cash flow or appreciations (in California)

[Jason Phu]

HI everyone,

My goal to purchase an investment home now is to keep it long term and eventually it will become my place to retire (goal to retire in the next 10 years). At the moments, I'm looking at 2 properties both in California:

-  First one is a beautiful, bigger home, completely high-end upgraded, in a higher value area with a good school district, and of course it comes with a higher cost to buy, rent can only cover the monthly expenses (mortgage, insurance, tax, etc), this one is expected to have higher appreciations in the long term.

- Second one is a decent remodeled home, smaller, in a lower value area, I can get it without financing (pay cash), so it will cash flow (about $2200/moth after all expenses such as tax and insurance), it also has a potential for an ADU, but future appreciation is not as great as the first property due to location.

Which one I should go for? and why?

Appreciate your input!!

[Jon Schwartz]

Quote from @Dan H.:

Quote from @Jon Schwartz:

@Jason Phu, California's a big state -- and LA is a big market, if that's where you're buying -- so we'd need a little more information about where exactly these two homes are, but here's my two cents as an LA investor/realtor:

Most CA markets are appreciation markets, which means -- to me -- that you'll always do better focusing on appreciation over cashflow. The high-appreciation asset will gain more value monthly than the low-appreciation asset that spins off some cashflow.

That said, are you sure the first home will appreciate more over time? Often, it's the transitioning neighborhoods that offer more potential appreciation. Is the second home in a neighborhood that's likely to gentrify in the next decade? That's an important consideration.

Additionally, adding an ADU to a property forces appreciation, especially if you have a one- or two-decade timeline. The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

And lastly, are you sure it's best to buy the less-expensive property in cash? You'll cashflow, but you'll also be tying up a lot of capital. What if you bought the second property with a loan such that it was also cashflow-neutral? Then maybe used your saved funds to do the ADU conversion right off the bat?

If you want to discuss the options you're considering in more details, please feel free to message me!

Best,

Jon

 >The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

The property income does not correlate to value unless there is more than 4 units. So additional income does not equate to additional value. In my market, JADUs are regularly being removed when selling a property to achieve top price even though they can generate income. I have seen crazy claims from ADU developers including attempts to indicate a value based on income. When challenged on it you get either a back down or indicating they were referring to cases with more than 4 units. I had one in the last couple weeks on this forum of a ADU vender stating that value can be based on income. When I challenged his assertion, he indicated he was referring to more than 4 units but this was conveniently left out of his initial post.

I also do not know whose expectation is that ADUs will appraise better in the future. maybe ADU venders are stating these are the expectations. The reality is ADUs, casitas, mother-in-law suites, etc have existed for decades, much longer than the fairly recent state level ADU laws some of which are already 5 years old. I cannot think of a single reason, with the poor valuations that have existed for decades, that the poor valuations will be changing any time.

ADUs have poor valuations, have always had poor valuation, and seem likely will continue to have poor valuations.  

Dan, I've seen you attack ADUs as an investment vehicle here and on other posts, and I think you've maybe lost touch with what's happening with ADUs -- at least in Los Angeles.

Just to share some boots-on-the-ground information with you:

Appraisals are beginning to account for the real value of an ADU because ADUs are very attractive to traditional homebuyers. You suggest that only an investor would buy a house with an ADU; in fact, since work-from-home took off four years ago, homes with ADUs have been in huge demand in LA. Add to that the ridiculous affordability crisis, and a lot of buyers are all too happy to buy a house with an income-generating unit in the back. So homes with ADUs sell for more, and the appraisals have followed pricing for four+ years now.

I personally know an investment group that targets neighborhoods, mostly in the San Fernando Valley, where comps with ADUs are outperforming non-ADU comps so that they can refinance out the value created by their ADUs. They incorporate ADUs into all of their BRRRR projects. And JADUs, too!

You seem to think that JADU's owner-occupancy requirement is a dead end. In Los Angeles, the owner who builds the JADU must sign a covenant stating owner-occupancy, but there's no enforcement. I've personally transacted on a house + ADU + JADU that was rented to three separate tenants. And we financed it!

You seem to think homes with a JADU aren't financeable. Technically, you're correct, but like I said, I've gotten around this. Just remove the oven from the JADU kitchen during the appraisal.

Anyway, back to ADUs...

You seem to think that income isn't a factor for appraisal or value. Firstly, conventional loans now allow for ADU income to be counted as borrower income for financing. Secondly, residential multifamily in Los Angeles reconciles the sales comp approach and the income approach on appraisal. Thirdly, selling a house with an ADU collecting rent significantly boosts the value for traditional homebuyers. I recently sold one of my duplexes in a bidding war; the highest bidders were all traditional buyers looking to occupy the vacant unit. They couldn't afford a single-family home in the same neighborhood, but with the income generated from the other unit of my duplex, they were more than happy to pay top dollar. (And I know this example is of a duplex, not a house + ADU, but I've seen the same bidding wars over homes that have rent-collecting ADUs.)

Speaking of ADUs versus duplexes -- you make the point that adding an ADU doesn't turn a property into a duplex. Why is this a negative? It's better that the parcel maintain it's single-family zoning so that an SB9 strategy can be executed in the future.

What else...? You had so many objections to ADUs, and they were mostly so baseless...

Oh, yes! The long time is takes to build an ADU, "a year or more," according to you. Yes, it can take more than a year to build an ADU, but it's much more common -- in LA, at least -- to finish an entire ADU project in six months. ADUs are so popular here that an whole cottage industry has sprung up around the quick and inexpensive conversion of garages. There are designers who focus on ADU layout, drafters who just draw ADU plans, and contractors who just pump out garage conversions. Prices have fallen as a result. I recently saw a garage conversion quote of $120K -- fully executed by a GC, no DIY.

You also seem to think one's capital for an ADU has to sit unused for a year. Where did you get this idea? During permitting, all you're out-of-pocket is the drafting and permitting costs. You don't pay your GC until he starts work, and a garage conversion is done in three months.

You also have a problem with ADU financing, which traditionally comes from a HELOC. Yes, HELOC financing isn't as cheap as owner-occupant or even investor financing, but the leverage can still be worthwhile...

...because the fundamental cap rate of an ADU is SO FREAKIN' HIGH. That's why ADUs aren't the worst investment in LA, but the best. Look, a garage conversion costs $150K and collects $1500/month. Let's put expenses at 15% since it's a new build, and you're looking at a 10.2 cap rate. In Los Angeles!

In LA, when we're assessing small multifamily, we usually look at the gross rent multiplier (GRM) instead of cap rate. The above example has a GRM of 8.3. That's about half the GRM you'd get in LA's worst neighborhoods (and the lower the GRM, the better the buy).

ADUs aren't perfect, but they're still an amazing investment in Los Angeles, especially for homebuyers or homeowners looking to get started.