The short-term rental (STR) market has been picking up speed for months with no signs of slowing down. Throughout the pandemic, a crisis posing threat to virtually all industries, the overwhelming sense among the STR sector has been one of growth, opportunity, and resilience. Organic strength continues to be the industry’s chief characteristic, strength that’s unlike anything previously experienced even in the traditionally low-risk, high-reward investment world of real estate.
Q4 2021 hedge fund letters, conferences and more
And while the buzz around STRs might feel new, the market can be traced back to the inception of home-sharing with Airbnb, and even further back to early models that came before that. Now, STRs are functioning as an almost completely differentiated asset class. With a close tie to market demand, rental revenue projections can be accurately forecast based on the performance of comparable properties in the area. With turnkey property management solutions, the hands-on work of hosting can be entirely abstracted. And with more investor interest flocking to the space, STRs can be institutionalized, scaled, and expanded to create robust portfolios with higher-than-average market gains.
For investors already involved, STRs are a lucrative avenue to low-risk, post-pandemic returns, with margins that are expected to remain high as the challenges of the pandemic finally fade. But rules and regulations in the space have been slower to update. In the near future, further updates to STR policy will be needed in order to properly foster and reap the benefits that can be the result of a booming asset class—both on a local and global economic level. Following is an overview of some of those changes, including what’s been working for investment activity within the space and what we believe is coming next.
What’s Happening in Housing
For traditional real estate investing, securing a second mortgage on an investment property can be a reliable source of funding. In some states, though, lenders have traditionally differentiated short-term rental activity in their funding considerations. Some lenders won’t consider an STR loan applicant without two years of tax returns or a signed one-year lease agreement from a tenant in place.
But a simple look at the STR market shows that there’s a greater case to be made for the reliably higher-than-average returns taking place within the space. For the first time, the National Association of Realtors (NAR) conducted a study on single-family property availability. Today, there are fewer homes on the market, making it more difficult to secure a home than it was before the pandemic took place.
As more and more people get priced out of the housing market, short-term rentals are becoming the preferred accommodation—not just to travel for a few nights, but to stay long enough to immerse in new locales or be closer to friends and family after many months of delayed visits. There is every reason for lenders to understand and believe in the market positioning of STRs for both the near and long-term future, and to have that faith reflected in their financing decisions. But the path to STR financing hasn’t always been a walk in the park.
The Bottleneck Of The STR Past
The debate around how to handle the unconventional STR investor-mortgage often invokes the changing minds of Fannie Mae and Freddie Mac, the federally backed home mortgage companies that were created by the US Congress. The Fannie/Freddie approach to short-term rentals has been in constant fluctuation since the early days of Airbnb, with some more restrictive phases negatively impacting the liquidity of the STR market. In 2019, some progress was made when Fannie Mae offered a rule that seemed to favor STR owners with Fannie Mae-backed mortgages, allowing them to rent a second home on a short-term basis and count broader STR income when qualifying loan applications.
But in January of 2021, the Treasury added restrictions that meant Fannie Mae would no longer buy loans secured by second homes and investment properties. Most lenders are more hesitant to make loans that can’t be sold to Fannie or Freddie; the restriction made the traditional approach to second-mortgage short-term rental investing more expensive for borrowers across the board.
Alternative Paths, Accelerated Growth
In September, the Treasury announced some modifications to their earlier restrictions, reconsidering how their provisions had constrained healthy industry growth. There’s reason to hope that rules and regulations enforced by government entities on the STR market will continue to be more aligned with, and in favor of, the market growth moving forward. But in the meantime, forward-thinking lenders, borrowers, and brokers have found alternative paths to less conventional mortgages.
Most popular among those paths is the DSCR loan approach. Investors can calculate their debt service coverage ratio—the relationship between monthly rental income and debt owed to the property—to inform their financing options. DSCR loans are traditionally employed in commercial buildings, but short-term rentals are eligible for the same loan product, and it’s becoming more popular as a way to assess the borrower’s ability to repay the loan based on their rental business rather than their personal employment or income.
For larger deals with multi-property STR portfolios, many lenders are also considering securitized financing; a new approach to STR loans that would be able to offer investors non-recourse debt. Another loan structure that has its roots in the commercial real estate space, securitized financing will help to support the strength of the expanding STR market and allow investors to properly represent their rentals as tradable assets.
The next step in supporting the STR asset class is to transition to financial models that recognize short-term rentals as the businesses they can be; new loans are becoming more popular to that end, and regulatory change is expected to follow closely behind. As is the case with any watershed market development, it can take time for rules and regulations to recalculate and reflect what’s best in the investment space. But the change in favor of full STR funding and support seems inevitable considering the ongoing strength of the market; lenders who are early adopters of that fast-approaching future might find many open doors waiting for them when they arrive.
