I recently wrote an article analyzing the return potential for real estate that used the returns I’ve gotten on long term rentals. The final estimate was a 27% return on long term rentals. The thing is, Kate and I have been far more profitable with the properties we’ve listed on Airbnb.
So I want to know, just how profitable are Airbnbs, really?
It is possible to see 30% return on investment from an Airbnb investment property, and I’ll show you how I’ve done exactly that.
Leverage, Appreciation and Mortgage Payments
In my article about return potential for real estate, I went into some depth about how you get returns from the appreciation of your home and equity gained through mortgage payments over time. And I also talked about how using leverage can super charge your returns.
These things will be the same for an Airbnb property, so I want to give a quick recap.
Return from home appreciation (15% ROI)
Over the history of the housing market, it is estimated that the value of a home will increase, on average, by 3-4% each year. This is one of the things that makes real estate such a great investment. It keeps pace with the 3-4% rate of inflation.
But the thing that really allows investors to use real estate effectively is leverage. By putting 20% down on a home, that 3-4% return on investment becomes a 15-20% return on investment.
If I pay $20,000 to purchase a $100,000 home, when that home’s value goes up to $103,000 I get 100% of that $3,000 increase in value (not 20%).
And $3,000 ÷ $20,000 = 15% return on investment.
But what happens if we were able to buy that same home for only $10,000 down?
$3,000 ÷ $10,000 = 30% return on investment.
This is the power of leverage. By using the bank’s money to purchase assets that appreciate in value over time we can super charge our return on investment.
Return from equity on mortgage payment (5% ROI)
When you use the power of leverage, you always get a mortgage payment in return. Part of the mortgage payment goes towards interest on the loan the bank gave you. The other part goes into further equity/ownership of the real estate.
The part that goes into equity adds to your net worth and therefore counts as a return on your investment.
It turns out that the terms of the loan don’t even matter for calculating the return on investment. All that matters is the size of the loan, or in other words, what your down payment was.
And with a 20% down payment, we would have a 4.7% return on investment over 30 years.
$20,000 down and $80,000 paid off when we make our last loan payment.
($80,000 ÷ $20,000)1/30 = 1.047 which is about a 5% ROI over 30 years.
The 1/30 exponent just shows us the return over 30 years.
We’ve seen that we can reasonably expect a 20% return on any real estate investment from home appreciation (using leverage) and equity gained through the mortgage payment. However, what separates the successful real estate investors from those who crash and burn is positive cash flow.
If your rental income from the property is just enough to cover the mortgage plus all expenses, then you would have a 0% return from cash flow and you’re looking at a 20% return on investment.
In my previous article, I showed that we have seen about a 7% long term cash flow return from our investments, but that was based on long term rentals.
We’ve done much better with our Airbnb properties.
Our cash flow from Airbnb
I’m going to use the numbers from our two standalone Airbnbs.
We purchased the first of these for $100,000 and put 20% down. Here’s what the cash flow looks like:
- Average monthly revenue from Airbnb = $2,100
- Mortgage, taxes and insurance = $600
- Utilities and internet = $250
- Other costs = $350
- Cash flow = $900 per month
We bought the second property for $180,000 and again put 20% down. Here what that property’s cash flow looks like:
- Average monthly revenue from Airbnb = $2,400
- Mortgage, taxes and insurance = $1,100
- Utilities and internet = $300
- Other costs = $200
- Cash flow = $800 per month
Our cash on cash return
Usually you measure cash flow ROI in cash on cash return, so we’ll start there. Then we’ll try to get a number for the long term cash flow ROI.
For the first property, our cash on cash return is 54%.
$900 monthly cash flow x 12 ÷ $20,000 down payment = 54%
54% cash on cash return is pretty ridiculous. That means we get our $20,000 down payment back in less than two years. All returns beyond that are pure profit.
For the second property our cash on cash return is about 27%.
$800 monthly cash flow x 12 ÷ $36,000 down payment = 26.666%
We shoot for a 20% cash on cash return, so this property has performed up to our expectations. We’ll expect to make back our $36,000 down payment in less than 4 years. Still very solid.
Our long term cash flow ROI
It is very difficult to calculate cash flow ROI over long periods of time. You may have a 27% or 54% return on investment from cash flow in the first year, but that cash flow won’t grow another 27% or 54% in the second year. It might go up by 3% the next year.
This means your cash flow ROI after 1 year is say 54%, but then after two years your average ROI from cash flow drops to 40%. This average ROI from cash flow slowly falls as time goes on. I want to guesstimate what that number will be after 30 years.
Here’s how I’ll arrive at my estimate.
I’ll assume that my monthly cash flow will increase by 3% each year. I’ll use that 3% to estimate my cash flow in year 30. Then I’ll take the average of the year 1 and year 30 cash flow and use that number to estimate long term ROI.
- Cash flow in year 1 is $900 per month
- Cash flow in year 30 is $2,180 per month
- Estimated average cash flow over 30 years is $1,500
So I’m estimating that on average I’ll have a $1,500 per month cash flow for the 30 years. This comes out to $540,000 total cash earned from the investment over that time frame ($1,500 x 12 months x 30 years).
The estimated ROI from cash flow over 30 years for property 1 is 11%.
($540,000 ÷ $20,000 down payment) 1/30 = 11.6%
- Cash flow in year 1 is $800 per month
- Cash flow in year 30 is $1,940 per month
- Estimated average cash flow over 30 years is $1,350
An average monthly cash flow of $1,350 over thirty years results in total cash earned of $486,000 ($1,350 x 12 months x 30 years).
The estimated ROI from cash flow over 30 years for property 2 is 9%.
($486,000 ÷ $36,000) 1/30 = 9%
The estimate for a long term rental was about 7% from cash flow.
ROI before tax
Before we talk about how income from Airbnbs is taxed, let’s analyze our return on investment so far.
We have a 20% return from our mortgage and the appreciation of the home and we have somewhere around a 10% return from cash flow.
That’s a 30% return we’re seeing from our Airbnb properties!
But wait, we can do better than that.
Stock market investors talk about reinvesting their dividends. Dividends are just cash payouts that are given out by companies to their investors.
You can do one of two things with this cash, you can spend it in some way, or you can reinvest it. By reinvesting your dividends you can squeeze out more ROI on your investments.
I’m not going to do a deep analysis here, but it should suffice to say that reinvesting your “dividends” from the cash flow of your Airbnb property can raise your ROI above 30%.
Real estate investors get some huge tax benefits. The two biggest are depreciation and tax deferment on the sale of a property.
Cash flow taxes
The gains you realize on cash flow are treated like income. Income is taxed based on how much you make, but more accurately, income is taxed based on your “taxable income.”
It’s possible to earn $100,000 in income, but have a taxable income of less than $20,000. Especially if you’re a real estate investor!
Real estate depreciation is a tax benefit given to real estate investors that allow them to deduct a portion of the value of their real estate from their income. The crazy thing is that this tax deduction will often cover all your income from your investment property.
For exceptional cash flowing investments (like Airbnbs), you may have more income than your depreciation benefit can cover. But real estate investors use depreciation to earn relatively tax free income.
The rest of your ROI comes from the value of the property you own. You won’t pay taxes on that unless you sell the property.
The good news is that there are additional tax benefits that allow real estate investors to defer those taxes indefinitely through the 1031 exchange.
I guess what I’m trying to say is that you can expect to keep the vast majority of your returns. You won’t have a large tax burden with proper planning.
When it comes to cash flow, it’s hard to beat an Airbnb. The real estate Kate and I have bought and listed on Airbnb has been, by far, the most profitable of our investments.
We’re expecting 30% return on investment (or better if we “reinvest our dividends”) over the next 30 years when we buy a property to list on Airbnb.
I will say that not all cities will support this kind of success with short term rentals, but many will. Kate and I will certainly be looking outside our hometown to find more property to list on Airbnb.