How Does Rental Arbitrage Work?
What are the Benefits of Rental Arbitrage?
Rental Arbitrage vs. Subletting
Finding a Rental Arbitrage Property
The post-pandemic short-term rental (STR) market is here to stay. Pre-pandemic guests would rent a unit for a weekend, but hybrid and remote work have allowed more people to extend their stays, increasing occupancy for STRs. The beach trips and mountain weekends are turning into working vacations, expanding the need for short-term leases.
Not only have these stays become more popular for renters, it has also increased the attractiveness from an investment standpoint. However, STRs require more upfront costs and management than the traditional long-term model. While this is justified by the high profitability of a short-term lease, it creates a higher barrier of entry for those looking to get started. Rental arbitrage is an investment model that allows operators to cash in on the high profitability of STRs, without needing the capital to get started.
If you do not have the capital for a down payment and startup costs, you may think STRs are not a possibility for you. However this may not be true, and Rental arbitrage could be your entrance into the STR market.
How Does Rental Arbitrage Work?
At its most basic level, rental arbitrage is when someone signs a long-term lease on a property, and in turn operates the property as a short-term rental. If done correctly, the short-term bookings will cover your monthly rent over the course of your lease plus profit. These STR tenants are usually found on Airbnb, VRBO, and other sites as nightly, weekly, or monthly rentals.
The profit is generated from a long-term lease having a monthly rent payment that is less than the revenue you bring in via short-term bookings. STR tenants will pay more per night in return for occupying the unit for a shorter amount of time. For example, you sign a one year lease on a townhouse in Wilmington, NC for $2,000 a month. You then find STR tenants for 20 nights out of the month at $200 a night. This will generate a smooth $4,000 in profit without owning the townhouse or paying the costs associated with ownership. You are simply profiting off the advantage short-term leases have over the long-term lease in locations that attract short-term tenants.
However, you will need to consider the cost of:
- Furnishing the unit
- Marketing to short-term rental tenants
- Utilities and amentities
- Cleaning services
- High-speed Wi-Fi
- Damage deposit
STR margins are large enough to cover this and still maintain profitability. This profitability comes without the upfront costs of purchasing a home or paying the bank off for 30 years.
What are the Benefits of Rental Arbitrage?
- Low Initial Investment - You do not need to purchase a property meaning no down payment, closing costs, or 30-year mortgage. You only need to pay for the first month’s rent, furnishing, amenities for the STR, and a damage deposit to the landlord.
- Minimized Risk - You do not own the property and therefore do not need to pay for maintenance on the property such as replacing the roof or HVAC, the landlord will pay for this. If the unit does not produce enough occupancy to maintain profit you can walk away from the lease. Walking away from the long-term lease will have a significantly smaller financial burden than purchasing a unit that does not generate profit.
- Scalability - Any real estate rental operation is most profitable when you are able to scale to multiple properties/locations. Rental arbitrage promotes scalability with a small initial investment and software such as Airbnb for tenants and Hostaway for managing multiple locations. The small initial investment allows you to spread your money towards more long-term leases to perform an arbitrage operation.
- Pivot Location - When you purchase a STR unit, you have less liquidity to pivot locations quickly/easily if the area did not support your investment. On top of that, if you do not have a buyer lined up it can be a headache to list on market. However, rental arbitrage allows you to pivot quickly by signing one year leases and changing markets after the lease expiries if you feel it’s necessary.
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Rental Arbitrage vs Subletting?
Rental arbitrage and subletting are not the same. Subletting is when one tenant for a long term takes over the lease at the same price as you. Ideally, rental arbitrage is with multiple tenants that cover your long-term lease payment plus profit from nightly to weekly rentals.
Is Rental Arbitrage Legal?
This all depends on your lease agreement with the landlord and zoning laws in the area. Examine your long-term lease and ensure there is no clause that prevents you from subletting or creating short-term leases. It is best to have this discussion with the landlord and directly explain your intentions with the rental arbitrage operation. Ensure you check the HOA, apartment, condo, city, and county regulations as there may have zoning laws that prevent short-term rentals in the area. It is essential to check the laws/regulations in your intended location before signing a long-term lease.
Finding A Rental Arbitrage Property
Rental arbitrage can be very attractive with small financial barriers but due diligence is essential for a profitable model. Here are some aspects to weigh in before starting:
- Location - Choosing an area that has a strong STR market is essential for having a profitable occupancy rate. You may need to branch out from where you live in order to be successful. Markets that support traveling nurses, vacation rentals such as the beach and mountains, and areas predominantly populated by tourists are good locations to consider first. We recommend using platforms such as AirDNA, VRBO, Vacasa, and Airbnb to help determine the best rental arbitrage locations near you. Finding the averages for occupancy and STR rates between these tools will help you pinpoint the location best for you.
- Furnishing and Property Damage - It is key to consider your desired cost of furnishing the unit during your search to help decide the ideal SqFt and number of bedrooms. Long-term leases are usually not furnished but your short-term rental tenants will expect furnishing. You will also need to replenish amenities such as linens and toiletries before your next STR tenant moves in. Property damage is another expense that needs to be factored in. If one of your STR tenants damages the property you, the long-term leaseholder, will ultimately be responsible for these repairs. Airbnb and your insurance provider may be able to help alleviate these costs but still needs to be factored into your numbers before signing the long-term lease.
- Profit Margin - After calculating the expenses for the long-term lease, furnishing, property damage savings, and amenities are you confident the location’s occupancy and rent rate will cover this and allow for profit? Even though you do not own the property outright there are still STR expenses that need to be covered.
Learn the Ropes
Rental arbitrage sounds great on paper for the aspiring investor with limited start-up capital but markets change every day. The rental arbitrage operation that works in one location today may not produce the same margins the next year. Thus, requiring on-going market research to know if you should renew the long-term lease or not. As more investors take advantage of this strategy the profit margins will become smaller.
Due diligence and patience is required to be successful in this space. Start with a one year lease after solid STR market research and learn the ropes. After one year, reassess the market and STR demand in the area. You may need to switch locations even if your first year was profitable. That is the beauty of rental arbitrage. You can easily pivot your location to a more profitable area after one year.
If rental arbitrage is not for you and you wish to purchase a STR property, get in contact with us here or read this blog to learn more!
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