Los Angeles: Adding an ADU to a Multi-Family (2-4 units) Property
Member since 2019 · 2 posts · 2 votes
Hey BP investors/landlords, first post on the forums, and looking to get some advice when it comes to ADUs in the Los Angeles area. I currently own a 2-unit property with a garage that I plan to convert into an ADU. Does anyone have any insights as to how the ADU will impact property value? Is it realistic to expect at least a 1:1 level of appreciation (i.e., $100k in renovations = $100k+ in appreciation)? Given ADUs are relatively a new trend, are there enough comps when it comes to the appraisal process to significantly drive value?
Dan you are making an assumption that the $100k cost to build is only worth $50k today. That may or many NOT be true. Secondly, when it comes to a long term buy and hold, and your goal is monthly cash in your bank, then that $14,400 is there no matter what the value is. Lastly, you have completely eliminated the probability of market appreciation in LA which is (based on history) higher than most areas of the country and the likely fact that in 5 years from now, appraisers and lenders will be giving full valuations of these products. So again, play the long game and add to your cash flow with low risk is the play here.
Are there higher returns out there, sure. You could have invested in Gamestop yesterday and sold today but could you do that consistently day in and day out like that cash flow comes in day in and day out? Doubt it.
Hi Edwin,
As a general rule in Los Angeles with SFR, a nice ADU can easily add $100k of value or more. I've been seeing more and more listings that have ADUs on the market, even including small multifamily, so it should be possible to find comps. However, with a duplex or any multi-unit, the valuation is based more on the income and specifically the NOI, rather than the comps. An appraiser would likely use the income approach for multi-unit, whereas they would use the sales comparison approach for single family.
So rather than looking for a rule of thumb, the real question is how much income could the ADU add to the bottom line? Let's say hypothetically the additional unit can rent for $1,200 per month, and after expenses it will add $10,000 per year to the property's overall NOI. If you spend $100,000 on the ADU, then that would equate to a 10% ROI in the first year.
Then, let's say you are assuming a 5% cap rate to value the property. So, a property with 50,000 NOI would be worth $1MM based on a 5 cap. If the ADU add can $10k per year, then it brings the total NOI to $60k, which at a 5% cap brings the property value to $1.2MM. So, the $100k ADU has effectively increased the value of the property by $200k. Of course this is a very rough example based on a lot of assumptions, but hopefully you get the idea.
I would start by researching the market cap rate for small multifamily in your area, and pull lease comps to get an idea of what the ADU could rent for. Then once you know the numbers you can work backwards to see what the value-add would be.
Good luck!
@Marc Sinnott is a broker but I have to question his experience with duplex to quad.
Duplex to quad are valued on comps. Most appraisals will include an income based approach, but that will not be the value used in the loan if getting Freddie/Fannie loan. I had a property 2 months ago that had income approach reflect $50k higher value than the value the appraiser provided based on his comps (which were terrible comps).
If you are adding the ADU with a hands off approach (doing minimal work yourself), you are very unlikely to have a value by appraisal that reflects at least 1-1 on the money invested. Make sure you understand the value of the ADU versus the cost in your particular locale. This is because the negative initial position will consume the initial cash flow to achieve a neutral position. This neutral position can take years to achieve in some areas.
It is my opinion that there are many investments that are likely to achieve better returns than a hands off ADU addition in most areas (there are exceptions).
Note if you take an active role such as a developer, GC, or skilled owner willing to work to achieve sweat equity, then an ADU can avoid the initial negative position.
Good luck
@Edwin Loredo My two cents. I do not see the value of ADUs are 1:1 and 1-4 units are based solely on comps. Cap rates are not a factor in this asset class. 5+ MF are based on income. When appraisers review these properties, they do list the income approach but not to value the property, mostly when doing rent comps, called a 1004D, for MF to gauge how on market the rents are.
ADUs are not valued on 1:1 since whatever property you are adding to (SFR, duplex, tri, or Quad) will be ZONED as the existing unit count. So adding an ADU will be a cash flow move. Appraisers are valuing ADUs at 20-50k across the board. What the market is saying is different but when you are working with a lender and the appraisal comes in at X amount, they wont go over the appraised value and over leverage just because there is market demand.
So take @Marc Sinnott's comment with a grain of salt as there were some mixed info for the asset class you are asking about. Run conservative numbers and DO NOT purchase a property with an ADU value add in a 1:1 ratio.
For background, I purchased a triplex in 2019 and converted the garage into an ADU this year, the appraisers I spoke to gave me a verbal value of 40k more but cost me about 75k to complete. I did this as a cash flow move. The other properties I have analyzed reflect this ball park range.
For ADU valuations, you may run into problems as appraisers do not have enough comps or precedence to properly valuate an ADU. On single family properties, I have seen 25%-50% of cost valuations given by appraisers. That said, the strategy SHOULD be longer term hold periods to take down the cash flow and wait for a few years when there are enough sales comps to get proper valuations.
On the multi family level, if under 5 units, it is still considered residential and not commercial in the lending space, however, investors more often than not look at the income approach as that is what they are essentially buying (disregarding upside potentials and value adds). Therefore, if you convert a garage for $100k into livable space that yields you say $2k monthly in gross income, after an expense ratio (operating plus vacancy factor) of say 40% for the added unit, you have $1200 in cash flow (excluding debt service). So in 7 years, your cash flow returns your initial investment of $100k. That is a 14.4% cash on cash return, not bad. Add into that leverage and your cash on cash could go higher.
Point being, look at it from a long term hold standpoint and don't worry as much about valuations right after. ADU laws on multi family is a huge opportunity for you and are very popular right now. I have 3 ADU projects ongoing right now that I have started building or are in plan check currently for my clients.
I would have to disagree with Dan above regarding returns. While it is certainly true that a good investor can find better returns elsewhere, it is also true that returns can be outstanding when adding an ADU. Location is key and LA has one of the best opportunities for this as you already own the dirt and in cases of conversions, some of the construction is already there as well, so your returns can be in excess of 20% often times. Find that without having major risk in other investments!
@Marc Sinnott that is a great and informative post! I appreciate your knowledge and experience. Above all your willingness to put the post in here helps alot of us that aren't even in the SFR market.
For ADU valuations, you may run into problems as appraisers do not have enough comps or precedence to properly valuate an ADU. On single family properties, I have seen 25%-50% of cost valuations given by appraisers. That said, the strategy SHOULD be longer term hold periods to take down the cash flow and wait for a few years when there are enough sales comps to get proper valuations.
On the multi family level, if under 5 units, it is still considered residential and not commercial in the lending space, however, investors more often than not look at the income approach as that is what they are essentially buying (disregarding upside potentials and value adds). Therefore, if you convert a garage for $100k into livable space that yields you say $2k monthly in gross income, after an expense ratio (operating plus vacancy factor) of say 40% for the added unit, you have $1200 in cash flow (excluding debt service). So in 7 years, your cash flow returns your initial investment of $100k. That is a 14.4% cash on cash return, not bad. Add into that leverage and your cash on cash could go higher.
Point being, look at it from a long term hold standpoint and don't worry as much about valuations right after. ADU laws on multi family is a huge opportunity for you and are very popular right now. I have 3 ADU projects ongoing right now that I have started building or are in plan check currently for my clients.
I would have to disagree with Dan above regarding returns. While it is certainly true that a good investor can find better returns elsewhere, it is also true that returns can be outstanding when adding an ADU. Location is key and LA has one of the best opportunities for this as you already own the dirt and in cases of conversions, some of the construction is already there as well, so your returns can be in excess of 20% often times. Find that without having major risk in other investments!
Cash on cash is not a good method when the value is less than the costs. COC assumes the value is the cost which is not the case in the ADU addition case.
Typical example, I spend $100K for an asset valued at $100K which produces a cash flow after expenses of $14,400/year, excluding debt service, has a COC of 14.4%.
ADU addition example, I spend $100K for an asset valued at $50K typically reflects 0% COC until the value has been recouped. in this case, $14.4K goes into $50K 3.47 times. The initial cash flow goes to recover the negative position. In this example calculation, it takes 3.47 years to recover the negative position.
Calculate it how you want, but the ADU COC calculation is very different than the typical COC calculation as depicted in my two examples.
The garage conversion ADU also has the disadvantage of having consumed a garage.
I still hold by my statement "It is my opinion that there are many investments that are likely to achieve better returns than a hands off ADU addition in most areas (there are exceptions).", especially seeing that I explicitly indicate there are exceptions.
My example using Will's return, I would not do. Because I only achieve $50K of value for the $100K investment, the $14,400 cash flow (not including debt service) is not comparable with a typical investment producing 14.4% COC. I'm not adverse to the 14.4% COC but the ADU does not compare to a typical 14.4% COC. In addition, I would never go through the effort for 14.4%. Our threshold for the rehab on BRRRR is a doubling of value. If I spend $50K, I want it to project $100K of value. Otherwise it is not worth the effort for us. If I spend $100K to get $50K of value that requires 3.47 years of cash flow to be neutral implies my first return on investment (after recovering the negative position) starts basically 3.5 years after the investment.
I realize this is not a perfect comparison, but I have no example that is a good comparison to the ADU addition and the associated return. Typically investors do not invest to start with a negative position. Investing in hands off ADU additions, it is common to start with a negative position.
If you go the route of adding an ADU, make sure you understand the valuation of the ADU and the likely negative position. Factor in the negative position into your return calculations. Understand the financials. Basically do the work you should be doing for this size of investment.
Also recognize my comments are for hands off ADU additions. If you are a developer, contractor, or owner willing to put in significant sweat equity, the ADU addition can cost significantly less reducing or eliminating the initial negative position. The cash flow in a case with no negative position would be actual return.
Dan you are making an assumption that the $100k cost to build is only worth $50k today. That may or many NOT be true. Secondly, when it comes to a long term buy and hold, and your goal is monthly cash in your bank, then that $14,400 is there no matter what the value is. Lastly, you have completely eliminated the probability of market appreciation in LA which is (based on history) higher than most areas of the country and the likely fact that in 5 years from now, appraisers and lenders will be giving full valuations of these products. So again, play the long game and add to your cash flow with low risk is the play here.
Are there higher returns out there, sure. You could have invested in Gamestop yesterday and sold today but could you do that consistently day in and day out like that cash flow comes in day in and day out? Doubt it.