Wednesday, 20 August 2008 09:54 am

Can You Make A Profit

Unless you have unlimited funds and have no interest in whether or not your vacation rental home is profitable, at some point you will need to sit down and do some figuring. Think in terms of two broad areas when calculating the cost of owning a rental home:

• The first area is the capital cost of purchasing the home, which will be represented in the profitability equation by the cost of having this amount of money tied up in the property.  This cost may be mortgage interest, or it may be lost interest in capital that could have been invested elsewhere, or in most cases it will be a combination of the two.
• The second cost area is the day-to-day running costs that leave your bank account, hopefully to be replaced by regular rental income.  Into this area we will also put any costs of improvement, upgrading or maintenance.

We also need to think in terms of two broad areas when we calculate income to offset these costs.

• The first area of income is the regular rental cheques that you are putting into your bank account.
• The second area is the more obscure, but also important, area of capital appreciation - the fact that your home will likely increase in value year by year.  We will also need to offset this against the cost of ownership.

Capital Costs:

Let us say that you buy your rental property for $160,000.  You may set up a mortgage for part of this sum.  Here, we will assume a 50% mortgage, but you can put in your own numbers.  Let us say you pay 5%, which seems to be in the right sort of range these days.  Let us also say that the part of the purchase price that we paid up front from savings would have earned 3% if we hadn't tied it up in our new home.  So every year we are paying 5% of $80,000 ($4,000) to the mortgage company, and losing 3% of $80,000 ($2,400) from the capital we put in.  This totals $6,400 a year, which we take forward to add on to our running costs in the next section.

Annual cost of capital investment = $6,400

Running costs:

There is really no such thing as a 'typical' set of costs, but we have to set down at least an indication to try and help you.

• Taxes, insurance, licenses, etc. $2,500
• Routine maintenance, lawns, pest control, etc. $2,000
• Utilities, phone and TV $3,000
• Margin for unexpected 'extras' $2,000 (variable)
• Maintenance and replacements $2,000 (variable)
• Fund towards major costs $3,500 (variable)

Average annual running costs = $15,000

You will notice that one major running cost is not included here.  This is the cost of end-of-rental cleans.  Since this is a cost that is directly dependent on the number and pattern of your rentals, we have included it below in the income calculation.  All of the other costs are more or less fixed irrespective of how many rental bookings you take.  In particular, don't underestimate the cost of major replacements, refurnishing, etc.  It is easy to be complacent if everything runs smoothly for a year or two, but these costs will appear at some stage! Even if you don't have a real tangible reserve fund, you still need to include it in your calculations if you want a realistic picture of how your investment is performing. 

Total costs to set against income:

This is an easy one.  Just add together the annual cost of capital investment and the average annual running costs.  Taking the typical figures used above, the total comes to $21,400 per annum.  You can allow a sum for the capital appreciation of the property to offset against these costs.  It is not easy to come up with a credible and widely accepted figure for this, as there are too many uncertainties involved.  For example, will the property appreciate at all in the long term? Will it deteriorate over the years, or will the market value decline rather than rise? Will an older property absorb an unreasonable amount of money in upkeep? Despite all these, we will assume that a rental home will increase in value by 2.5% a year above inflation over the next few years, net of any major renovation costs.  This is worth $4000 a year on our $160,000 home.  This $4000 nominal increase in the value of our property takes the net costs of ownership down to $17,400 a year, or $1,450 per month.

Income targets:

With a reasonable, indication of how much it costs to own a rental home, we now need to consider the level of rental income needed to offset these costs.  We can approach this from two directions.  We can either estimate the number of weeks of rentals we think we can get, then work out what the rental rate would need to be to cover our costs.  Or we can estimate a realistic average weekly rental rate, and calculate how many weeks of rentals we will need at this rate.  Having done this, we can look at a real situation, and see what a well-filled rental schedule can achieve in terms of profitability.  In all the calculations that follow, we have to allow for taxes (where applicable) and the cost of end-of-rental cleans when we refer to a rental rate.  For the sake of simplicity, let's take a total figure of $100 per rental week to cover these two elements together.

• Based on rental weeks:
  How many weeks of rentals can we achieve? To cover all of our costs with 30 weeks of rentals will require an average gross rental rate of $680 per week including taxes.  If we work really hard at filling our own rentals schedule, we may be able to achieve a much better 40 weeks a year.  On the same basis, we would then need to average just below $535 a week gross. 
• Based on average rental rate:
  Almost every owner has a different idea of a fair rental rate for his or her home.  Let us take $700 as typical.  We need to take off $100, as before, to cover taxes and cleaning, so the remaining $600 per week will require 29 weeks of bookings to reach break-even point.  Some owners go for a high rate, say $1000 a week, and accept fewer bookings.  Others go for full capacity at an average of $700 a week.  The income from these two different approaches may be quite similar, as the number of bookings is likely to be closely linked to the rental rate offered.  A rate of $1000 a week needs less than 20 weeks of bookings to cover costs, while a rate of $700 needs 29 weeks.  A 'typical' rental rate for a 4-bedroom house, averaged through the year, may be $820 gross ($720 net), which would need 24 weeks of bookings to break even.  The actual rate can of course vary with season, so that an average of $820 may be made up from a few high season weeks at $950, and a larger number of low season weeks at $700. 

What is the potential profitability?

We have established that the cost of owning an average-value rental home is $17,400 a year.  Is it possible, or realistic, to make more than that in rental income, and to turn your vacation home into a profitable investment? The short answer is, yes, it is possible, and it is realistic.  However, you do need to do things right, and you do need to be prepared to put a significant amount of time into it.

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