Short-Term Rentals for the Long Haul
Investors in the multifamily sector are examining properties designed for shorter leases and higher turnover.
As the market shows signs of cooling and multifamily investors ready their portfolios for a possible downturn, some are diversifying their holdings with a niche asset class with significant potential for growth: short-term rentals.
With roots that go back at least a decade - Airbnb was founded in 2008 - short-term rentals, or STRs, have grown to include new players that have scaled to institutional investment-grade multifamily assets that cater to both business and leisure travelers. This includes companies creating purpose-built STRs - that is, multifamily properties designed and built expressly to rent out some or all units for short-term stays.
Large-scale short-term rental operators like Stay Alfred and WhyHotel are two case studies to help understand how to successfully tap into this sector. Along with peer companies The Guild, Lyric, and Sonder, these firms now manage more than 5,300 beds in 63 markets, attracting at least $319 million in venture capital, Cushman & Wakefield recently reported. The bigger players may differ in their approach; Stay Alfred master-leases multiple apartments in a building and rents them to travelers, while WhyHotel offers pop-up hotels that are created by leasing out empty apartments in new buildings during the lease-up phase. Through a new division called Hospitality Living, WhyHotel also will build new multifamily properties specifically for STRs. Regardless of the approach, both companies aim to provide a homelike space with the convenience, access, services, and consistency of a hotel.
While feasible, STRs are not without risk. Regulations governing how these buildings are developed, operated, and taxed vary by municipality, and laws are in continuous flux. Still, the long-term fundamentals of the sector are favorable. As Deloitte stated in its “2019 U.S. Travel and Hospitality Outlook” report, “While regulatory hurdles remain, rental demand is proven.”
Responding to a Changing Market
Right now, the market forces driving demand for short-term rentals include:
Homelike Accommodations. Travelers increasingly prefer an experience that blurs the line between home and hotel. According to Conde Nast Traveler, 50 percent of millennials prefer lodging that feels like a home away from home. STRs are typically furnished and decorated, with complete kitchens, full baths, and in-unit laundry. At the same time, many offer the services and amenities of a hotel, including cleaning service, pools, spa rooms, gyms, and more.
Affordability. Rates can be cheaper for STRs than traditional hotel rooms, depending on the city. Airbnb reports its average rental in New York, for example, is $164 per night, compared to $245 for a hotel room. According to Vrooms, the average nightly rate for short-term rentals in the U.S. is $217. This summer, Stay Alfred was offering rates as low as $100 a night in downtown Chicago, versus the $240 per average hotel night, according to Bloomberg. WhyHotel rooms in Washington, D.C., can be $150 per night - a steal compared to $269 for a hotel, per Statista.
Loyalty Points. Airlines such as Delta and Qantas are starting to offer loyalty points for short-term rental stays like they do for hotel reservations.
Easy Access. Like many hotels, some STRs allow you to open the door with an app on your phone that has a timed entrance for the duration of your stay and then expires afterward. Security isn't breached, and convenience is maximized.
“The industry has always been overwhelmingly supported by the end consumer, which has made it an attractive segment for years,” says Mike Wilson, senior vice president of real estate for Stay Alfred. “Occupancies have never been an issue due to the traveler demand clearly demonstrating they prefer a unique experience and a differentiated product.”
A potential adverse market force is the regulation of STRs. In Chicago, for instance, not all parts of the city or buildings allow STRs. Hosts with more than one home-share unit must be licensed by the city, and various charges are associated with STRs, such as a hotel accommodation tax and shared housing surcharge. In buildings with more than five units, only the lesser of one quarter of all units or six units may be used as STRs.
Some companies, of course, have many more units than that. One large STR firm recently announced it will offer more than 90 units in Essex on the Park in Chicago's Loop. “The only way to do that [given Chicago's regulations] is to operate as a hotel,” says Katriina McGuire, a partner with Thompson Coburn who focuses on land use, zoning, and developer incentives. “Downtown districts generally permit lodging, meaning hotel uses. However, many planned developments, even if in the downtown area, do not necessarily include lodging as a permitted use.”
The Rental Premium
STRs often are more affordable than traditional hotels for the consumer, and they can be more profitable than conventional apartments for landlords. Apartment owners who offer short-term stays, either directly or through a third party, can realize a rental premium ranging from 25 to 45 percent. This revenue more than offsets STR-related expenses such as unit furnishings, daily cleaning services, and associated fees and taxes.
“The building owners have now recognized that we present a higher and better use of a downtown multifamily asset,” says Wilson. “We can have a material impact on their financials, and more are turning to us to help them capture that upside by allocating some or all of the property to short-term rentals.”
Stay Alfred generally pays market rent +/-5 percent, Wilson reports. “Where we have the significant financial impact on the revenue side is on the lease-up of a property,” he says. “As opposed to going through a lengthy lease-up process of six or 12 or 18 months, we have the ability to take those units on Day One.”
For owners, leasing carries numerous financial and operational benefits: Property management fees are typically lessened; vacancy expectations are adjusted significantly downward; and building payroll, lease administration, and turnover cost are eliminated.
Typical downtown multifamily properties run a 35 to 40 percent operating expense ratio on average, while Stay Alfred building owners typically run a 23 to 25 percent average on their portion of the building - an increase in annual net operating income.
“When underwriting ground-up development for our hospitality living projects, we analyze our flexible asset functioning across three distinct consumer scenarios,” says Will Hu, senior vice president for acquisitions and development for WhyHotel. “First, as traditional multifamily. Second, as furnished STRs with stays between one night and nine months. Third, and this is WhyHotel's Hospitality Living concept, as a combination of traditional unfurnished homes blended with short-stay furnished accommodations. The allocation of inventory between the two uses is dependent on market dynamics, such as seasonality.”
While top-line revenue for traditional multifamily may only be half that of furnished short-stay rentals, WhyHotel generally projects multifamily to have a 20- to 25-point advantage in occupancy and a 10- to 15-point advantage in operating expense margin, he adds. As a result, NOI for traditional multifamily can still be 70 to 80 percent of a short-term stay use.
Hu explains that in markets without much seasonality in short-stay pricing, such as Los Angeles, multifamily may not be the primary use, but it does present a unique NOI floor in the event of a downturn in the hospitality market. In markets with significant seasonality - for example, Chicago and Boston - traditional multifamily has the potential to generate higher income in off-season months.
“One additional advantage not yet captured in our underwriting is the value of the long-term optionality in the asset,” Hu adds. “The ability to adjust between unfurnished homes and furnished short-stay accommodations is a great hedge against changing market conditions and should theoretically drive the asset's exit cap rate down, but this is a feature to which we don't yet ascribe value.”
Can STRs Buffer a Recession?
Diversifying income streams is prudent in any market, but it's especially valuable during a downturn. Assets that have a more varied customer base, while not entirely insulated from broader shifts in the economy, are less likely to experience sudden declines in NOI. After all, in general, multifamily is often more insulated than other CRE sectors. And while more developments are being dedicated to short-term rentals, it doesn't have to be an either/or proposition for building owners.
“A recession is inevitable at some point in the likely near term,” Wilson says. “Our leases give owners the ability to lock in a tenant in an acceptable portion of the building and receive a pre-negotiated annual rent escalation on those leases.” He adds that having Stay Alfred in the property allows long-term guests and full-time residents to utilize other units for visiting friends and family members. The tenant can also stay at other Stay Alfred units nationwide at a significant discount, which carries additional value in the eyes of consumers.
As venture capital continues to pour into these operators and consumer demand fuels the sector's growth, STRs are a strong multifamily niche asset for investors. As STRs expand beyond the early days of renting a room to a corporate service scaled for profit, they are well worth a look by multifamily investors - especially in today's competitive landscape.