Last updated on July 3, 2021
When people think about buying a vacation home in the United States or Canada, they often imagine getaways to Maui, Lake Tahoe, Palm Beach, Whistler, Muskoka Lakes, Mont Tremblant and other vacation hotspots. Typically, people are drawn to vacation properties as places to go to relax. While it is undoubtedly true that second homes serve that purpose, they can also make fantastic investments. Typically buying real estate is a wise decision, as property values tend to appreciate over the years. But is a vacation home a good investment relative to other asset classes? With this question in mind, we consider the pros and cons of owning a vacation home as an investment.
Curious about your potential return on investment should you decide to purchase a vacation home? Simply complete the inputs in our vacation property investment calculator to find out more.
Historically Safe Investment
Like many other industries, real estate is prone to price fluctuations. Yet, by looking at historical home prices in the United States and Canada, it’s clear that real estate offers a fairly safe investment.
In the United States, apart from the housing crash of 2008 (which prices have since recovered) real estate prices have increased consistently since the 1950’s, going from a median home price of US$180,039.29 (inflation adjusted) in 1953 to over US$300,000 in 2021. Canada has also had historically steady growth when it comes to real estate. In fact, Canadian real estate prices have continued to appreciate despite the 2008 housing crash in the United States.
In short, it’s rare to have a complete collapse in prices as historical real estate prices illustrate. Instead, real estate prices have typically shown slow and stable growth over time.
Additional Safety Net
Perhaps one of the reasons why real estate is a relatively safe investment is that the land and structure you own will always be worth something. People will need a place to live and travel. This fact remains true both in a bull market and a bear market. While your vacation home may go down in value, it will never be worthless like other investment types.
Therefore, many people look at property as a relatively safe investment with less downside than other equities. If you are looking for a way to preserve your wealth, real estate is often a stellar way to do this. Of course, there is an added benefit that you get to enjoy your investment while simultaneously knowing that you are using your money wisely. If the worst case scenario happens and there is a complete crash in the real estate market or tourism industry, then at least you can use your vacation home for weekend getaways or family vacations.
Real estate is also unique in that there are relatively well-defined processes for extracting equity out of your home without actually selling the property at comparatively meager interest rates. If you ever find that you need money, unlike stocks and bonds, you can apply for a second mortgage or a home equity line of credit (HELOC) and access your equity for an interest rate that is typically only slightly above inflation. Meanwhile, while you are borrowing that money, your underlying asset – the vacation home – continues to appreciate and can still earn rental income to pay that HELOC back.
Ability to Generate Rental Income
When you are not using your vacation home, you have the option of renting it out. If you buy in a prime tourist destination, your home will be able to command fantastic rental rates. If you hire a property manager to coordinate these rentals for you, then most of the work will be taken care of for you. If you would like to manage things yourself, then there are any number of vacation rental platforms to choose from.
There are also tax benefits to renting your property out when you are not using it. Expenses you incur while renting it out (e.g. property taxes) can offset rental income. If your annual property tax bill is $2,000 per year, and you rent out your vacation home 80% of the time, then you can write off $1,600 of your taxes against that income.
Of course, tax laws in the United States and Canada are nuanced and varied, so you should consult with a qualified accountant before deciding to rent out your particular vacation home.
Renovations Increase Value
Investing in your vacation home has two benefits. First, it enables you to enjoy it more while you are using it. Second, it increases the value of your vacation property.
Furthermore, if the renovations help to rent the property out or increase the amount of rent you can charge, you might be able to deduct those expenses against rental income (again, consult with a tax professional for your particular circumstance).
This point is particularly true if you buy a vacation home at a discount that needs work. As a quick example, suppose that you buy a distressed property for $300,000. Houses of similar size go for $500,000. Now, you put in $50,000 worth of renovations to make it habitable. Over the next five years, you put in another $50,000 to make it pristine. In the meantime, you’re able to enjoy the property and occasionally rent it out for other people to use.
After all those renovations, your home is now worth $600,000 because it is better than all the other homes on the market. You put in $400k between the purchase price and renovations. You were able to rent it out for some passive income during those five years. After all that time, your home is now worth $200k more than you paid for it, netting you $100k in additional equity after the cost of the renovations are taken into account. You got a place to enjoy, some passive income, and still come out ahead financially. If you’re willing to put a little bit of elbow grease into a distressed property, a vacation home can be a great way to make a little bit of money while having a fun and enjoyable place to go.
It Can Help You Achieve Your Savings Goals
If nothing else, owning a vacation home results in forced savings.
A vacation home can act as a delightful savings account. If you sometimes find it challenging to save, buying a vacation home as an investment can help you achieve your savings goals without being a bank account that you can withdraw from effortlessly. For some people, it’s easier mentally to save money by investing in a goal or a dream than it is to sock away cash for the sake of socking away cash. If you fall into that category, a second investment home might help you achieve your savings goals.
Of course, unlike a bank account that might earn 1.5% interest if you are lucky, the capital appreciation on a home has historically been much higher. If you are looking to accelerate your wealth building, having properties besides your principal residence is a fantastic way to achieve that.
Tax-Advantaged Wealth Building
You needn’t rent out your property to see the benefits of investing in a vacation home. Any property appreciation that you achieve is tax-deferred until you sell and is subject to capital gains tax instead of regular income tax. In the United States, capital gains are generally included in taxable income, but are typically taxed at a lower rate. For instance, short-term capital gains are taxed at rates up to 37% and long-term gains are taxed at rates up to 20%. In Canada, you are taxed on 50% of the capital gain, not 100%. If you held a property for ten years that appreciated in value by $100,000, you would owe tax (at the relevant rate) on 50% of that ($50,000). Whether you’re resident in the United States or Canada, you can take advantage of the lower level of taxation on capital gains.
Of course, if you invest in stocks, bonds, etc. you also get this tax advantage, but those tend to be a little riskier than real estate. Further, if you put that money in relatively safe investments like Certificates of Deposit (in the US) or GICs (in Canada) and savings accounts, then you owe income tax on any interest generated from those accounts immediately once you earn it. With real estate, you don’t realize a gain until you actually sell your vacation home. Therefore you can defer any tax obligation until you decide to sell. Real estate blends the best of all worlds by offering a tax-advantaged way to build wealth while still providing strong returns on investment.
You Can Build Wealth Using the Bank’s Money
One somewhat unique property of owning real estate as an investment tool is that the bank will lend money at relatively inexpensive interest rates to purchase it. This money will then typically earn a higher ROI than the underlying mortgage costs. In effect, buying an investment property enables you to make “free” money.
Consider the following example. Suppose you buy a $500,000 home. You put down 50% or $250,000. The bank puts down the other $250,000 at an interest rate of 3% on a 25 year amortization schedule, and the property appreciates 8% per year. At the end of 5 years, your home will be worth $734,000. Not bad! You’ll also owe $213,000 on the mortgage after paying approximately $71,000 in monthly payments, $37,000 of which went towards the principal. You can sell your property for $734k and pay off the $213,000 balance with the proceeds. You will have $521,000 left after the sale (excluding real estate commissions, taxes and fees). That $521,000 is off of your original $250,000 investment plus the $71,000 in mortgage payments. Therefore, your net profit is $200,000, which is not bad, considering you only put in $321,000! That’s an ROI of over 60% in 5 years.
The reason you were able to have such a substantial return on investment is that you were earning 8% on the full value of the vacation home, while only paying 3% to the bank on half of that value. No other investment has access to “cheap” money quite like this. The margin rates on stocks are quite expensive. Bonds don’t have loans like this either. The only investment with interest rates that hover this low is real estate.
Historically Outperformed by Other Investment Types
While past performance is not necessarily indicative of future performance, historical returns are an important consideration for any mindful investor. At the very least, the long term results of different investment types will paint a clearer picture as to what you can reasonably expect over the long term. Given that there are various different competing investments you can make, from stocks and bonds to gold and other precious metals and even crypto currencies, it’s important to do your research before you put your money to work.
Comparing historical real estate returns, however, is not necessarily an apples to oranges comparison with the stock market for instance. For example, real estate returns can vary substantially from city to city so national data may not be completely accurate. Further, with real estate you have the potential to not only earn a return on your investment through price appreciation but also rental income which is not always easy to measure. Finally, real estate purchases are typically highly mortgaged (or leveraged), which can magnify gains. Still, by working with the available data we’re able to see how real estate stacks up against other investments.
In the United States, the long-term nominal (not inflation-adjusted) annualized return from 1928 to 2020 was 4.0% for U.S. real estate. By comparison, US large-cap stocks returned 9.8% over the same period. In Canada, similar data suggests that equities have been a more effective way to grow wealth compared to real estate. For instance, from 1996 to 2020, house prices in Canada increased on average 5.7% whereas the TSX composite index rose 8.0% over the same period. Of course, none of the data can accurately account for rental income nor the magnified returns when using the bank’s money.
In short, the data suggests that US and Canadian real estate are a relatively poor investment choice as compared to other asset classes. Keep in mind, however, the limitations with this data as further described above.
Not Truly Passive
The reality is that owning a vacation home will require a certain level of active involvement.
If you plan on renting out your vacation home, perhaps as a short term rental, then you’ll need to manage the bookings, collect payments and attend to other matters, although short term rental websites such as Airbnb and VRBO have certainly made this easier. Yet you will still be responsible for the guest experience and have to deal with any issues that arise. Even if you hire a property manager there will still be annual obligations such as paying property taxes, renewing insurance etc. Undoubtedly, unexpected issues will arise such as major repairs or renovations that will require your time and resources.
By comparison, investing in the stock market is a truly passive investment and, as illustrated above, may outperform real estate in the long run.
Lack of Diversification
Diversification is an important component of any investment strategy. Simply put, rather than risking all of your resources on any single idea, venture, or asset, it’s important to invest in multiple asset classes. For instance, while investing in gold may turn out to be a prudent choice over a five year period, it may turn out to be a bad choice for the next ten years after that. Similarly, the real estate market has periods of strong growth and little to no growth. Look no further than the 2008 financial crisis for a recent example of a period of depressed real estate prices.
Assuming you own your primary residence, then committing further money to a vacation home may be risky, depending upon how well diversified you are in other asset classes.
Stricter Lending Criteria
Mortgages for vacation homes will often be accompanied by larger down payment requirements, higher interest rates and more stringent lending guidelines.
This is because vacation home mortgages are more risky as owners may be more willing to default on their vacation home mortgage (as opposed to the mortgage on their primary residence) when faced with financial hardship. For example, many lenders will require at least a 640-credit score, and a 20% to 30% down payment on a vacation home. The higher down payment reassures lenders that you’ll make your payments on time. You can also expect to pay mortgage rates that are 0.25% to 0.5% higher than you would for a primary residence
If you can’t satisfy these more stringent lending criteria or the requirements otherwise make the investment uneconomic, then there may be other more attractive investments to make.
Assuming you qualify, a second home mortgage will increase your leverage and overall debt to income. While you may be able to handle the monthly payments (with or without rental income), it’s not without risk. For instance, as the COVID pandemic has shown, unforeseen events can seriously impact your finances. Whether it’s loss of income due to career setbacks or loss of rental income due to a downturn in the travel industry, there are many potential events that could adversely affect your finances. Even weather related events could result in your once promising vocational rental sitting idle.
The point is that with increased leverage comes increased risk. Most financial experts recommend that you have a debt to income ratio of no more 43% overall and 30% on housing expenses. Try to ensure you stay within these limits and, when crunching the numbers on your vacation home, assume the worst. If you can handle the monthly payments in the worst case scenario, then buying a vacation home may just be a good idea.
Vacation Home Freeloaders
If you’re buying your vacation home as an investment then it can often be a challenge for friends and family to accept that they can’t use the property whenever they want, either for free or at a substantially reduced rate. Many people may even feel entitled to use your property. This is where it becomes more difficult as an investor as opposed to someone who simply wants a second home to spend time with friends and family. As an investor, you should be maximizing your investment and looking for new ways to generate revenue or increase your return on investment. Yet some people can’t understand that. With alternative investments such as stocks, you won’t have this issue as your uncle’s second cousin can’t borrow your Amazon shares for the weekend. If you do rent out your property, provide a universal friends and family discount between 10-20% and don’t deviate from it.
Vacation Home as an Investment: So Where Does That Leave Us?
Like any other asset class, investing in real estate has its pros and cons. Historically, home prices in the United States and Canada have shown consistent if not unspectacular returns. Yet you can also extract value through rental income and home renovations all the while using the bank’s money to do so. What really separates buying a vacation home as an investment from other investment types is the dual purposes for which it serves. While a vacation home can make a great investment, there are intangible benefits that can’t be measured. You can’t, for instance, put a price on pride of ownership or memories with the grandkids. The joy that a vacation home can bring is something that other investment types just can’t come close to matching.
Ultimately, if you’re looking to maximize your return with a truly passive investment then perhaps investing in the stock market is more appropriate. However, if you’re willing to assume all of the responsibilities as a vacation homeowner, then you can still enjoy the fantastic returns on investment while you have fun!
No matter what your investment and lifestyle objectives are, buying a vacation home as an investment can often get you there. For more articles and resources on buying a vacation home click here.