipalities have begun to get pressure on several fronts that they are in turn dealing with which are putting short-term rentals right in the cross hairs. The first is the impact on housing. Every short-term rental property that gets listed is one less property that an owner-occupant cannot buy. With housing a major concern in almost every market, politicians are taking note especially when votes and public are at stake. Add to this the complaints by many of the current homeowners living next to short-term rentals about noise, trash and even crime and you have a major concern for local government. Finally, the revenue or potential revenue for municipalities in terms of inspections, licensing and taxes mean that governments will want these properties but only when it benefits them and right now that is a problem. A recent study on the Los Angeles market showed that almost 50% of short-term rentals did not adhere to local regulations and statutes and I would expect this to be more the norm than the exception as this is a very new space. I anticipate that this will not last and regulations and enforcement will increase.
Does any of this mean that the short-term market is poised to crash. In my opinion, no. As an experienced lender with a history of lending to real estate investors, I can tell you that the current products are much more thoughtfully designed and managed than previous cycles. There is no doubt that some investors will fail, but a large scale implosion is unlikely. What I do expect is a consolidation. As costs and challenges grow there will be failures, foreclosures and short sales. Some of these properties will get snapped up by stronger investors. Others will find their way into the residential inventory where buyers are still eager for homes. In the end, a reset of this market is coming but it will be far from a vacation rental home apocalypse.