Fixed-Rent Contracts, Leasebacks, Net Commission Arrangements, Guaranteed Payments, Fixed Leases…
These are all terms used in the vacation rental industry to describe an arrangement between the property owner and the property management company in which the management company pays the homeowner a predetermined, “fixed” or “guaranteed” monthly payment for rental rights to the property. In this arrangement, the manager is able to keep all revenue he makes from the rental over the amount paid in monthly payments to the homeowner.
Vacation rental managers have been hearing a great deal about the benefits of “Fixed-Rent Contracts” over the last two years. Every VRMA conference has at least one session promoting this type of business arrangement with homeowners, and in the most recent VRMA Review, the cover story was entitled, “Fixed-Rent Contracts: Good for Managers, Good for Owners.” (VRMA Review, Winter 2016, Volume 28, No. 1)
But are Fixed-Rent Contracts really good for managers and good for owners, like the article says?
At VRM Intel, we receive emails, calls and comments from vacation rental professionals, homeowners and employees on a range of issues. After hearing multiple reports about several companies across the country who utilize Fixed-Rent Contracts experiencing business difficulties, we reached out to industry experts to find out more about these “net arrangements” or “Fixed-Rent Contracts.”
According to Tim Cafferty, President at Outer Banks Blue in North Carolina, “Net arrangements are not legal in this state and are not looking out for your client’s best interest in the eyes of the Real Estate Commission.”
“In a client relationship you owe the fiduciary loyalty, duty and obedience,” Cafferty explained. “The NC Real Estate Commission has been strong on this. They feel you are not fulfilling your ‘duty’ to the client.”
And the North Carolina Real Estate Commission has a point. These contracts encourage VRMs to favor one property over another for reservations. Let’s look a little deeper into this model that – for simplicity – we will refer to going forward as “Fixed-Rent Contracts.”
Advantages and Disadvantages for the Owner
The major advantage for the homeowner in signing a Fixed-Rent Contract is securing a steady, guaranteed income stream for the home. Jeff Paglialonga, owner of TeemingVR, said, “For older retirees looking to eliminate fluctuations in income, these contracts work well.”
Steve Milo, founder and managing director at Vacation Rental Pros added, “We are starting to see builders of vacation rental homes in Orlando discuss leaseback options with potential buyers. It is most attractive for foreign buyers, particularly if they are looking for bank financing as leaseback contracts offer guaranteed cash flow to show the bank.”
With Fixed-Rent Contracts, homeowners are also able to eliminate market risk. In a bad market, the homeowner covers his expenses.
However, in a good market, the owner is leaving money on the table. There are several additional key disadvantages for the property owner:
- The Owner has Less Access to His Vacation Home – While Fixed-Rent Contracts vary on how many days of use are allowed, the owner has significantly less flexibility to enjoy his vacation home.
- More Wear and Tear on the Home – Vacation rental managers are more likely to book a home in their inventory under a Fixed-Rent Contract than a commission-based home since they are able to keep all of the revenue. As a result, there are more stays in the Fixed-Rent home resulting in more wear and tear on the property.
- Higher Utility Bills – For similar reasons, higher occupancy leads to higher utility bills. In some cases, vacation rental managers are opting to pay for utilities as part of the contract.
- Risk of the VRM Experiencing Cash Flow Issues – If the vacation rental management company experiences financial issues, the VRM will prioritize paying trust accounts for commissioned homes for which they have collected advanced rental payments before paying Fixed-Rent expenses.
Advantages and Disadvantages for the Vacation Rental Manager
For the vacation rental manager, the decision to pursue Fixed-Rent Contracts is more complicated. While the utilization of Fixed-Rent Contracts can help a company quickly obtain – or buy – market share, there are other considerations. These arrangements are not new. In Orlando in the mid 1990’s, many property managers utilized these contracts, and some went out of business as a result. Fixed-Rent Contracts require discipline, deep market knowledge, strategic construction and flawless execution.
Why are Fixed-Rent Contracts complicated for VRMs?
1. Trust Accounts vs. Fixed-Rents
For vacation rental managers who responsibly operate under trust accounting rules, there are specific ways in which rental payments are protected for the homeowner. In contrast, the Fixed-Rent payments to the owner are allocated as an expense. Therefore, the money due to the homeowner is not protected, and there is a temptation for the VRM to use monies collected from rental payments for homes under Fixed-Rent Contracts to expand the business or to pay expenses. Even the best VRMs can easily find themselves upside down paying fixed payments to owners if rental payments are not set aside.
2. Fiduciary Responsibility to All of Your Property Owners
To revisit Tim Cafferty’s comment, according to the North Carolina Real Estate Commission, “In a client relationship you owe the fiduciary loyalty, duty and obedience.”
The VRM is more likely to push reservations for the home for which they get to keep the revenue over a commission-based home where they only get to keep a small percentage. Consequently, demand is not evenly distributed across the VRM’s inventory, resulting in favoring the Fixed-Rent home and harming the commission-based property owners.
3. Revenue Requirements for the Property Owner
In the vacation rental industry, a large percentage of homeowners are using short-term rental income to supplement the cost of owning a vacation home instead of requiring a profit-driven income stream from the rental of their home. In contrast, once a VRM is paying for a Fixed-Rent Contract, he now is required to make money on the property.
We reached out to George Volsky to help explain this principle:
A key difference between vacation rentals and hotels lies in the goals of investors. A hotel is often owned by a real estate investment trust (“REIT”), which assigns operations to a management company. The REIT expects the manager to generate enough rent to both pay the mortgage and generate a return on investment.
A vacation rental home, however, is usually owned by an individual who expects to lose money for five to eight years until he can sell the property at an appreciated price (enjoying lifestyle benefits in the meantime).
Take a poll of all the vacation rental companies you know. Find out how many of these companies (or these companies’ owners) actually own homes in their own rental program. Of those that do, find out how many generate positive cash flow. There is a reason why VRMs – our nation‘s experts on vacation rentals – tend not to own the properties they rent.
4. Risk vs. Reward
According to Volsky, “Under traditional contracts, VRMs charge whatever renters will pay. The homeowner assumes the market risk. However, when a VRM executes a Fixed-Rent contract, the VRM effectively ‘buys and owns’ the weeks, assuming all risks.”
The vacation rental industry is built on the premise that the homeowner is able to absorb the risk associated with rental income since the owner prioritizes the value of the home over the rental income. Fixed-Rent Contracts shift all of the risk to the VRM, while the homeowner is quite willing to accept the risk of less rental income as they still maintain value and appreciation of the actual home. Unlike the owner, when the VRM takes on the risk, he cannot afford to lose money.
TurnKey Vacation Rentals Chairman John Banczak explained, “Anyone who takes on more risk needs to see more reward, and vice versa. If you are a business getting 35% from a property, when moving to Fixed Payments, you are going to want to see more reward. That means the Fixed Rents to owners have to be so low that it likely will not be appealing.”
5. Reservation-Based Model vs. a Property-Based Model
What is the difference between a reservation-based model and a property-based model? In a reservation-based model, the VRM makes money by increasing reservations, largely based on fees to the guests. In a property-based model, the VRM primarily makes money from the owner through higher commissions or service fees for managing the home.
If a VRM’s revenue model is reservation-based instead of property-based, more inventory doesn’t lead to more reservations. It just leads to more capacity. The demand has to be there to fill it. Knowing how your VRM generates income helps you to make an informed decision regarding Fixed-Rent Contracts.
Most experts agree that there are instances where Fixed Contracts can be beneficial when used intentionally, strategically and skillfully, but managing Fixed-Rent Contracts requires the VRM to be disciplined with the money, outperform the market in rentals without taking away from the commission-based inventory, and manage the risks associated with market and destination conditions.
“There is a place for Fixed-Rent contracts, but that place is defined in terms of strategic goals,” said Volsky. “Fixed home contracts will not generate profits for a majority of homes in a typical rental company. They will not earn long-term profits for even half of the units in a typical rental company. Fixed-rent contracts must be used in special situations by VRMs with sophisticated growth expectations.”
By Amy Hinote