7.2 VRP Financial Projections

CHAPTER 7

the fourth year—and then remains steady. For example, when equipment or furnishings are new, you may choose to allot two percent to your reserve, increasing this to three, four, and fi ve percent in the next three consecutive years. This way, when it is time to renovate or replace, you will have the necessary funds.

Incorporating a preliminary FF&E budget during new construction planning is an essential cost control measure. You may fi nd that without it, FF&E can easily equal or exceed the cost of construction. A preliminary budget can help you determine whether your ideas fi t within your dollar limits. Thinking about FF&E needs during the planning stages can also help you create a shopping list—which may even be fun.

7.2 VRP Financial Projections

To make a reasonable fi nancial projection for your VRP, start with home sales data in vacation markets throughout the country. Then, look at actual performance data from all of the VRP markets in which you have interest (the places that you have an interest in traveling to and vacationing in). You can spend as much or as little time on this initial analysis as you wish, but it will impact your business performance.

You will be creating your own vacation rental investment guide that is both informed by local experts and confi rmed by comprehensive data. Make use of local Realtors and vacation management companies.

A few steps to remember:

• First, analyze historical home sales in your market of highdensity vacation rental sales. • Next, factor the average gross rental incomes less typical operating costs for vacation rental properties in your region. • Finally, compare each of your market’s net operating income with the cost of buying a vacation property. This will you a

WEALTH AS A VACATION

capitalization rate (cap rate), the rate of return on a real estate investment. • Cap rate does not consider the impact of mortgage fi nancing.

Look at whether it is above or below the interest rate. If the cap rate is greater than the interest rate, you’ll likely come out ahead.

How to Calculate Cap Rate The formula for calculating cap rate is simple: income, less expenses, divided by the purchase price. To estimate income for a vacation rental, there are websites that off er vacation rental income calculators that analyze millions of data points about the market and specifi c vacation home you’re considering. You can compare a particular home to similar properties with similar appeal to create a custom income estimate—an idea of how much the home could earn as a vacation rental. After estimating your earning potential, the next step in fi guring cap rate is to subtract your anticipated annual rental expenses and operating costs.

Cash Flow Analysis: A Sample Cap Rate Calculation for VRP A home with low expenses and operating costs in a high-demand market is likely to have a good cap rate. Expenses and operating costs will vary depending on location, the type of property you buy, and the method of property management you choose.

Don’t forget to factor in seasonal services that the property may require. For example, a four-bedroom beach house on the Florida coast may require additional maintenance due to wind, sand, and salt. A four-bedroom cabin in Vail, Colorado, may need regular snow shoveling or fallen tree removal. Take the time to fi gure utilities and taxes for each property when determining your expenses in vacation rental markets. Look for homes in lower-tax neighborhoods if you can.

Factor in wear and tear, or about 5–10 percent of your net rental income to cover updates. Add in your mortgage expense and your property management expenses. If you plan to self-manage, you will

CHAPTER 7

need to account for everything from cleaning, maintenance, supplies, and marketing to guest support, accounting, and insurance.

Is a higher or lower cap rate better? Bigger is generally better when it comes to cap rate—but it’s not everything. Cap rate doesn’t include things like potential equity growth or emotional value such as locking in a dream home for your retirement. Sometimes a home with a slightly lower cap rate is a better fi t for you and your family.

Note that cap rate doesn’t consider the benefi ts of potential appreciation. You can add the anticipated appreciation to your cap rate to estimate your total return. A 5 percent cap rate and 5 percent appreciation rate together provide you with a total return of 10 percent.

Imagine that a family wants to buy a four-bedroom vacation rental property near the beach. After speaking to experts in the area, they determined the average operating cost for two four-bedroom townhomes in the neighborhood they want to buy. The analysis is done by gathering similar homes in the area and calculating the average.

As an example, VRP #1 is beachfront but in poor condition and will need investment of about $100,000 into the home to make it vacation-rental ready. The home is on the market for $540,000 and it is expected to generate $40,000/year after operating costs. That’s a cap rate of 6.2 percent ($40,000/$640,000).

VRP #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 percent.

Comparing cap rates alone, even though VRP #2 is more expensive, it could provide them a better return on investment. But that isn’t the only consideration. The family could point to the work that house #1 needs to negotiate a better price. For example, they could negotiate the price of the sale down $100,000 to account for the $100,000 of upgrades needed. With the home price now at $440,000, the cap rate jumps to 7.4 percent ($40,000/$540,000), which is much closer to the earning potential of VRP #2.

To improve the cap rate for VRP #1 even further, the buyers could transform the unfi nished garage or bonus space into another