Hello dear friends! My name is Andria Santos, CEO of Fulhaus, the interior design company that offers comprehensive furnishing packages to short-term rental providers. This is the second feature of our series with ShortTermRentalz on the strengths and weaknesses of rental revenue models.
I’ve learned a thing or two watching you all scale over the years. In fact, we’ve helped a lot of you along the way! I’ve listened to your concerns, watched you grow, and had many a meaningful conversation along the way. And, after hearing a lot of the same concerns, it made sense for us to compile them in one place through a series of columns in collaboration with ShortTermRentalz… or at least begin to.
Through this feature, I will share some of my thoughts on areas of the short-term rental industry that are at the forefront of everyone’s mind. In this September piece, I touch on dominant business models and highlight areas of advantage and concern in each.
Worldwide: People are travelling more than ever before, and what they expect on their travels is changing the way hospitality providers do business. Consider that:
● By 2025, millennials will account for 75 per cent of all consumers and travellers, and 50 per cent of millennials expect lodging to feel like a home away from home.
● Revenue from the vacation rental market grew by nearly 11 per cent in 2019 and is projected to show a revenue growth of 8.6 per cent in 2020.
● Business travel is growing at six per cent per year, and 30 per cent of home-share bookings will be for business stays by 2020.
As the numbers indicate, we are living through the great maturation of the short-term rental market. The pendulum has swung away from conventional hotel models towards unique apartment-style stays in coveted neighbourhoods. Contrary to what the average Airbnb user believes, there is an array of host models. Joining homeowners and apartment dwellers as short-term rental market providers are professional property management companies, branded short-term rental providers, real estate developers, globally renowned hotel chains, small scale owner/operators – and practically everything in between.
While I don’t propose to make a comprehensive list of all the revenue models out there, there are three approaches that I see a lot of companies taking, and I think they are worth highlighting. Companies are entering the short-term rental market either as branded providers, traditional property management companies, or owner/operators.
I want to break each of them down, discuss why they work, and locate some points of tension that might lead them astray.
STR Revenue Model #1: Branded providers
One revenue model that is proving to have some legs is the master lease model. Companies leveraging this model function kind of like a property management company in that they take on a master lease from the landlord, usually of an entire building, or several units/floors for several years. Branded providers go beyond the normal purview of property management by designing their units to feel like apartments and by incorporating some aspects of hotels in their service offerings. Examples of this kind are Sonder, Stay Alfred and Lyric.
Features of the branded provider model include:
● Signing master lease agreements with landlords for a fixed monthly rate
● Managing a portfolio of properties in coveted urban locations, generally multi-family
● Creating a branded experience around their units that is part of apartment living, part-hotel experience
Branded providers are counting on the spread between their long-term master lease commitments, and the short-term revenue coming from guests. That means they need to maintain a high occupancy rate, high average daily rate, and low overhead in order to break even. Here are some strengths and weaknesses of the master lease model.
One key area where these startups are innovating on hospitality standards is in technology. They all use tech to optimise every area of their business, automating processes and analysing meta-data to maximise operations wherever possible. This allows them to keep operating costs down while simultaneously keeping occupancy rates higher than average.
Let’s look at Sonder as an example. Sonder’s use of property scouting platforms, automated property management algorithms, supply chain management applications, mobile-first services, and all types of custom tech allow them to cut standard hotel operating costs by 74 per cent – while offering an equally seamless service experience to guests.
Sonder uses a machine-learning process to source and lists new properties, cutting downtime to market for new units and allowing Sonder to scale at a rapid pace. When it comes to occupancy rates, the company also uses next-generation household management programmes to keep things running smoothly. In 2018, Sonder held an occupancy rate of 77 per cent, which outdoes the North American average of 72 per cent (data taken from their Series D pitch deck).
A focus on technology is similar for WhyHotel, StayAlfred and Lyric. Branded providers use technology as a competitive differentiator, carving up a space of their own where hotel and vacation rental providers could not. Technology helps them retain high occupancy rates, cut operating expenses and maintain a strong pipeline of appealing properties. However, relying on a technological edge might not be enough to overcome financial issues with this high-turnover model.
Weakness: Shrinking margins over time
Issues around timing and profit margins exist for branded providers. Let’s look at Sonder again, which operates on a high risk/high reward model that may not last that much longer. The risk comes in the type of arrangement Sonder and these other providers sign with landlords. Sonder and others tend to sign master leases with landlords or a real estate investment trust (REIT) and agree to pay a fixed amount every month over a five-year period. The companies generate revenue by renting out their rooms every night to travellers; they pay the fixed monthly and get to keep the rest. An influx of cash is absolute gold for these companies, who generate cash way faster than they have to pay their rent. They turn around and re-invest it in the company as fast as possible, allowing them to scale at a fast pace.
The problem on the horizon is that while lease agreements are affordable today, they will not continue to be as the market matures. In other words, as more companies crowd the market the margins that branded providers enjoy today will shrink. Problems with the master lease model are bubbling to surface for providers, and they will need to look elsewhere for new sources of revenue, move upmarket to serve the luxury hospitality market, rely on technology to continually cut their operating costs – or all three – in order to survive.
STR Revenue Model #2: Traditional property management companies
A second revenue model in the short-term rental market that continues to predominate is the conventional property management company. These types of companies partner with landlords and will, for a monthly fee, take responsibility for managing the rental income of the property (or properties). Their revenue comes as a percentage of monthly rental income earned. Companies in this category range from small local businesses to multinational management companies and their primary focus tends to be in vacation rentals, a global market worth $57.669 billion in 2019.
Traditional property management companies aim to minimise vacancies by:
● Using property management platforms to automate tenant recruitment steps, manage accounting and listings management from a central source.
● Market units effectively (whether on Airbnb, HomeAway, VRBO, Bookings.com and others).
● Do all cleaning and maintenance work
● Provide 24/7 communication for guests
Let’s look more closely at how these partnerships are set-up, money is made, and where this revenue model might go astray.
Strength: Consistent cash flow
Traditional property management companies in the vacation rental market and the residential rental market can enjoy a consistent monthly cash flow. The income comes from the contract they sign with the landlord. A standard contract is for a percentage of monthly revenue generated by the properties under management, which incentivises the management company to differentiate their offerings and outperform the market standard for quality in design and care.
Let’s break down the revenue model a little more.
Say a property management company has 25 units under management, with an average of $1,500 rent per unit.
50 units x 1,500/month = $75,000/month in collected rent
The industry standard is to charge between five – 15 per cent on this amount. Let’s say the company charges a reasonable ten per cent.
75,000 x ten per cent = $7,500 gross revenue for property manager
Then let’s assume total overhead for the month is $2,500 (wages, software, marketing budget, cleaning supplies).
7,500 gross revenue – 2,500 operating expense = $5,000 net revenue
In this hypothetical example, the cash flow from managing 50 units is okay (though the overhead is probably on the low side). It allows the company to continue operating month over month without constantly having to seek new jobs. In addition, if they do a better job marketing their units than the competition and achieve high occupancy rate, their monthly revenue goes up in turn.
Weakness: Limited scalability
When you consider that 70 per cent of vacation rental management companies in the United States are between one-19 in staff, it becomes clear that traditional property management companies have a problem with scale.
The lack of scalability is largely because of the downward pressure applied to them, in the vacation market as well as the residential and commercial lease markets. In both cases, the roadblocks to scalability are partially self-inflicted, and partially a result of market conditions. They are self-inflicted because there is a tendency amongst small scale management companies to charge less than they should. Low-balling an offer to get a contract is not great for the management company because it limits their growth potential. It’s not good for the landlord either, who winds up paying for a management company that is not able to perform as well as it could if it had invested in better software, tools, and/or manpower.
But the property management model also offers low scalability because the margins are not great. Going forward, as Airbnb, Sonder, Vacasa and other providers expand their presence, it is very possible that they will nudge out existing property management companies and offer all the same services in-house.
STR Revenue Model #3: Owner/Operators
Owner/operators run a hybrid model in which real estate development is coupled with property management. This model has been a part of commercial and hospitality real estate for some time now, and in recent years, some of these developers (and others) have entered the short-term rental market. The owner/operator model is a self-contained business proposition, with the real estate development often funding the construction of the residential units and then managing the units on the market. Partnerships are sought along the way in terms of interior design support and other specialised areas, but the key is that the developer stands to benefit from consistent cash flow once the building is on the market.
Features of the owner/operator revenue model include:
● Large upfront capital invested in the construction of a new building
● The developer rents out the units to residents (often in the form of a co-living ecosystem), and collects monthly income in cash
● The operator or residents can choose to rent their units on Airbnb or other booking platforms, increasing revenue stream options for the operator and offering flexibility to the tenant
In order to make revenue, owner/operators need to collect enough from either rent or condo fees to cover their debt repayment obligations they accrued to finance the construction of the building.
Here are some of the strengths and weaknesses of the owner/operator model:
Strength: Solid Long-Term Revenue
Owner/operators’ revenue projections are not as exposed to market trends in short-term stays as branded providers are. This is because they are not reliant exclusively on people travelling more to make their money. Although substantial upfront capital is required to get any project off the ground, the co-living ecosystems these companies tend to create are in demand for renters as much as travellers. They enjoy the flexibility of getting a condo licence and doing what YOTELPAD is going: selling condos that allow owners to rent out their units on the short-term rental market. They can do what Brix just did in Montreal: build and rent out uniquely designed apartments in a building that offers all sorts of appealing amenities.
Any route they choose will bring in long-term revenue, either in the form of rent or the sale of condos (plus monthly condo fees). In this way they are getting ahead of the curve as the sharing economy changes the way people want to live. A secondary strength is the high barrier to entry for owner/operators interested in entering this space, as this will reduce competitive pressure.
Weakness: Not Set Up to Manage Guests
The clearest roadblock to expansion for owner/operators is that they are not usually set up to manage guests. The examples mentioned above are the anomalies in what remains a pretty traditional market, as developers, in general, do not yet see the revenue potential of adjusting their operating model to accommodate frequent guests – nor do they want to, so they rely on property managers to manage. This relationship is fraught with pitfalls, as partnering with a poor manager will put a dent in their revenue. Owner/operators are therefore caught between a rock and a hard place. The commercial and residential lease markets might be stable, but forward-thinking developers are going to be the ones who, despite the associated risks, adjust their model to better service the burgeoning short-term rental market.
The future of short-term rentals: More competition on the horizon
New companies will continue to enter the market and disrupt traditional models. The pressing question is how they will do it, and what differentiators will help them succeed. These three revenue models have proven effective in the short-term rental market of today, but each show areas of weakness that could lead these impressive companies astray. With lots of competition on the horizon and regulatory changes to come, as the market matures, it will be exciting to see how the revenue models I sketched above evolve.
For more information on revenue models, visit the Fulhaus website here.