John Carney was looking for more ways to say yes. As a principal at the Cleveland-based Landmark Cos., an owner and operator of around 700 units, he’s often approached by visitors or businesses looking for something beyond a hotel stay, but who aren’t interested in signing a traditional, 12-month lease.
With Cleveland’s emergence as a low-cost shooting location for big-budget movies like “Spider-Man 3,” “The Avengers,” and “Captain America: The Winter Soldier,” because its downtown serves as an easy stand-in for New York City, Carney has lots of opportunity to go Hollywood, right in the heartland.
“They were shooting two movies in Cleveland last fall, and we got a call asking if we could put five to 10 people up at our property over the short term,” Carney says. “So we didn’t say no. We said yes, let’s learn more.”
The company ended up accommodating four film producers at its Shoreline property, a 138-unit converted warehouse space with breathtaking views of Lake Erie, putting them in vacant, furnished units for the roughly two-month shoot.
“They were amazing people, and they went back to California having had a great experience with us,” says Carney, who has engaged with short-term rental operators Stay Alfred and FrontDesk to rent out vacant units at Landmark’s properties in Cleveland and Indianapolis. “Being open to saying yes to something other than a 12-month lease, and being more flexible, has led to higher occupancy for us. We’re making more money saying yes to these short-term leases.”
A 180-Degree Pivot in the Apartment Industry
Carney and Landmark aren’t alone. One-time pariahs in the institutional apartment space, short-term rental firms are suddenly getting the star treatment from the multifamily industry. While owners and operators shunned the mention of companies such as Airbnb and VRBO just a couple years ago because they enabled tenants to sublet their apartments—often in violation of the lease—when they were away, today apartment firms are partnering with a raft of institutional short-term rental operators to rent out their empty units themselves.
In addition to Stay Alfred and FrontDesk, firms such as Sonder, Lyric, Domio, The Guild, Locale, Mint House, Niido, WhyHotel, and Kasa are collectively taking down tens of thousands of units in the multifamily industry to suck up vacancies at stabilized properties or put short-term residents in lease-ups until new buildings achieve full occupancy.
According to global real estate services firm Cushman & Wakefield, there are now at least 23,000 units being leveraged at the institutional level for short-term rentals nationally, a number that has grown rapidly since last summer.
(Note: All data and insights from Cushman & Wakefield were provided prior to the COVID-19 crisis. Like the hospitality sector, the short-term rental industry has been impacted by the spread of the virus, and the long-term implications for operators in the space are not yet known. Cushman & Wakefield will be issuing new guidance in the months to come.)
“There’s been a flip,” says Susan Tjarksen, managing director at Cushman & Wakefield, and author of the report, “Short-term Rentals: The Next Evolving Asset Class.” “The apartment industry woke up and said, ‘Hey, wait a minute, if we can rent out the same unit two, three, or four times a month, we can make more money.’ ”
Indeed, for Philadelphia-based Korman Communities, a pioneer of short-term furnished luxury rental and corporate housing going back to the 1960s, which today runs 7,000 units under its AKA, AVE, and ARK brands, the sector’s finally enjoying its day in the sun.
“We were always the redheaded cousin of accommodation. When we tried to explain this concept to people in the industry, they looked at us like we had three heads,” says Larry Korman, co-CEO at the firm. “Now, this is the fastest growing part of hospitality, the fastest growing part of housing.”
Twice Shy, Now Bitten by the Short-Term Bug
At the Washington, D.C.-based National Multifamily Housing Council (NMHC), an apartment industry advocacy group, observers say the sector’s swift attitude adjustment is the result of being burned previously by rapid changes in the business.
“They have enough history with changing models to realize that some of these trends you can’t stop,” says Rick Haughey, vice president, industry technology initiatives at NMHC. “They experienced the quick shift online with ratings and reviews, so now they know they need to figure this out.”
Short-Term Rental’s Multitude of Models
There are a number of operating models currently in the short-term rental space.
In one, short-term rental firms sign multi-year leases with institutional owners at or above market rates for blocks of apartments in a community and then rent the units out at a higher nightly rate for short-term stays. In doing so, they effectively become long-term tenants of the buildings themselves and alleviate occupancy risk for operators, while taking down large swaths of apartments in one fell swoop.
Other short-term rental firms target the green field area of lease-ups, where entire new buildings have hundreds of empty units, to generate fast, short-term income for themselves and owners, and exit the building once permanent occupancy is achieved.
Still others will manage a block of designated short-term units on a fee basis within buildings for operators, who enjoy higher short-term rates than they would get for a traditional, 12-month lease. “Sometimes that can be 30% to 50% more, depending on the submarket,” says Cushman & Wakefield’s Tjarksen.
In Cleveland, Carney’s been able to double his income on some units under the last model. “We’re getting almost twice the rent with a furnished unit,” says Carney. “The old school model is everyone wants a 12-month lease, but today people move around more. We know we get a premium on short-term leases, so when someone asks us if we’re open to a three-month lease, we definitely have that conversation.”
Renting Entire Buildings Under the Short-Term Model
For one developer in Dallas, being open to that kind of conversation led to a 10-year lease for the entire building with a short-term rental operator before the project has even been built.
Austin, Texas-based Rastegar Property Co. is still in the initial phases for 1899 McKinney, a 26-floor, 270-unit high rise in Dallas’ Uptown area that it eventually plans to sell as condos. But before the firm has even put a shovel in the ground, every unit is essentially already occupied, thanks to a jaw-dropping deal with San Francisco-based Sonder, which has agreed to lease the property for 10 years and rent the units out for short stays.
“I always look at everything from a risk-management standpoint,” says Ari Rastegar, the firm’s founder and CEO. “On this deal, we have a very clear bull’s-eye of what we need to hit for the condos in the future, but we’ve also de-risked the initial development side by having a corporate guarantee for the lease-up phase that’s already in place.”
The deal will allow Rastegar to focus on development and approvals, while Sonder markets the initial units. The quicker occupancy will also enable the property to transition to a lower interest loan faster, netting Rastegar savings on his debt service up-front.
“In a traditional multifamily deal, to put permanent financing on the property and get that lowered rate, you’re talking about a couple years to reach the requisite occupancy level,” Rastegar says. “But here, not only are we saving money on marketing for the lease-up, we’re also taking out the accrued interest of higher-rate debt. This allows you to move into permanent financing quicker, while saving some of those marketing dollars at the same time.”
Rastegar and Sonder aren’t alone in the whole building concept. “About a quarter of our units are in locations where we have 100% of the building,” says Mike Wilson, senior vice president of real estate for Spokane Valley, Wash.-based Stay Alfred. “So if we have a five- or 10-year lease at those properties, which isn’t uncommon in our portfolio, you can consider your vacancy erased during that period.”
Almost Too Good to Be True?
Yet, while the advantages of the short-term rental model for institutional apartment operators have materialized quickly, they also bring with them their own list of uncharted risks.
One is simply the newness of the space, and the raft of companies operating in it. For example, when Cushman & Wakefield put out an earlier report on the short-term rental sector in summer 2019, it highlighted just five companies and about 5,300 units being leased under a short-term rental model nationally.
Fast forward to February, when it issued an updated analysis, and the number of short-term rental companies on its list had doubled to 10, with unit counts topping 23,000. Cushman & Wakefield emphasizes some of those additions were simply due to it expanding its own data set to include more companies, but acknowledges it’s also the result of “rapid growth from the largest operators in the space.”
“Unicorn Risk” and the Ghost of WeWork’s Past
Given that break-neck expansion, the memory of shared office space firm WeWork’s highly publicized corporate implosion in 2019 still weighs heavily on traditional real estate pros’ minds.
“Institutional owners are very worried they’re going to partner with a company that goes belly up because it’s a unicorn,” says Sarah Yaussi, vice president, business strategy, at NMHC. “That’s very real to them.”
The reason why is because the business model behind short-term rentals, at its core, is essentially the same—take out long-term leases on space in bulk and then make a profit by renting it out in smaller, higher-margin chunks.
“As long as they don’t pull a WeWork, everything’s fine,” says Landmark’s Carney. “But it’s like any new partnership. Starting out, you want to go with something that’s manageable on your end and manageable on their end. When it works out, you give them more. When it doesn’t, you end up taking everything back.”
Rastegar also acknowledges the unique risks inherent to the model, particularly for his watershed deal. For instance, while he’s all but eliminated his lease-up risk by securing a 10-year lease from Sonder for his entire building, that also means he’s taking on more concentrated tenant risk, should things go sideways.
“If you’re running five units at a 100-unit building, you’re only adding risk to 5% of the portfolio,” Rastegar says. “But when it’s a larger deal like this that’s a couple hundred million dollars, the credit of your tenant becomes that much more important. That’s the risk.”
Sonder, for its part, is the largest and most well-heeled of all operators in the space, running 10,000 units and backed by $360 million in seed capital, more than a third of all funding in the sector, according to Cushman & Wakefield. “They’re the big boy,” Rastegar says.
Standing Out in a Crowded Field
Indeed, the CEO of one short-term rental firm points to capitalization risk as the reason why his company eschews long-term leases with multifamily owners altogether.
“We don’t engage in multiyear leases,” says Jason Fudin, CEO at Washington, D.C.-based WhyHotel, which currently runs about 400 short-term units in partnership with institutional clients. “Capital intensive, lease-based models have a huge question mark around their long-term sustainability. Just look at WeWork.”
Instead, WhyHotel’s model is based on working with owners and developers specifically at lease-up to increase occupancy in the short term while the building’s marketing team signs permanent residents. After that, WhyHotel exits the deal.
“More flexible approaches like WhyHotel are adaptable to changing market conditions, which is why we’ve found success with our pop-up hotels to date,” Fudin says.
Indeed, the firm launched its Hospitality Living business unit last year to develop buildings from the ground up, designed for flexible use to be run as pop-up hotels and apartments simultaneously on a permanent basis.
Long-Term vs. Short-Term Tenants
Another concern of institutional operators is killing the golden goose of their long-term residents, who don’t always look favorably on having short-term tenants living next door. For example, according to data compiled by Kingsley Associates for the NMHC’s “2020 Apartment Resident Preferences Report,” a combined 44% of renters 34 and younger said they would view short-term rentals at a community positively. But 82% of those 35 and older said they would view it as a negative.
To ensure long-term residents don’t get mad because there’s a different person in the apartment next to them every weekend, many short-term rental firms install decibel meters in units that get triggered by noise at odd hours to police bad behavior, while offering permanent residents discounted or free use of friend-and-family units for their own visitors on-site as well as discounts at short-term rental buildings in other cities for themselves while traveling.
Testing the Waters
When Chicago-based Waterton, whose portfolio includes $5.6 billion in assets, partnered with San Francisco-based Kasa to rent out a limited percentage of its apartments at select communities, impacts on long-term residents were one of the firm’s first considerations.
“We worked very carefully to design a program that meets the needs for our in-place residents, because we want to keep them there,” says Lela Cirjakovic, executive vice president at Waterton. “The customer experience and renter preferences to us are a primary driver.”
One of those steps included letting Kasa serve its short-term residents directly, so Waterton doesn’t have to. “We looked at doing it internally, but we recognized that short-term housing is a distinct business and different from what we do in many ways,” Cirjakovic says.
For example, specialized short-term rental companies can efficiently supply rental furniture for the units they run, while implementing a structured short-term tenant screening program and providing maid and concierge services.
Waterton also diversified its exposure within the partnership. On some units, Kasa has signed a longer-term lease, to effectively become Waterton’s corporate tenant. On others, Waterton has contracted with the firm as the manager to run its own, in-house short-term units. And it keeps a close eye on how much of its portfolio it dedicates to the space.
“What it gives me is this opportunity to protect occupancy in low-demand periods,” Cirjakovic says. “Depending on how much demand you have in a specific submarket, you might be able to take 5% or 10% of your units off the table. But you want to vet very carefully who you’re getting into business with. And we’re certainly not giving them 100% of the portfolio, not even close.”
The flip side is operators can use a short-term rental program as a built-in marketing channel. “Some of our long-term residents were first introduced to our communities by staying with us as a short-term guest,” says JoLynn Scotch, managing director of operations at Greenbelt, Md.-based Bozzuto Management Co., which operates 71,000 units. “If it’s done with the care and concern of all residents in mind, it can be successful in terms of stabilized occupancy and increased profit.”
A Word on Regulatory Risk
Another area of risk is regulatory. With cities like Boston, New York, Washington, D.C., Denver, and San Francisco cracking down on short-term rentals at the behest of their hotelier constituents, knowing what regulations apply to your building is crucial.
Indeed, short-term rental firms specialize in making sure their institutional apartment partners stay in compliance with those rules. But beyond short-term stay regulations, different zoning laws may kick into effect, depending on how a building is used. For example, most traditional multifamily buildings are zoned R-2, which usually requires a minimum 30-day rental period. Buildings with an R-1 or commercial hotel zoning designation may be rented by the day or week, but that usually triggers additional hotel licensing and tax requirements, as well as health and safety regulations for fire suppression systems, entrance and egress routes, and Americans with Disabilities Act compliance.
“The biggest risk to all this is that the municipalities are really starting to enforce the laws that always existed to create more of a level playing field with the hotels,” says Korman. “The days of not respecting those zoning laws are over. You can still do something shorter term, but these traditional apartments have to rent it on a monthly basis, as opposed to daily or weekly.”
Others note that short-term use can also affect covenants with lenders. “We worked very closely with Kasa to ensure we were fully compliant, not just with local laws but with our lender agreements,” Cirjakovic says.
Thinking Differently About Apartment Lease Lengths
Meanwhile, traditional institutional apartment players, who for generations have thought in terms of 12-month leases, are still trying to figure out what’s the best path forward in the short-term rental world.
“There are just still so many different models, and there’s really no consensus in the market yet,” says NMHC’s Haughey. “All the players are still doing different things.”
