How do you estimate vacation rental or Airbnb expenses and operating costs when determining cap rate?
A vacation home with low expenses and operating costs in a high-demand real estate market is likely to have a good cap rate. Expenses and operating costs will vary depending on a variety of factors, including location, the type of property you buy, and the method of property management you prefer (full-service or self-management).
When estimating your anticipated vacation rental expenses, don’t forget to factor in seasonal services that the property may require. For example, a four-bedroom beach house on the Gulf Coast may require additional maintenance due to wind, sand, and salt. In contrast, a four-bedroom cabin in Keystone, Colorado, may need regular snow shoveling or fallen tree removal services.
Take the time to figure out utilities and taxes for each property when determining your expenses in vacation rental markets. Sometimes finding a better cap rate is as simple as searching for homes in lower-tax neighborhoods that still hold appeal for guests.
If you plan to host guests regularly in your vacation home, you should expect a bit of wear and tear. Factoring in things like maintenance, replacement, and repair costs, you should budget around 5%–10% of your net rental income to cover updates. You can then factor in your mortgage.
The most variable expense to consider when determining cap rate is property management. If you plan to self-manage, you will need to account for everything from cleaning, maintenance, supplies, and marketing to guest support, accounting, and insurance. Or you can use a full-service vacation rental property manager, like Vacasa.
Working with a full-service property manager not only means someone else is doing all of this work for you, it also consolidates all of your property management expenses so that you can more easily factor cap rate.
Which is better: a higher cap rate or a lower cap rate?
A higher number is generally better when it comes to cap rate—but it’s not everything. If you’re deciding between a vacation rental property with a 6% cap rate and another with a 2% cap rate, you’ll get a higher return on investment with the 6% property. But there’s more to think about.
Cap rate doesn’t include potential equity growth or emotional value such as locking in a dream home for retirement. Sometimes a home with a slightly lower cap rate is simply a better fit for you and your family.
What is a good cap rate for rental property?
What you’ll consider a good target cap rate will vary based on the market—due to differing rental demand, property types, and home prices. For example, for a large cabin in Moosehead Lake, Maine, you might be negotiating for 5% to 8% cap rates, whereas, for a condo in Park City, Utah, you may be happy comparing properties in the 3% to 5% cap rate range.
Does cap rate take into account appreciation?
Cap rate doesn’t consider the benefits of potential appreciation. As a shortcut, you can add the anticipated appreciation to your cap rate to estimate your total return. A 5% cap rate and 5% appreciation give a total return of 10%, comparing favorably to current interest rates and long-term stock market returns.
How is cap rate used in real estate?
Consider this example:
The Smith family wants to buy a four-bedroom vacation rental property near the beach. After speaking to rental property managers, they've determined the average operating cost for two four-bedroom townhomes in the neighborhood they want to buy.
Vacation home #1 is beachfront but in poor condition. The Smiths estimate they would need to invest about $100,000 into the home to make it vacation-rental ready. The home is on the market for $540,000 and the Smiths expect it to generate $40,000/year after operating costs. That's a cap rate of 6.2% ($40,000/$640,000).
Vacation home #2 is two blocks from the beach but features modern design and a hot tub. It costs $553,000 and is expected to generate $40,000 after operating costs. That's a cap rate of 7.2%.
Comparing cap rates alone, the Smith family sees that even though vacation home #2 is more expensive, it could provide them with a better return on their investment. But that isn't their only consideration.
They could leverage the work that house #1 needs to negotiate a better price. For example, let’s say they’re able to negotiate the price of the sale down $100,000 to account for the $100,000 of upgrades they need to do. With the home price now at $440,000, their cap rate jumps to 7.4% ($40,000/$540,000), much closer to the earning potential of house #1.
To improve their cap rate for home #1 even further, they could transform the unfinished basement into another room for $10,000, bringing the earning potential of the home up from $40,000/year to $60,000/year. Factoring the additional construction cost for the new room into the home price means they’ll be investing a total of $550,000. But with the increased earning potential, their cap rate becomes 10.9%($60,000/$550,000)—their best option so far.
If they can’t negotiate, the Smiths must figure value beyond cap rate. For example, does owning beachfront property where they may someday retire warrant buying a home with slightly lower earning potential on the vacation rental market?
Can you find market cap rates for vacation rentals?
We compile market cap rates to help vacation rental property buyers find the markets that are delivering the best returns on investment. You can learn more about these markets in our Top 25 Best Places to Buy a Vacation Home report.
Knowing what a cap rate is and why it’s important will help you make a more informed decision when buying a vacation rental. And you don't have to be a real estate investor to understand the basics. Check out all of our tips on buying a vacation rental.
What is cash-on-cash return?
A related metric that considers mortgage financing is cash-on-cash return, which compares cash flows, minus financing expenses, with the down payment. Cash-on-cash returns just consider the difference between the income and the mortgage against the down payment, so they can be extremely sensitive to variations in performance.
For example:
$600,000 purchase price
$100,000 down payment
$1,800 monthly mortgage payment
