ADU tips appreciated

14 Replies

Hi everyone, I am brand new to BP website. I have read multiple books from BP and listen to their pockets regularly. So I like in Southern California and as many of you might know the market here is pretty insane in regards to high prices. I am a current homeowner and I recently started to conduct some research into building an ADU at my current residence. I have an attached 400sq ft garage that I would be converting. Any tips, suggestions, or guidance from people who are familiar with ADU's would be very helpful.

Originally posted by @Javier G. :

Hi everyone, I am brand new to BP website. I have read multiple books from BP and listen to their pockets regularly. So I like in Southern California and as many of you might know the market here is pretty insane in regards to high prices. I am a current homeowner and I recently started to conduct some research into building an ADU at my current residence. I have an attached 400sq ft garage that I would be converting. Any tips, suggestions, or guidance from people who are familiar with ADU's would be very helpful.

I suggest you research how your ADU will be valued by appraisers. In many areas ADUs have a value far less than the hands off costs of the ADU addition. This means ADUs often start with a negative position. This negative position can consume many months, often multip,e years, of cash flow.

If the ADU adds a value less than the hands off ADU addition costs, this impacts the investment in that it can make it difficult to extract the ADU investment via a refinance. This limits leverage options.

Depending on how the ADU will be valued will significantly dictate if an ADU addition is a smart investment.

Good luck

I will echo @Dan Heuschele  here. I recently built a detached 1 bedroom ADU above a 2 car garage in San Jose. It had a horrible return. For the construction cost of $330K, the appraiser gave it a value of $190K. It was a total joke.

In your situation, it may be cheap to convert the space (mine was a brand-new structure).  But again, I think you would be surprised at these returns.  They are generally not very good.

Thank you so much for that information. I will do some research in how it would be valued. I am a newbie so my approach was going to be to pay for the conversion out of pocket and let the unit cashflow each month since I wouldnt have a monthly payment. I also believe the rent from the ADU could cover my entire mortgage on the property since I have a very low mortgage. Therefore, my idea would be to pay for the conversion cash, then let the ADU pay for my mortgage and then I would use my monthly "freed up money" for future investments. What do you guys think of this approach? As of now I am very conservative on the approach because I am afraid of the home prices in my area and I thought this would be a good approach to get my feet wet. Any suggestions would be greatly appreciated. Thank you

Originally posted by @Javier G. :

Thank you so much for that information. I will do some research in how it would be valued. I am a newbie so my approach was going to be to pay for the conversion out of pocket and let the unit cashflow each month since I wouldnt have a monthly payment. I also believe the rent from the ADU could cover my entire mortgage on the property since I have a very low mortgage. Therefore, my idea would be to pay for the conversion cash, then let the ADU pay for my mortgage and then I would use my monthly "freed up money" for future investments. What do you guys think of this approach? As of now I am very conservative on the approach because I am afraid of the home prices in my area and I thought this would be a good approach to get my feet wet. Any suggestions would be greatly appreciated. Thank you

 I am a fan of leverage, but not over leverage.  I am also a fan of not creating items that result in stress; I like my sleep.

As such I suggest the highest leverage you can achieve without causing you undue stress.

Real estate provides opportunity to use leverage like few other investments.  IMO the ease to leverage RE is the #1 reason it is such a smart investment (#2 IMO are the tax benefits of RE).

Here is an example of what leverage does to your return.  We will ignore any initial potential negative position from the value being less than the hands off cost (you will educate yourself and recognize this prior to proceeding and not proceed if the negative position consumes years of cash flow).  In this example I will have the hands off garage conversion have a cost of $150K and a rent of $1.5K. it does not matter much the accuracy of these numbers to depict my point.  In both scenarios we will assume 50% rule is accurate (Conservative in Coastal So Cal).  We will also assume 5% annual long term appreciation (I would use a slightly lower number in my pro forma but am selecting this for calculation ease and historically it is pretty accurate depending on what So Cal market you are in).

The first scenario you use 0 financing. The return is 6% from the cash flow ($9K on on $150K invested) plus the 5% from the appreciation (over the long term, in short term values go up and down) for a total of 11% on year 1 (but using long term appreciation that fluctuates in the short term). Seems pretty good, but it is not good due to the effort involved in adding an ADU and having a buy n hold rental).

Second scenario is at 80% LTV, 4%, 30 year fixed rate loan for a payment of ~$575. Return on cash flow is 7% ($2.1k on $30K invested) plus 25% from the appreciation for a total return of 32%.

Power of leverage.  Leverage has more risk, but produces better return.

BTW the lifetime S&P 500 return approaches 10%. I would never choose an active investment such as an ADU addition and associated buy n hold rental responsibilities for less than 2% difference in the long term projected return. You would be better off keeping your garage and not having the work associated with the ADU addition and placing the money in a passive investment.

However, for 32% of the 80% LTV ADU, the return far out produces S&P 500 lifetime return.

As indicated, everyone has their own threshold of risk and were it starts to negatively impact life. I would use 80% LTV fixed loan and consider it such low risk that it would not bother me. Others have different risk tolerance.

Make sure you understand how the ADU will be valued. If the ADU is valued $140K below cost like @Brian Larson ADU project (not possible on your garage conversion which should cost ~$150K), the negative position would consume 186 months (15.5 years) of cash flow in scenario 1 and 800 months (almost 67 years) in scenario 2.  This does a great job of showing why it is critical to understand the value added by adding the ADU.

Good luck

My broker recently pulled some idle equity off his line, and converted a detached garage into a sweet 1BA/1BA apartment. It cost him just about $100k to have it built out (This was before lumbar was the most precious commodity on earth). At $100k his monthly interest cost was $321 in month 1, and obviously gets cheaper every month with positive cashflow. 
I think especially for newer investors/first time landlords, it's a great way to get your feet wet. When you're using dead/idle equity, all the better. 
ADU's are definitely a cashflow play, not a value add/forced appreciation play. So it also depends on your goals.

You're in the right place though! Tons of great wisdom crowdsourced here on BP. 

@Javier G. Attached ADU is an option. One thing i've seen some cities allow is making that attached garage a JADU (of course this requires owner occupancy of the property). But what this can do is still allow you to do a detached ADU later. If this route is not allowed in your area then a garage conversion to ADU is the path for you. You will want to budget the hard costs (build price per sq ft. $200/sq ft for example) as well as the soft costs (permitting 6k; design fees 8k; water/sewer fee 5k; ect)

Originally posted by @Brian Larson :

I will echo @Dan Heuschele  here. I recently built a detached 1 bedroom ADU above a 2 car garage in San Jose. It had a horrible return. For the construction cost of $330K, the appraiser gave it a value of $190K. It was a total joke.

In your situation, it may be cheap to convert the space (mine was a brand-new structure).  But again, I think you would be surprised at these returns.  They are generally not very good.

 @Brian Larson Have you tried Figure.com for refinancing? They value ADU sqft the same as main home sqft.

Originally posted by @Dan Heuschele :
Originally posted by @Javier G.:

Hi everyone, I am brand new to BP website. I have read multiple books from BP and listen to their pockets regularly. So I like in Southern California and as many of you might know the market here is pretty insane in regards to high prices. I am a current homeowner and I recently started to conduct some research into building an ADU at my current residence. I have an attached 400sq ft garage that I would be converting. Any tips, suggestions, or guidance from people who are familiar with ADU's would be very helpful.

I suggest you research how your ADU will be valued by appraisers. In many areas ADUs have a value far less than the hands off costs of the ADU addition. This means ADUs often start with a negative position. This negative position can consume many months, often multip,e years, of cash flow.

If the ADU adds a value less than the hands off ADU addition costs, this impacts the investment in that it can make it difficult to extract the ADU investment via a refinance. This limits leverage options.

Depending on how the ADU will be valued will significantly dictate if an ADU addition is a smart investment.

Good luck

You wouldn't be negative if you use the right lender. Try figure.com. They value ADU sqft the same as main home sqft.

Also don't overspend on ADU. Use an affordable contractor is the key.

@Chen Zhou - Thanks for the recommendation. However, appraisal value has nothing to do with your lender. You may have had a great experience with figure.com but implying you got a “good” appraisal from them is fundamentally wrong.  Lenders and appraisers are intentionally disconnected to prevent fraud.

@Javier G. the option for you would be to do some digging on the city you live in, and what they require. You should look at JADUs and ADUs. Do some research on the area too, see if there were any properties with ADUs that have sold that you could use as an ARV. The trouble is as Dan mentioned is that there are not a lot of comps to support a great return, that is where the research comes into play on finding a good agent, or doing the research yourself to see what the market shows.

A couple pieces of insight, we have an ADU project now we are working on, and this is what we have for our current market. We are converting a garage and adding onto it cost will be 140-150psf of the project cost, it will cost us $112K for build, $7,500 for plans/drawings, permit fees $3,500, and $5K for the utilities. All in $130K, for rent of just the back unit $1850 a month. There was a property one block away on our street that sold for $580,000, front house had 1 less bedroom and 200sf smaller, and the back unit was an ADU that was 200sf smaller than our current ADU will be. We had another comp with an $575,000 that had an ADU down the street as well from our property, and that puts us 400sf more as a total and two good solid comps if they wanted to just use those comparable properties. We bought for $420,000 last year, so we are already ahead $30K projections after build not including the newer construction we will have and bigger square footage we have as well.

There is a contractor in LA that I had on my podcast, he does all ADU builds and the values come out of their properties due to the comps in the area that they do them in. They have comps throughout LA because that county is very progressive in their approach to housing/ADUs.

Originally posted by @Brian Larson :

@Chen Zhou - Thanks for the recommendation. However, appraisal value has nothing to do with your lender. You may have had a great experience with figure.com but implying you got a “good” appraisal from them is fundamentally wrong.  Lenders and appraisers are intentionally disconnected to prevent fraud.

I don't see why there's anything wrong with different lenders' different appraisal approaches. Figure.com uses public data to do appraisal without a human involved. There's nothing wrong with it. Otherwise there will be legal/regulatory implications. 

Originally posted by @Peter Mckernan :

@Javier G. the option for you would be to do some digging on the city you live in, and what they require. You should look at JADUs and ADUs. Do some research on the area too, see if there were any properties with ADUs that have sold that you could use as an ARV. The trouble is as Dan mentioned is that there are not a lot of comps to support a great return, that is where the research comes into play on finding a good agent, or doing the research yourself to see what the market shows.

A couple pieces of insight, we have an ADU project now we are working on, and this is what we have for our current market. We are converting a garage and adding onto it cost will be 140-150psf of the project cost, it will cost us $112K for build, $7,500 for plans/drawings, permit fees $3,500, and $5K for the utilities. All in $130K, for rent of just the back unit $1850 a month. There was a property one block away on our street that sold for $580,000, front house had 1 less bedroom and 200sf smaller, and the back unit was an ADU that was 200sf smaller than our current ADU will be. We had another comp with an $575,000 that had an ADU down the street as well from our property, and that puts us 400sf more as a total and two good solid comps if they wanted to just use those comparable properties. We bought for $420,000 last year, so we are already ahead $30K projections after build not including the newer construction we will have and bigger square footage we have as well.

There is a contractor in LA that I had on my podcast, he does all ADU builds and the values come out of their properties due to the comps in the area that they do them in. They have comps throughout LA because that county is very progressive in their approach to housing/ADUs.

Agreed that it's just a matter of time before houses with ADUs have more comps and can be properly valued.

Great job on cost control and value creation!