There’s no question about whether or not you deserve a second house. You work hard, care for your family and have your sights set on the future. Why shouldn’t you own a cabin in the woods or a condo on the beach?
Real estate is an excellent investment, and it’s one you’ll hear me praise regularly. For those who have the money to invest, buying a vacation rental that brings in passive income makes for a savvy purchase. However, it takes a lot of calculating to know if you’re ready to make this type of investment. It’s possible you’ll crunch the numbers and realize you’re closer to buying than you originally thought. There’s also a chance you’ll discover it’s going to be a few more years before you’ll be able to invest.
Beyond the initial asking price, you have to prepare for all the long-term issues that come with homeownership and renting. Owning a vacation property requires a unique combination of time and money management, so let’s get into the nitty gritty and figure out if it could actually work for you.
To have this conversation at all, you have to start with purchasing power. When it comes to acquiring property, I’m always encouraging homebuyers to avoid taking on an ugly mortgage. For those thinking about buying a vacation rental, you have a little wiggle room on the financing. My rule is to avoid debt whenever you’re buying something that isn’t an asset; in most cases, I don’t consider a home an asset, as people plan to live in their houses for quite some time without seeing any active returns.
With a rental property, money functions a little differently. If you’re going to generate steady income just by owning the house, you have some revenue to offset the costs of your mortgage. This opens the door for bringing in lenders who might help cover the down payment and then get reimbursed from earnings generated by the property.
When you consider a house that covers its own mortgage, you get a different perspective on borrowing and how much you can afford to spend. However, you still need to have enough capital to cover the initial fees and ensure you get the best purchasing terms. Depending on where you’re looking to buy, you can feasibly raise this type of cash in a reasonable amount of time. Affordable properties exist in a lot of nice U.S. cities. Here are just a few that were among the best places to buy in the summer of 2017:
You can’t answer the question of whether or not you can afford a second house until you decide where you want to look. With a little research, you can see where the housing market is still lagging, and that will help clarify how much money you need to buy a rental.
If you aren’t planning to rent the property out, you need to have enough cash to cover the purchase. Taking on a large mortgage just to have a second property is a dangerous proposition, as it can leave you underfunded when it comes to your day-to-day life. As much as I believe in real estate investing, I don’t think it’s smart to take on too much risk. Unless you can comfortably make payments and cover most of the cost upfront, it’s not the right time to buy a house you don’t plan on filling with tenants.
I’d be remiss to discuss buying a vacation property without getting into the business side of things. After all, if you do plan to use your second house as a part-time rental, you’d better make it worthwhile.
Let’s look at the two most common ways people use their vacation rentals, then break down the financial pros and cons of each.
You may or may not have heard these folks referred to as snowbirds – people who live half the year somewhere in the northern states, then book it for Florida, Texas or Baja when winter rolls in. If you love fall in New England but find the snow unbearable, you could probably get behind this lifestyle.
In this situation, the property becomes much more of a vacation home than a rental, but the house is still available for a large part of the year. In order to consider buying a vacation property that serves this purpose, you have to work out a lot of variables ahead of time.
For starters, you’re not going to be able to earn the same tax deductions as you would with an actual rental property. If you’re living in a house for six months out of the year, the IRS isn’t going to view you as much of a landlord. In addition to thinking about lost deductions, you also have to consider reduced earnings. For a large portion of the year, that property won’t net you any income, and that means the mortgage and property taxes will take a bigger bite out of your finances.
Perhaps the most fundamental question for seasonal renters is how to keep the house occupied. When you lose the ability to keep long-term renters, you have to specifically cater to the vacationing crowd, and that means a lot more work on the management side. Frequent turnover leads to more upkeep and more time spent finding tenants for your place. In some cases you can benefit from short-term rentals; it’s easier to charge a premium rate when people are only going to use the space for a few days at a time. The more pressing issue is getting the word out and making sure enough renters make use of your property.
This option makes the most sense for retirees who have enough money to cover the basic costs and just want a little rent money to help with property taxes. If you’re flush with cash and have the flexibility to make use of a second property, the only thing you really have to think about is how much effort you want to put into managing a rental when you’re not there. For those who rely on tenants to offset money spent on real estate, it’s best to steer clear of snowbirding.
In this case, the house you buy is specifically a rental and not so much a vacation property – at least not at first. If you want to own a house that will pay for itself and provide you with a valuable asset, this is the way to go.
As long as you don’t stay in your rental for more than two weeks out of the year, you can deduct insurance, interest and maintenance fees against the money paid by renters. This makes a massive difference in your out-of-pocket expenses. If you use the property beyond those 14 days, you can still claim some deductions, but the process just becomes much more complicated. Renting a vacation home also allows you to deduct yearly depreciation, though that can mess up your capital gains numbers if and when you decide to sell the property.
If you’re worried being a full-time landlord defeats the purpose of buying a vacation home, that’s a very legitimate concern. However, this is often the best way to pay for a house that can be used for vacations or retirement in your later years. You can also rent at a discount to friends and family, and you’ve always got those two weeks out of the year when you can stay somewhere for free.
When it comes to affordability, you’ll clearly save money by renting your property throughout the year. That might not be ideal for someone who wants to have near-constant access to a second house, it is the best way to buy a vacation rental without taking on a bunch of cumbersome debt.
While I readily endorse investing in a rental property (check out this post where I discuss real estate investment in detail), I have to stress that this will not make you rich. Even if you buy a multi-family building and fill every unit immediately, you can’t expect to be free of financial woes. It’s not my intention to scare you out of buying a vacation rental, but I do think it’s necessary to go over the financial realities of this type of investment.
First of all, think about the general fees that come with homeownership. Beyond the deposit, mortgage and taxes, you have to fix things; you have to buy materials and hire contractors; you have to cover inspection costs and deal with permits. There’s nothing simple about buying a house, and there’s certainly no world in which it’s a cheap endeavor.
Let’s assume you get a fixed interest rate on a 15-year mortgage, and it seems like rental fees will mostly cover that monthly bill. That’s a sweet deal, right? More often than not, I’m going to advise you make that investment. However, you still have to watch out for a tax hike or a change in code that reduces some of your tax benefits. The fees you pay on your property are always subject to rise, and those costs don’t necessarily coincide with the rental market. If you’re planning on renters’ fees covering the cost of your property, you need to give a generous estimate as to what’s going to happen with property taxes.
You also have to account for fluctuations within the real estate market as a whole. Some of the hardest-hit areas during the recession were places with a large percentage of vacation rentals – that’s part of the reason it’s still more affordable to buy in states like Florida, Nevada and Missouri. If you sink money into a rental and the economy takes a turn, will you be able to weather the storm until the market is able to right the ship? For all the years during which a rental will provide income, there may also be times when that second house proves to be a financial burden. This shouldn’t make you avoid real estate all together, but you certainly need to consider economic ebbs and flows before saddling yourself with a second property.
Should fees stay reasonable and the market holds strong, there’s still one last pitfall that can throw a wrench in your gears – bad renters. You know how some property owners talk about certain tenants like they’re the best people in the world? That’s because the opposite type of renter is out there, and they make the life of a landlord very difficult.
I’m not talking about your average tenant who’s late on paying rent and doesn’t take good care of the yard. Those people can also set you back, but it’s the renter who actually does damage to your property you need to be prepared for. Whether it’s making a mess inside that costs thousands of dollars to clean, or legitimately destroying part of the house through a negligent act, part-time renting has the potential to become a full-time headache.
While insurance can take care of a lot of the damage-related costs, and small claims court can settle ongoing disputes, the thing that can’t be replaced is the time you lose. For every hour spent trying to get the money you’re owed, you miss out on rental fees that could be coming from a respectful tenant. The cost of insufficiently vetting prospective renters is higher than you might think.
In a roundabout way, all of these issues factor into affordability. Even if you’re financially prepared to buy a vacation rental, you have to figure out whether you have the time and drive to make it all worthwhile. The better prepared you are to handle these issues, the more likely you are to be happy with your vacation property.
While it’s necessary to think about all the minutia and variables that come with buying a vacation home, that analysis alone won’t give you all the answers. To figure out whether or not you can truly afford a second property, you have to weigh the pros and cons against your personal goals.
If your main objective is to earn income, you need to decide how much monthly income is enough to make it worthwhile. Let’s say you’re going to get $2,000 each month in rent, which is a generous amount in some parts of the country, and not a lot in others. Will that cover your expenses and still put a little cash into your bank account?
For those looking to turn cash on hand into a future investment that can also be used for weekend getaways, you have to research the region in which you’re looking to buy. You might not be able to predict the real estate market with much accuracy, but you can certainly check trends and see if housing sales are on the rise. Realtors are constantly releasing housing market data, and that information can be very useful to anyone who’s on the fence about making a purchase.
As you consider these factors and assess your own finances, remember that a second house is a big commitment. Deciding whether or not you can invest in real estate is as much about your lifestyle as it is your wealth. As long as you’re fully aware of the risks, rewards and realities of a vacation property, you can afford to start shopping around.