As the affordable housing crisis worsens across the country, states like California are considering new legislation to reduce red tape for building accessory dwelling units (ADUs), which are also known as granny flats, backyard homes, casitas, or in-law suites. These can be attached or detached structures on an existing residence. It can even be a converted garage that meets state and local health and building codes (junior accessory dwelling unit or JADU).

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California is short three million housing units, which has placed additional pressure on home and rent prices. Several California cities are looking into legislation targeting rent control and vacation rentals. As investors look to create value in a market where finding deals has been challenging, ADUs have lots of potential. The risk lies in navigating each city's current and future approach.

ADU legislation in California seeks to address our housing shortage. It’s forcing the hand of local cities, requiring they make building ADUs streamlined and less costly for homeowners and investors. SB 13 is the latest bill seeking to address a few lingering issues, and investors are watching closely to decide whether this is an investment opportunity of a lifetime or a money trap. If California gets it right, other states will likely follow.

Real estate investors are already incorporating ADUs into new construction, as part of flips, and adding units to existing rentals. Although small in size, ADUs can come with some big headaches, so here’s some advice on how to get started on the right foot.

Tips for Investing in Accessory Dwelling Units

1. Do your homework

Do a lot of homework before building an ADU. Each city has its own approach to ADUs, employing different ordinances and overlays. Some are pro-ADU, and some are not. As another round of regulation plays out at the state level, some cities are only now updating ordinances that should have been completed over a year ago. Also, investors can’t rely on a city’s website for the most up-to-date information, because it’s changing so quickly. It’s forcing investors to keep a close eye at both the state and local levels.

2. Know what you want to build

Get design plans in place and run it through your area’s planning department—preferably before you buy. ADUs are small (400 to 1,000 square feet), but the cost to build them can be eye-popping. This is because they include the two most expensive rooms of a house: a kitchen and a bathroom. Your city may have size restrictions, set-back requirements, and zoning issues that could completely change the cost of and scope of the project.

Manufactured homes can be ADUs. Now that the hurricane and California wildfire demand has subsided, it takes roughly eight weeks on average to get a response. While an investor may find savings on the structure and lead times, mixing a manufactured home ADU onto a stick-built site may cause issues with lending (as in a lender may not include the manufactured ADU square footage in the loan at all). If ADUs gain in popularity, this may change, but you might not want to chance it.

3. Pick a strategy

For rentals, you not only need to know what you can/will build but also who your renter can/will be. Part of California’s pending ADU legislation, if passed, would disallow cities from placing an owner-occupancy requirement from 2020 to 2025. However, after 2025, it’s entirely up to each municipality to decide whether to allow a landlord to continue renting each unit separately. It may choose to force the property owner to rent out both units to the same renter or require one of the units to be owner-occupied. Five years is likely too short a timeframe to recoup the initial investment of an ADU, which may steer landlords away from the ADU strategy.

It’s also critical to be aware that the tide is shifting in certain municipalities regarding vacation and short-term rentals. Some cities are prohibiting them altogether or restricting them to tourist zones at the same time that they are relaxing ADU rules. City councils don’t like to get complaints about short-term rentals from permanent, voting residents. They complain about noise, lewd behavior, drinking and drugs, litter, and traffic. The intent of California’s new statewide ADU ordinance is to provide affordable, long-term housing—not vacation rentals.

If you plan to build and lease your ADU to vacationers or business travelers, double-check your city's rules. Gauge their future commitment to allowing short-term rentals to avoid running calculations on income levels you'll never realize.

4. Call the local planning department

Connecting with the planning department where you want to build is vital in establishing what’s possible. They’ll have the latest ADU rules and inform you (hopefully) on upcoming changes. Ask about impact, utility, and other fees. Some cities have no fees while others are upward of $50,000! If the jurisdiction is unfriendly toward ADUs, they may make your life very difficult.

While on location or on the call, ask about any incentives for affordable housing, homelessness initiatives, or additional resources for ADUs. Some cities like Los Angeles have raised millions to address its growing homelessness issue. Some cities, like Encinitas, already have pre-approved ADU plans that get you fast-tracked through the permitting process. You never know what might be available until you ask.

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5. Talk to the utility

It’s not always the city that will grind your project to a halt. Are there power lines overhead where you want to build an ADU? If so, you may end up in a year-long battle between a utility and a city still trying to figure out who is responsible for injury or death in the case of fallen power lines. Keep in mind that different utilities may serve different areas, too—even within the same city.

Don’t forget to ask about utility incentives or rebates for energy efficiency upgrades. In some instances, you may be able to get money back on energy-efficient appliances, roofing, insulation, windows, toilets, and landscaping. If you’re renovating the primary structure as part of a flip, you may get rebates for both structures.

6. Check for NIMBYs

Call the local elected official that represents the area where you want to build as a backup plan to the planning department. Does the community support ADUs or is there a strong “not in my backyard” (NIMBY) sentiment? Worse yet could be a “build absolutely nothing near anything” (BANANA) sentiment.

A local elected official can point you directly to the neighborhood groups that often have the most vocal critics and champions of a city. The elected official may even be able to connect you with someone who’s already gone through the process.

7. Get those comps

Flippers and new construction builders alike should be mindful of comparable sales. If an appraiser can't justify the ultimate sales price—even with a consumer willing to pay—good luck getting a lender to fund at that price. If the appraiser doesn't have ADU comps available, they will compare based on square footage, which won't always work in your favor. Start hunting for comparable sales as soon as possible via the planning department, elected official, or the MLS.

8. Talk to your lenders now

Some lenders are triggering duplex rules and requiring 25 percent down payment to buy a property with an ADU. This can severely limit a flipper’s buyer pool. An ADU added to a single family home is not a duplex. However, it’s a newer strategy and lenders haven’t entirely caught up. If ADUs catch on, this will get easier, but it’s been one of the sticking points for investors looking to sell.

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9. Expect the unexpected

Rules are changing at the state and local levels, and timelines are typically longer than an investor wants them to be. Take the time needed to do the research required to mitigate your risk and to put you in the best position to be successful.

10. Get political

The California state legislators behind the string of ADU legislation, particularly Senator Wieckowski’s office, has been incredibly open to receiving feedback. While you may roll your eyes at this suggestion, understand that affordable housing is an extremely important issue as it impacts many other issues. Sending data-driven reports and personal experiences to your local and state legislators allows them to understand the impact of changes and provides insight on potential opportunities for needed adjustments to bills. Report difficulties with local cities overlaying rules that go against state regulations, as well as pictures of completed ADUs, with feedback on who purchased it or rented it.

Main Street real estate investors have the talent, skilled labor, and access to capital to get ADUs done. Let’s hope the powers that be allow us to be part of the affordable housing solution.

What issues/solutions have you encountered related to ADUs? Where do you live, and what’s your state’s/city’s take on this type of property?

Share in a comment below.