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Do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin.
– Warren Buffett
The entire premise of investing is that what you buy today will go up in value in the future, and if you buy something at a “discount”, you will get a better deal than you pay for. Figuring out whether you paid a price that is less than or more than the actual value of the business is a very difficult job at many times. And if you are betting your entire portfolio on the chance that a stock will go up 5% with no room for error, that’s a dangerous play.
This is where the concept of “Margin of safety” comes in. Warren Buffett and his mentor Ben Graham before him made so much of their money not by being precise about their predictions – they removed the need to be precise. When they invested in a company, they ensured that if their prediction was wrong, they had a lot of room to fall. They did not buy a stock when the market was hyped about it, and they did not even buy it when the stock price was equal to what they considered its intrinsic value. They waited till the price dropped below the intrinsic value by a safety margin of 20-30%, and only then did they buy.
While this caused Ben Graham to miss out on some opportunities, it did make his portfolio a very safe one. Engineers follow the margin of safety principle too – a bridge built to handle 80,000 pound trucks would have a 5x margin so that a small deviation in the load won’t put it under stress. When the impact of failure is high, the margin of safety needs to be wide.
That seems to be one of the problems with the AirBNB model today. Like any bubble, the euphoria around making money with short-term rentals has led to a distortion of the market, and drove people to buy homes in the hopes of earning some passive income – but they neglected this margin of safety. Here’s everything you need to know about the AirBNBust, where it’s likely to go from here, and what you can do to keep your money safe.
The AirBNB Model
Nobody thought AirBNB was a force to contend with when it started. Not hotels, and not even the owners – It all started as an accident in 2007 when design graduates Brian Chesky and Joe Gebbia decided to rent out their apartment with an air mattress to people who would be attending a design convention in San Francisco. The demand for the listing was overwhelming. A business was born.
The acceleration of the business was super-fast. Within a year, the site had 10,000 users and 2,500 listings. Within two years, they had raised $112 Million, launched international offices, and had millions of recurring users, with their growth becoming exponential. This was all possible because they leveraged something for which the infrastructure was already in place – homes across the country. AirBNB was built on a model known as “The sharing economy.” These are companies like Uber, Lyft, and Doordash, which don’t provide services by owning their own infrastructure, but rather by connecting service providers and customers.
This had a two-fold advantage:
Most of the “infrastructure” was already built – people owned homes with extra space and wanted to earn money. Bringing them onboard was the main task.
Unlike hotels, AirBNB did not have the overheard of cleaning dirty units or managing tenants or maintaining properties.
All that AirBNB did was facilitate the exchange of information between a short-term tenant and a landlord, while receiving a cut of each transaction. AirBNB charges guests a service fee of 14% and a host fee of 3%. Almost one-fifth of each transaction is revenue for the company, and that added up fast. In fact, in 2022, they were able to generate $8.4 Billion in revenue – that’s about $23 million per day in income – and their current market cap is about $72 Billion. It makes them one of the largest companies in the world.
That sounds great. Who wouldn’t want a hands-off business that generated billions in revenue? But there’s a dark side to it.
Look ma, no hands
On the surface, AirBNB solved some problems that the hotel industry brought up – a more personal feel and cheaper rents for consumers, and the ability to earn passive income for homeowners. But hotels have an advantage that AirBNBs don’t: End-to-end control. By giving up that control, AirBNB faced three problems:
Quality control
Price control
Housing regulations
First, the issue of quality: Bloomberg reported on June 15th 2021 that Airbnb was spending millions of dollars making nightmares go away. They also detailed some of the ways that Airbnb hid crime, vandalism, damage, and assault. Of course, every business has its problems, and a company that does as much daily business as AirBNB will definitely have outlier issues (in 2019, they were getting 2 million bookings per day). But even if 99.9% of customers had no issue, that still meant that they would face 730,000 complaints on an annual basis just from the remaining 0.1%.
Then there is the issue of cannibalization of AirBNBs on each other leading to a price war. Once it was clear that the AirBNB business model was lucrative and mortgage rates fell throughout the pandemic, buyers began snatching up properties at a record pace. Inventory was low, prices continued to go higher, and the market appeared unstoppable. The pandemic was expected to slow things down but as remote work was encouraged and people wanted a change of scene, AirBNB hosts were perfectly positioned to make a profit. Consumer spending was at a record high of $1 Trillion in 2022. AirBNB was posting record profits, and hosts were rolling cash. The number of available short-term rental listings in America shot up 23.2% in September 2022 from a year ago to 1.38 million.
That’s how a bubble starts – Once a method is “proven” to work, the people sitting on the sidelines start to jump in because if others can do it, why not them? But that’s the thing about arbitrage – once the market starts getting flooded, the profit margins start going down. As competition increased, interest rates began to rise at the same time and consumers had less money to spend all of a sudden. Remote work was less of a novelty and companies began to call employees back to office. Bookings began to fall, and in an oversaturated market, that led to profits dropping quick.
Consider these stories: One couple who were generating $7,000 per month in revenue saw the numbers shrink to $3,000 last fall as bookings dropped and their homes were left vacant. And you might remember the viral story of the Super Bowl weekend in Phoenix, Arizona where a rental manager struggled to book out more than 50% of his rooms even after slashing prices from $1200 a night to $500 a night and dropping the minimum period to two nights.
Bookings are down, across the board, as more competition and inventory drives prices lower. As a result, short term rental vacancies began to spike, with many property owners unable to cover their overhead expenses. All this has just one reason: Way too much supply. From February 2017 to January 2023, “Airbnb and VRBO listings in Phoenix more than quadrupled, growing to 21,000 from 5,000.” This creates a vicious, downward cycle where people reduce prices to stay competitive, which causes other hosts to reduce their prices to remain competitive. Soon, it’s a classic price war where everyone ends up losing.
And if these problems were not enough, we have the third issue: Regulation.
Curveball
You see, when AirBNB started, it was the Wild West of short term rentals and nobody had ever tried anything like this before. But that also meant that the problems with the model hadn’t been known, and they soon started surfacing. The same way that migration from one part of the country to another raises rental rates and living expenses for locals, AirBNB is having an impact on the rental market called “The AirBNB effect”.
When AirBNB seems like a more lucrative model, inventory is taken off the market for the use of short-term rentals. Why bother renting out a property to a long-term tenant when you can make 4x more money operating the same home on Airbnb and renting it out short term? This ends up increasing the costs of long-term rentals and houses for everyone else. It was found that a “1% increase in Airbnb listings leads to a 0.018% increase in rents and a 0.026% increase in house prices.” In New York, it was estimated that residents were paying an additional $600 million dollars in rent, every single year, just because Airbnb was absorbing excess inventory.
Which area of the US do you live in? Have you seen AirBNBs affect rental prices in your area? Let me know below.
Of course, in such a situation, the government steps in and takes action. Many cities have begun banning or significantly regulating AirBNB entirely. Los Angeles no longer allows AirBNB to operate if the property falls under rent control, Las Vegas is about to remove all AirBNBs with the exception of 2,800 that get approved by a lottery system, and Atlanta, Georgia applied an 8% occupancy tax as a substitute for hotels. New York requires that hosts be living in the property full time.
This just a fraction of what’s happening, leading up to what we know as “The Airbnbust.” More and more short-term landlords are permanently going out of business.
Margin of safety
This brings us back to the concept of margin-of-safety. On a fundamental level, AirBNB makes sense on many levels. It’s a win-win for both parties as tenants get to stay in a home for a similar price as a hotel, and landlords get to make more money in the process. But when everyone jumps on the wagon, some trends start to emerge. All of a sudden, people began renting and sub-leasing properties in a process known as “AirBNB arbitrage”. They would guarantee the landlord a fixed rate, and profit from the difference from what the home generates. Some even bought properties with solely this intention – even though the home would never cashflow with other methods.
As a former real estate agent, I saw people do this over and over from 2012 to 2018 – Buy homes in popular destinations, or take leases, build a team to manage them, and scale up fast. But any good thing is eventually abused, and some problems emerged:
People renting out illegal structures for profit.
Circumventing HOA regulations by renting out condos.
Renting out homes for massive parties.
Exorbitant fees while also requesting you to do the dishes and take out the trash. (This one’s a personal experience)
I’m not even against AirBNB, I have nothing against it – in fact I’m pro-AirBNB. I think homeowners have a right to operate their property as they see fit. But pushing the limits of the system eventually breaks it, and this is when the safety margins have an impact. Once the interest rates start going up or regulations start kicking in, or demand starts dropping because of the pandemic, if there is no buffer zone or back-up plan, then your business plan can go into trouble real fast.
So here’s how you create a margin of safety: If you are buying a property for an investment, make sure that it can cashflow without AirBNB. If you decide to leverage AirBNB to boost the cashflow, that’s a good idea, but it shouldn’t be the only possibility. If regulations or lack of demand kicks in and you realise that there are no takers for long-term rentals, you’ll be in a tight spot. By taking a desirable property and repurposing it, your money will be safer despite the circumstances.AirBNB should be seen as a way to supplement your income.
One more point to remember is that AirBNB requires a lot of work – Always make sure that the business idea is viable after considering the effort you put in to maintain it. With cleaning, washing sheets, restocking, and posting good pictures, it’s a 24/7 job and less of a passive income idea.
If you use AirBNB responsibly: Comply with local regulation, and buy a cash-flowing property from the beginning, and use AirBNB for additional income, I’m all for it. You could make some extra money doing that. But keep in mind that arbitrage is always a limited window, and the more people see this as a profitable venture, the more your margins will be affected.
We haven’t seen the bottom yet and with rents falling nationwide, long-term landlords might continue to list on AirBNB to pay on their mortgage. This will drive competition between AirBNBs, reduce profits, and that continues the cycle. That’s why I think we are definitely in the middle of an AirBNBust which is thinning out the inefficient operators. But by focusing on improving cashflow independent of AirBNB, you have a plan for all seasons.
Stay safe, stay invested, and I’ll see you next time – Graham Stephan.
Hours of effort and research went into making this ten-minute read. If you found it insightful, please help me out by clicking the like button and sharing this article.
This too comes down to greed on the landlord's. Have had first hand experience. Personally I like to see most of them cut down to size and get a reality check.
Unfortunate. I love the authentic experience staying with locals. As a type of holiday. Now i see so many ads about managing bnb's from a distance and make profits. What is happening with our values on keeping personal contact! I must say that AirBnB was a sollution for me as well as extra income for my morgage payments back in 2009, I met a lot of interesting people and discovered the hospitality part of myself. I just did it for a year because it is time consuming and you just have less privacy in your house. I chose to take 2 international students in for one semester each year which gave me 700 euro extra a month and i would have the house for myself the rest of the year. This way i also did not have to serve them.The great thing was they cooked for me. I tasted so many international dishes. So thank you AirBnB. Love your articles Graham. Much appreciated. Esther