Until recently, the private lending world had significant concerns about the consistency of income from short-term rentals. Lenders are much more comfortable with an annual lease for a defined rental amount, which results in a low risk of significant vacancy.
With the explosive growth of Airbnb and VRBO, however, more real estate investors are looking to increase cash flows by renting properties on a short-term basis. In the past, it has made sense to rent this way in coastal towns or vacation destinations. But now, savvy investors are considering leasing a portion of their properties on an interim basis, whether they’re located in a hot tourist location or not.
Hurdles to Overcome
Here are the major hurdles to clear when investing in a short-term rental:
- Greater likelihood of vacancy than annual rentals
- Inconsistent rental rates during different times of the year
- Lack of data available for lenders to validate and confirm the rental estimates provided by the buyer—including both the expected vacancy and the rental rates.
For example, a real estate investor would like to purchase property in a Northeast skiing destination. If the property did not have an established history as a short-term rental, the lender would assume the property could be rented for about four to six months a year and would have zero income for the other six to eight months. This risk was something the lenders couldn’t fit into their previous credit models. As a result, they financed these properties with a reduced Loan To Value (LTV) of around 65%-70% and charged a rate 0.5%-1.5% higher than normal rental loans.
Methods for Evaluating Cash Flow
The private lending market is working hard to understand the risk and improve the loan options available for short-term rental purchases, but lenders are at different stages of product development.
The top lenders in the short-term lending space use these methods to evaluate the cash flow of a new short-term rental property:
- Require a 12-month history as a short-term rental
- Use the market rents from the appraisal, as if it were an annual rental lease
- Use a data source, like AirDNA,to estimate vacancy and rental rates
Typically, these lending practices are applied in the following ways.
Established rental history
If the property has a 12-month history as a short-term rental, the lender will review that information and the data from an AirDNA report, with a 20%-30% reduction from that estimate. The lender will use the lower of these estimates to determine whether the property will meet cash flow requirements with a full 75%-80% LTV loan in place.
No rental history – annual market rents meet requirements
Lenders will review the appraisal and the market rents, as if there were an annual lease in place. If the annual market rents work for the cash flow calculation, the lender will assume the property can be converted to an annual rental in the future, if needed. The lender will generally approve the loan if the income from the AirDNA report is equal to or greater than the annual market rent.
No rental history – annual market rents do not meet requirements
Lenders will consider financing properties at the maximum 75%-80% Loan to Value (LTV) even in situations where the annual market rents do not support a loan of this amount. Currently, lenders are using the AirDNA full report and assuming a reduction of 20%-30% from the gross estimated revenue. If the property meets the lender’s cash flow requirements with that reduction, the loan is approved for maximum LTV.
So, if one of these methods works for the loan request, you can expect similar rates and loan amounts as an annual rental loan from a private lender.
If all else fails, and the property does not meet any of these methods, there are a few lenders that will lend up to 75% LTV without considering the cash flows. These rates will be markedly higher, generally 0.5-1.5% based on the FICO score of the borrower.
So, while you’re on vacation this spring, stop by a real estate agent’s offices to see if you too can pick up a vacation rental for your portfolio. It could be the start of riding a new wave of investing.
Damon Riehl, founder and CEO of Investment Property Loan Exchange, has more than 35 years of lending experience in a broad array of asset classes, including commercial and residential mortgage, small business, and construction lending.
He held top leadership positions as head of commercial lending for Ocwen Mortgage, head of unsecured lending for Citibank, global mortgage leader for GE Capital, head of construction products at Fannie Mae, and a member of the Harvard Joint Centers for Housing Studies. Riehl has built six de novo lending platforms and used that knowledge to build and grow Investment Property Loan Exchange and the FinTech platform LoanBidz.com.
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