Detailed Analysis of Investment Cabins In Gatlinburg, Pigeon Forge, and the Smokies

My goal and objective of this article is to help explain some of the ratios, multipliers, and other measures I use to evaluate an overnight cabin rental investment in the Smoky Mountains. There are various different metrics that can be used in order to analyze and determine the profitability or viability of an investment cabin rental. Below I will give my opinion on the strengths and weaknesses of using several different methods to analyze your potential cabin investment.

I must note that although I do have a degree in Finance, I am not a financial advisor and you should seek advice from an independent financial advisor if you see fit. Overnight rental cabins gross rental incomes can vary greatly depending upon the individual cabin’s amenities, location, and management company used. Expenses can also vary greatly depending on the individual investment cabin such as the HOA fees (if any) from the cabin location, the utility costs, property taxes (properties located within the city limits of Gatlinburg, Pigeon Forge, and Sevierville have higher property taxes than cabins located within Sevier County), homeowners insurance (based on the location, fire zone, and company used for insurance), and the overall condition and repairs necessary for the individual cabin. Cabin investments may not be suitable for all investors or property owners.

Different Ratios and Multipliers Used to Evaluate An Overnight Cabin Rental Investment in Gatlinburg and Pigeon Forge

Gross Rental Multiplier

The gross rental multiplier (GRM) is a very simple metric I use to quickly determine which cabins are most likely to be viable investments. The formula is quite simple (Price divided by Gross Rental Income). For example, a cabin with a listing price of $300,000 and a gross rental income of $50,000 per year has a gross rental multiplier of 6. The lower the gross rental multiplier, the more likely it is to be a better investment for a buyer.

Often I will take the database of all the properties available within our market, extract the gross rental incomes noted in the MLS for the property along with the listing price, and then come up with the simple gross rental multiplier for the individual property. This method is a very quick way of ruling out a large portion of cabins based on past performance. It is important to note that there are some drawbacks in the use of this method.

First, many Realtors in our area do not include the gross rental income for overnight cabin rentals. So, there is the possibility of skipping over potentially lucrative cabin investments from listings where the Realtor hasn’t included the gross rental income within the data of the listing. Also, sometimes a Realtor may only have a partial year of income listed which would cause the data and gross rental multiplier to not be accurate.

Second, the gross rental income derived from a cabin can vary greatly depending on the management company the owner uses. If the existing owner of a cabin is using a sub par management company that doesn’t produce a very high gross rental income, the results shown in the MLS will often show a poor GRM.

The same property under the management of a better company within the industry may create a substantially better GRM. Also, the gross rental multiplier only takes into consideration the gross rental produced from a cabin. With management companies offering varying rates of commission (management fees) this substantially influences the net income derived from a cabin.

For example a cabin grossing $50,000 per year with Company A and $50,000 per year with Company B will have the same gross rental multiplier. However, the gross operations income to an owner using Company A that has a 60/40 split is $30,000 while Company B with a 70/30 split would have $35,000 of income to an owner. Obviously this has a substantially impact on the cash flow of a cabin.

Third, some properties may be underperforming not only from a management company perspective, but have the potential to increase the gross rental income from fairly simple changes or amenity additions to the cabin. There are numerous examples to improve the gross rental income on a cabin. Some examples include removing a few trees to open up a mountain view, adding additional features/amenities such as theater rooms, outdoor fire pits, arcade machines, and many other upgrades. Each of these can have a positive impact on the gross rental income obtained.

To summarize, the GRM is a useful tool to quickly determine if a property may have viability as an investment. However, it is important to dig deeper and in more detail to determine if a cabin is a wise investment. I regularly study and create data of past sales of cabins within our Smoky Mountain MLS to gather information on the average and median gross rental multiplier of cabins. Nearly always my clients obtain properties for less than the average and median GRM of sales within our MLS. I take great pride in researching properties in detail and striving to locate the best possible investment for my clients.

Capitalization Rate (Cap Rate)

The cap rate is another simple formula that is often used in commercial real estate to evaluate a property. A cap rate is simply the first year “stabilized” Net Operating Income (NOI) divided by the sales price. It is important to note that in calculating NOI for buyers when doing an analysis I always estimate replacement reserves.

Replacement reserves are a monthly amount allocated to hold in reserves for large future capital expenditures to maintain the cabin such as staining the cabin, replacing furniture, replacing a HVAC unit, new hot water heater, etc. Most Realtors in our area don’t have the first clue what hardly anything in this article is talking about. But among the very few that do this type of cabin analysis, very few (if any) have a detailed formula to anticipate replacement reserves.

For example, a cabin with a NOI of $25,000 the first year and a sales price of $300,000 would have a cap rate of 8.33%. A cap rate goes one step further than the gross rental multiplier as it takes into consideration the operating expenses of a cabin (such as taxes, insurance, HOA fees, utilities, repairs, management fees, etc.). However, it is lacking in getting a full picture to the cash flow if one is obtaining a loan on a property. The cap rate doesn’t take into consideration using leverage to purchase a property, so it doesn’t include any debt service, closing costs, initial repairs and improvements after closing, etc.

Using a cap rate to analyze an investment can be a good measure when comparing various different potential investments and the likelihood of the viability of an overnight cabin rental as an investment. However, if one is obtaining a loan on a property it lacks taking into consideration the cost associated with the loan such as the monthly mortgage, loan origination fees, and other upfront costs associated with obtaining a loan.

It also doesn’t take into consideration tax considerations such as depreciation or income taxes based on the cabin’s performance. Also, if the NOI has a substantial fluctuation after the first year it substantially alters the cap rate and therefore the value. A cap rate has an inverse relationship to value. Assuming the net operating income is the same, if the cap rate increases, the value decreases and vice versa.

When looking at investment cabins some buyers may say they want to find a property “with an 8 cap” or something similar. In my opinion using a cap rate can be a decent initial interpretation to determine if a cabin investment is worthwhile. However, there are more detailed and accurate measures to determine the overall return on an overnight cabin rental investment.

Net Rent Multiplier (NRM)

The net rent multiplier is another easy formula that is the Purchase Price/NOI. The lower the number the better for a buyer. This measure doesn’t take into consideration debt service either since it is based on NOI.

Operating Expenses Ratio (OER)

The operating expenses ratio is the operating expenses/effective gross income. This ratio is especially useful to determine, for example, whether certain types of overnight rental cabins are worth the additional operating expenses based on the rental income they’d generate based on that type of cabin.

One may consider a cabin with a private indoor pool. The operating costs will be undoubtedly be higher for the property with the indoor pool in comparison to a standard run of the mill cabin due to the utility costs to heat the indoor pool, maintenance & repairs, and a higher homeowners insurance cost. However, one must also consider the extra rental income that would be generated from the investment cabin having an indoor pool.

We could evaluate a hypothetical example of an investment cabin with an indoor pool that had operating expenses of $25,000 per year and had an effective gross income (gross rental income minus management company fee split) of $48,000 per year. The OER is 52.08%. Now let’s compare that to a cabin that has considerably less operating expenses of $15,000 per year, but generates quite a bit less in effective gross rental income ($28,000) because it doesn’t have the indoor pool as an amenity. The cabin without the indoor pool has an OER of 53.57%. In this scenario, since the indoor pool has a lower OER it can be justified that the pool was worth the extra expenses to operate due to the extra rental income it derived.

The OER can be used in comparing a wide variety of different type scenarios such as properties with city utilities (water, sewer, etc) versus those on an individual septic system and well water. For example, cabins within HOA fees will typically have higher operating expenses, but some cabins benefit from the additional amenities within the HOA and will produce a higher rental income. So although the expenses may be higher for a cabin within an HOA with the additional income produced it may still produce a higher OER. This scenario doesn’t take into consideration debt service.

Personally, I use it to obtain an indication if the expenses are abnormally high for a property and determine ways to reduce the overall operating expenses. Also, I use it to compare different segments or categories of investment cabins to determine which types are “worth” the extra expenses due to the income they produce (such as those in HOA’s, properties with indoor pools, etc.). Please note I use this calculation with the effective gross rental income after management fees. So it does take into consideration whether a management company charges 30%, 35%, or 40% for their services. In some commercial real estate circles they do not take into consideration management fees in this calculation (usually if it is long-term residential with perhaps a 5% to 10% management fee or commercial real estate building).

Debt Coverage Ratio (DCR)

The debt coverage ratio is determined by dividing the NOI by the cost of the debt service per year. For a quick and easy example, the DCR for a cabin with a NOI of $20,000 per year and annual debt service of $15,000 ($1,250 monthly mortgage payments) is 1.33. Basically, a property needs to have a DCR above 1.00 in order to produce a positive cash flow. The DCR measures the cash flow of a property to the debt obligations. The DCR can be useful in a few different ways such as determining cash flow under different loan scenarios (30 vs. 15 year amortization and at various different rates). The DCR is often used by banks when evaluating whether to make a loan to a consumer on a commercial property. The higher the DCR the better.

Internal Rate of Return (IRR)

The internal rate of return (IRR) is an important measure of analyzing a cabin because it takes into consideration the time value of money using a discounted cash flow. This is incredibly important for analyzing a cabin and its future rental income projections. Also, it is valuable to consider two competing cabins you would consider purchasing to determine which is the better investment. IRR is essentially the projected rate of growth from an investment.

One of the disadvantages to using IRR include not planning for replacement costs or “surprise” costs and the fact that the IRR assumes the positive cash flow received is re-invested at the same rate as the IRR. If the IRR is high on a cabin it may not be reasonable to invest the positive cash flow and receive the same IRR as what the cabin projects.

While the generally accepted method of calculating the IRR of a property doesn’t usually figure for “surprise” or replacement costs, I factor that in my estimate within the NOI which makes it way down to the cash flow projections. The “modified” IRR (or MIRR) generates what I would consider to be a more clear picture and real world results.

Modified Internal Rate of Return (IRR)

The modified internal rate of return (MIRR) is a more realistic real world solution to the negative aspects of using the IRR. With the MIRR the re-investment rate of the positive cash flow is set at a certain percentage determined by the investor. Most commonly the re-investment rate is set to a “safe rate” or the “risk-free rate of return”. A frequently used measure for the “safe rate” is the three month US Treasury Yield.

For example, if the IRR is 12% and the cabin produces a $15k per year positive cash flow, but a cabin owner feels they can’t realistically re-invest the $15k and reliably receive a 12% yield on the money, then using the MIRR would be a much more appropriate approach. Using the MIRR a person can set the anticipated return of the positive cash flow re-invested at a number such 2.5% or the risk-free rate of return.

The re-investment rate doesn’t necessarily need to be the risk-free rate of return, although it is a commonly used metric. Other treasury bills, safe bonds, or even the same rate as their interest rate on the cabin loan if they put the positive cash flow toward the principal could all be possibilities.

If a cabin owner put all of the positive cash flow back toward the principal of their loan it wouldn’t create an exact match of return as their interest rate due to mortgage interest deductions and other factors, but it would create a reasonably close scenario and principal reduction. If one were to set their re-investment rate the same as the result of their IRR %, then the MIRR would be the same as the IRR (assuming no negative cash flow year during the years evaluated)

The MIRR also takes into consideration any negative cash flows by using a “safe rate”. Anticipated negative cash flows are discounted back at the safe rate (aka finance rate) to figure how much has to be allocated today to fund future cash outflows. A real life scenario on a cabin would be a cabin owner anticipating to do a major renovation or addition to a cabin in perhaps year 3 of owning the property. The MIRR would take into consideration the negative cash flow in year 3 and discounted back at the safe rate to determine how much has to be set aside to fund the major cabin renovation (capital expenditure). The safe rate is best to be set at a rate of risk free return for placement of cash for long-term repair reserves, improvements, etc. when your NI is negative. The current yield on a savings account or CD would be an example. Along with short term treasuries such as the 3 month US Treasury bills.

In order to attempt to be as precise as possible and mitigate any minor flaws in the calculation of MIRR when I do an MIRR calculation I include an estimated replacement cost factored into the NOI (as noted above under Cap Rate) for each year. This anticipates longer term frequent costs such as staining a cabin, replacing a roof, HVAC, etc.

The MIRR metric is a superior method of calculating the anticipated return on your cabin than using IRR. The MIRR eliminates the negative cash flow limitations with IRR, the re-investment rate implications of the IRR, and isn’t a polynomial equation like the IRR which can produce (or result) in multiple solutions.

Net Present Value (NPV)

The net present value (NPV) is the difference between the Present Value of future cash flows and the amount you invested to acquire them. It is an important indicator and evaluates how much more or less your initial investment needs to be in order to achieve your desired rate of return

Profitability Index (PI)

The profitability index (PI), as the name would imply, is a measure of the profitability of the cabin investment. A number of 1.0 or above is important to have a viable investment. The higher the number the better. The profitability index is the discounted cash flow (DCF) divided by your initial cabin investment cost (down payment, closing costs, initial furniture/repairs, etc). The initial cabin investment cost is also known as the metric named “equity investment” or “initial cash outlay”.

Discounted Cash Flow (DCF)

The discounted cash flow (DCF) is the present value of future year cash flows. Typically the DCF is calculated based on anywhere from 5 to 15 years. It should be calculated based on the anticipated duration you plan to own the cabin.

If you were to own the investment cabin for five years, the year “0” would be your initial investment costs or total out-of-pocket cash costs (down payment, closing costs, initial furniture/repairs, all acquisition costs, etc). Years 1-4 would be your cash flow. Finally, year five would be your cash flow including your sales proceeds. The proceeds equals the sales price minus your existing mortgage, real estate commissions, and other related closing costs.

In order to create and determine the DCF first one must forecast the projected cash flows for each year for the number of years they intend to own the cabin. Next, one must set a “discount rate” (or required return) which should be set by the individual as their desired rate of return (in the case of an individual investor).

Corporate investors typically set their required rate of return as the weighted average cost of capital (WACC). When determining a discount rate it is important for individuals to properly consider the riskiness of the investment to establish their required return. This can be said for any investment.

The risk of a junk bond is much higher than a Treasury bill or safe corporate bonds, so the yield is higher. The discount rate isn’t necessarily an easy number to ascertain other than by just saying “I want to receive an xx% return”. The DCF can be used to compare alternate investments to each other as long as the discount rate set is realistic between the two competing investments based on the risk involved with each.

Once the discount rate is set, then the cash flows are discounted back to the present at the required rate of return (discount rate).

Summary of Ratios and Measures

Easy formulas and metrics such as the gross rental multiplier and cap rate are easy to determine and can give a decent initial outlook on whether a cabin investment may be viable. However, it is important to dig deeper and give a multi-year projected approach where cash flows may have significant swings from one year to the next (due to large capital expenditures or other circumstances) which can cause substantially different results. The MIRR, DCF, NPV, and to a lesser extent IRR are all examples of more in-depth analysis of a cabin’s anticipated performance.

I hope this information has been useful. I can go into much more depth on each of these metrics if you would like. Feel free to email me at jay@WearsValleyHomes.com or call me on my cell phone (865) 809-8600. I also have created an incredibly detailed spreadsheet (even more so than I have on my website under Cabin Rental Investments) which I use to evaluate cabins for my clients that includes graphs along with all the ratios, metrics, and measures mentioned in this article above and more.

It is essential to evaluate and really look at the performance of an overnight rental cabin in our area. It is way too often I see in our MLS and elsewhere where people have paid prices for cabins in Gatlinburg, Pigeon Forge, Wears Valley, or anywhere in Sevier County where the rental income the properties generate won’t produce a positive cash flow or are otherwise poor investments.

My goal is to find my buyer clients the best investment I possibly can and fit their needs. Not only for their ROI goals, but the type of investment cabin they desire as well. A very large percentage of buyers I have represented have purchased multiple cabins through me over the years and continue to do so.

Investment Cabin Depreciation and Cost Segregation

Some cabin owners elect to use a strategy of cost segregation when filing their taxes and calculating depreciation on their property. I have heard differing opinions from accountants on whether overnight investment cabin rentals need to be depreciated over 39 years (such as a hotel or commercial building) or 27.5 years such as a residential property. Some have argued that it is a residential stand alone single building, while others have stated the use of the property as transient, similar to a hotel, with overnight use and not long-term rental qualifies an overnight rental investment cabin as a commercial building and must be depreciated over 39 years instead.

One thing is for certain, an investment cabin owner may elect to use a strategy called cost segregation to depreciate certain improvements of the property reducing the recovery period in comparison to the structure of the cabin itself. This can result in tax savings.

For example, personal property has a recovery period of 5-7 years. Furniture, hot tubs, things of this nature would most likely qualify under the personal property category and can be depreciated quicker than the structure itself.

Land improvements such as driveways, fences, and sidewalks can be depreciated over 15 years. It is somewhat difficult to determine an exact value of each component of a cabin when purchasing the property. I suggest getting the expertise of a CPA and tax professional.

Hypothetically, a person could purchase an investment cabin for $300,000. The land value may be $45,000 of that purchase (which can not be depreciated). However, the structure itself could be valued at $225,000 (depreciated over 27.5 or 39 years depending on which CPA you talk to!), the driveway at $5,000 depreciated much quicker than the structure itself, and the personal property/furniture valued at $25,000.

These are just random hypothetical figures. Please contact a CPA and a qualified engineering consultant to give appropriate allocations for each category of cost for your cabin.

One negative ramification to consider when using a cost segregation strategy is that eventually you will be subject to recapture provisions under the tax code. It is important to have accurate representations of the different categories and consult CPA’s, experts in cost segregation, and qualified engineering consultants to give accurate figures of the true cost for each category. Otherwise, you could be subject to an audit and face penalties/consequences. The IRS has a good outline and idea of cost segregation here and here.

 

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