So far, I’ve talked about my military real estate strategy, mortgage rate shopping, and the tax advantages of real estate. The goal of this post is to delve into differences between the two, main types of residential real estate investments – active and passive real estate properties. This blog has dealt with real estate in general terms, but I wanted to go into depth with lessons learned between active and passive investments. The bottom-line-up-front: there’s significant potential to increase ROI with active real estate investments as long as you have time, a willingness to manage a short-term rental (STR), or can find a management company that will.
The name says it all. Active real estate investments require constant investor involvement to accommodate multiple guests per week or month. In my experience, dealing with a high churn of tenants, ensuring sheets/towels are clean, and making beds is much closer to the hospitality industry than I ever imagined or experienced with long-term tenants in passive real estate investing. Vertically integrating, accomplishing make-ready tasks, maintenance, and managing bookings yourself greatly increases your opportunity for a high ROI. However, it also leaves you open to doing multiple activities you may not enjoy – low return on your time investment! Finding a great make-ready company that can clean, re-supply items, and reset lock boxes following each guest can make all the difference in the world. We’ve been running an AirBnB for almost 5 months (and just made Superhost!), so I finally feel we’ve reached a point where we can honestly assess the experience and make a fair comparison with passive real estate investing. There isn’t a right answer, but hosting an AirBnB has definitely required more effort and time than I initially (or ever!) expected, but it has also been a rewarding experience (for the most part). Below are my initial thoughts and experiences while hosting with AirBnB.
Ratings Matter: First off, you have to be ok with entering the hospitality industry and dealing with guests. Accommodating last-minute schedule changes, refunding cancellations, providing additional pots and pans, high-chairs, etc, are all a part of the typical AirBnB hosting experience. Because the AirBnB algorithm for search rankings depends on your reviews and “Superhost” status, there is a definite preoccupation with being customer-focused to receive good reviews, especially in the beginning. Before you’ve received 20 or more reviews, 1 bad review can be a challenge to recover from. Besides dealing with occasional maintenance requests, being a landlord for a long-term tenant, however, has always felt like an investment versus hospitality. While I like to provide the best value and resident experience possible, there’s no universal feedback mechanism for long-term tenants to broadcast their experience to new, potential tenants, or a preoccupation with receiving a “5-Star Review.”
Upfront Expenses: We generally buy newer homes for our passive real-estate investments to keep maintenance and repair expenses low. So far, this strategy has avoided any persistence or late-night maintenance headaches and has not required a large capital outlay to begin generating revenue from long-term tenants. However, we underestimated the initial investment in furniture, appliances, and utensils required to get an AirBnB up and running. The great thing about receiving reviews from guests is that they will definitely let you know if your space lacks any necessity they’re looking for! Specifically, because we were purchasing items that we rarely purchase and had never done a STR before, we had no baseline of what to expect. $200 mattresses/bedframes, $250 washer/dryer, and $12 spatulas add up! In total, we spent around $2,800 getting the initial items required for our AirBnB to be up-and-running (2 bedroom, 1 bath home of about 1000 sqft). This doesn’t account some additional pots/pans and blinds that we had to buy after receiving some critical reviews from guests 🙂
Revenue Fluctuations: Passive investing nets you the same check every month, as outlined in your contract. While there’s not a lot of opportunity for increasing ROI besides annual rent increases, there’s stability and a safety-net knowing the exact amount that will be deposited on the 1st of each month. However, with our STR, especially during the COVID-19 Pandemic, we have had high-magnitude fluctuations in revenue each month; our largest fluctuation was a revenue reduction of around 21% when the colder months began approaching. We reduce risk with these fluctuations by utilizing three methods which were not as critical (although still involved in) our passive real estate investments: carrying a cash reserve, ensuring lean operating expenses, and making conservative occupancy assumptions.
- Cash Reserve: Because of the high degree of due diligence we do with long-term tenants, we never considered a high cash reserve to be critical when dealing with passive real estate investments. We do a thorough credit and background check, ensure a low debt/income ratio of our tenants, and verify the tenant’s gross income is a 3x multiple of the required monthly rent in our passive real estate properties. The due diligence and lease contract in place largely guarantee the security of our monthly rent, which reduces the risk of non-payment. However, there’s no guarantee of monthly rent in a STR, and there’s no due diligence in who will be staying at your STR or if their plans may change. While you can have a strict cancellation policy in place, there’s still no guaranteeing your gross revenue will be the same each month. Because of this, we keep a 6-month cash reserve to cover expenses if there’s a rough month (or couple of months). In our case, for our 1x AirBnB, this requires a cash reserve of approximately $6,000 USD.
- Lean Operating Expenses: In our experience, we wanted to learn the AirBnB business inside and out before hiring any management services or automating the cleaning process; this also served to keep our monthly expenses as low as possible. We fixed the toilet, unclogged sinks, cleaned, and did the laundry ourselves. We learned a couple of things during the process. First off, have the guests help you have an easy make-ready and set you (or your cleaning company) up for success. Request that they strip the beds, wash the dishes, and take out the trash prior to the end of their stay. At a minimum, I think these requests are extremely helpful and well within your ability to request as a host. Secondly, try to make cleaning easy. Have all laundry items fit into as few loads as possible, all utensils/dishware fit into one load in the dishwasher, and have an extra set of all bedsheets/linens so you can rotate and have these cleaned and ready between guests; not having to do laundry at a STR after each stay can save hours. In general, our operating expenses included our mortgage escrow (principal/interest/insurance/PMI), utilities, and high-speed internet. Because we initially did all of the cleaning, our expenses were as lean as possible, but still higher than our passive investments. We have higher carrying expenses because utilities are in our name, we’re paying for internet, and insurance was higher for a STR.
- Conservative Occupancy Assumptions: In long-term real estate investing, vacancy between tenants should always be an important expense that you account for. However, vacancy/occupancy is even more important in STR because it will drive your monthly break-even as opposed to just being a factor between annual leases. In our specific example, we wanted to break-even with an occupancy rate of less than 50% per month. With our current expenses, our AirBnB break-even is after the 11th night is booked (with 1x assumed cleaning fee). These conservative occupancy assumptions reduce risk because the break-even is set at a very low bar, which is highly-likely to be surpassed. Essentially, as long as every weekend is booked, with three additional week days throughout the month, we have covered all operating expenses.
In summary, the primary differences we have observed with a STR are that guest reviews/ratings are important, there are higher upfront costs, and high-magnitude revenue fluctuations each month – be prepared! We mitigated risk associated with monthly revenue fluctuations by having a 6-month cash reserve, lean operating expenses, and conservative occupancy assumptions. These lessons learned are all in addition to the obvious, which is having a STR is a lot of work unless you have the profit margin and ability to automate the process with a management company, cleaning company, or both.