Clark Twiddy is the President of Twiddy & Company, a hospitality and asset management firm along North Carolina’s Outer Banks.
As the housing market continues to be a topic of conversation even during happily-returned backyard gatherings, questions around both the potential for a bubble and, perhaps more importantly, impacts of the bubble correction remain almost as hot as the real estate market itself. To be clear, no one knows what the future holds, but by using the past as a proxy, we can use data to develop some sense of the financial resiliency of real estate assets.
Real estate ultimately remains a local investment, and as such, national or even regional predictions are tough to apply to smaller specific areas or even smaller segments within a niche market. While we can and should contextualize our investments within a larger environmental scan, there is no substitute for knowing a specific market on the ground. As we scan for risk and opportunity on the ground in our investment options, it’s worth noting that any future prediction is predicated on how we judge uncertainty. And while that’s inherent in any investment. it also means that with uncertainty comes an opportunity to influence the outcome. Look no further than the recent boom in vacation rentals as a case study in risk, opportunity and uncertainty, yet still astonishing vibrancy. Is this a bubble market, and if so, what happens on the other side of it?
Nationally, the vacation rental industry has profoundly impacted the way real estate is bought and sold in many destination markets. As a result, the implications of a potential bubble in these short-term destination markets is distinctly different than in other more urban clusters — it’s important to note that up front. In scanning for a vacation rental bubble and its implications, it’s valuable to note the economic linkages within the local real estate infrastructure as strong versus weak links in a chain that could, with a drop, have a domino effect on other aspects of the local system. With the vacation rental market, the ecosystem itself is linked first and foremost to traveling demand and available supply; the greater and more consistent the revenue potential for an individual house as a function of demand, the more resistant that house will be to fluctuations or corrections in the larger market as a function of the scarcity of supply.
That’s easy enough to conceptualize — the more consistent the revenue a home produces, the less risk it carries and the more reliable the cash flows are further out into the future. In practice, we see that principle apply in distinct markets through two things: annual cash flows projections for a given home and the relationship of those projections to eventual sales prices. Think of this relationship as something akin to a more traditional price-to-earnings ratio that we’re used to in equity markets, with the point of that comparison being that the more we think of a vacation rental home as an operating company, the more we’re able to use pattern recognition from other asset classes to assess a home’s durable value across potential bubbles.
For example, let’s say a home produces gross rents of $10 a year. In many markets, the relationship of that gross number to a sales price — say, ten times gross rents — is an indicator of the future-facing reliability of those cash flows that the market builds into a price. In this example, that home might sell for $100 (meaning, in other words, that the sales price is essentially what an owner might be willing to pay for ten years of those annual earnings). In short, reliable demand equals a higher resiliency to any housing correction that we might anticipate in the short-term if we think of the short-term as something around 12 to 18 months. Of course, that financial model doesn’t accommodate some of the more emotional pieces to home-buying (the desire to own something on the beach for your family, for example), but it does offer a sound framework footing to assess risk versus returns should the market move in an unanticipated direction.
In boiling this down to an idea to take with you, here it is: For potential home buyers or recent home purchasers, this should be reassuring if you have a good sense of your home’s margin performance over not just the past year (that’s an all-too-common mistake to avoid) but the past several years (ideally three to five years, if possible). If yours is a new home or recently built, there are no doubt comparisons to similar income-producing homes that might be available as a guide. If you don’t have a data-driven revenue projection, get one from a professional provider to get their opinion based on their data (think of it as a kind of value appraisal). Remember to be a critical consumer of data in this area, though, and assess the data in light of the provider’s incentive system.
If thoughts of risk in the face of a correction keep you up at night, keep a weather eye on the resiliency of your annual rental revenue as the surest barometer of “tail risk” in a diminishing sales price. Watch for even the slightest drop, recalling that conceptual 10X multiplier, and maintain your ongoing investments in the home. Even though you no doubt love your home and consider it unique, from a financial perspective the consistency across market cycles of your home’s annual cash flows is your best single asset in many ways.
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