ADU for Old Littleton (Advice)

14 Replies

Hello Everyone!

I had posted many months ago about ADU plans I had for my house. At the time everything was hypothetical. Fast forward today, I have the zoning required and the necessary variances to build a full new build garage with ADU above. Green light from the city as the 1st legal ADU, in fact. While this was certainly all a large hurdle, what's becoming more cumbersome is the financial justification of the project as a whole. Construction costs are far more insane than I had thought. I'd like to disclose the financial picture I am looking at and invite any financial and real estate advice / experience anyone can bring to the table. I'd like to hear from others on whether or not this makes financial sense.

Current Property

Current Mortgage Balance: $334,000
Home Value: $500,000
Equity: $166,000

ADU + Project Overview


Total Estimated Cost: $200,000

  • Two car garage with work shop (property does not have garage today)
  • 576 sqft of livable space in ADU above
  • 1 bedroom, 1 bathroom, kitchen, living room, & laundry
  • ADU has private entrance outside of garage
  • ADU has 140 sqft patio with mountain views

    Additional Projects to be Included for Main Property 

  • Landscaping my current yard (no improvements to date)
  • Adding oversized deck/patio that extends living room outside
  • Includes all infrastructure, sewer taps, designs, permitting, etc.

Financing & Home Value

As a Veteran I have access to the VA Home Loan which I used to purchase the property back in 2016. I would be leveraging a VA Cash Out Refinance because it permits 100% LTV at 3.5% rate with continued absence of PMI. The cash out refinance would be on the total $500,000 value of the home, those new numbers are reflected below.

1st Mortgage: $1,950/mo (escrow + taxes)

2nd Mortgage: $2,602/mo (escrow + taxes)

Mortgage Increase: $652

Cash Out: $140,000 (after closing costs, taxes, VA funding fee, etc.)

Additional Personal Cash Needed: $60,000

Est. Home Value Increase: $200,000

Operating Expenses & Income

Est. Monthly Rental Income:$1,200

Est. Annual Operating Expenses: 1,200

Monthly Cash Flow: $448 (before taxes)

At times I look at the above numbers and they make sense. Other times, I struggle. I’m fronting $60,000 of cash which is far more than I was hoping to. I’m also onboarding $600+ more in my mortgage which is always a risk. The cash flow on the backend is tighter than I was hoping as well — easily could be whipped out should any major issues arise. I’m not well versed in how taxes will come into play, and for the most part, have not factored them into my calculations.

The garage, large patio, and landscaping are projects that will add great joy and utility to the home. I see these projects as being funded by the renter, which is huge a benefit. All said, I need to sh*t or get off the pot. With a pending economic downturn, I’m nervous about spending such a high premium on labor/construction when I know in the next 12-18months it could be 30-40% cheaper. I’m not sold that this is the best use of my money either.

Anyways, any thoughts?

Your income and expenses are both 1200 yet you show cash flow, not sure I understand. 

Let's say they do zero out. You get additional equity in your home and things like. Garage and workshop that someone else will be paying for that you can enjoy on a daily bases.

Also remember that your loan payment is fixed, but rents over time will likely go up.

Hey John — Expenses are annual, income is monthly :-) Expenses are just an estimate of 1% of total project cost related to the ADU specifically (around 120,000 if that was a separate item), again on annual basis. So the income is $1,200/mo, against my mortgage increase of ~600, plus ~$100/mo for expenses. So there should be cash flow.

Great point about the mortgage being fixed and rents going up.  

@Tyler Hardy

Building ADU's is not a great investment from a rental perspective. if you're doing it for a personal need or want (aging parents living with you) then it can make sense.

Rather than spending the $200k on an ADU build, take the $200k and use it as a downpayment on a multi-unit or 3-4 single-family rentals. You'll make way more cash flow that way. Plus, you don't have to deal with 12 months of carrying costs and the hassles of construction.

Just because you're spending $200k on an ADU, it does not mean it increases your value that much! Appraisers have a hell of time comping it and providing value anywhere near the costs to build. Make sure you figure out that piece too if you care about the total property value.

I've done a lot of research into ADU's and can't make the pencil out from an investment standpoint. Feel free to reach out if you want to chat more

In short, I wouldn't do it. The juice isn't worth the squeeze! Rather, refi and buy rentals.

Thanks Chris. Really appreciate that feedback.  I think that ADUs definitely have this trendy vibe that eclipses the economic realities of them.  

I have a pretty demanding job and am in the process of entertaining buying a small business on the side. My attraction to an ADU from a rental perspective is it's in my backyard. I don't have the appetite to mess with multiple renters / driving around town, etc.

Nevertheless your point is well taken.  I’m not sold on the value it adds to the home, and I believe there are other avenues (especially from a rental perspective) that would have better returns.  But if larger quantity rentals are out of the picture, it does make me think this is a good use of trapped / dead equity.  



@Chris Lopez

You make a good point for your market but as with most real estate...those comments do not hold true for Bay Area Real Estate where the ADU market is booming.

@Brian Larson I'm confused.... I believe the @Tyler Hardy is referring to a neighborhood in Denver. If so, then my comments are accurate. What's the SF bay area connection?

Tyler, you don't have the appetite for dealing with renters and driving around town? But you do have the appetite for a 12-month construction process!?!?  The construction is a much bigger time vampire. Hire a PM for the other rentals and you're hands-off.

@Chris Lopez

Sorry for the confusion. The connection is just commentary on ADUs. They are a great idea for many people in different markets. Although, I have seen many people talk about them in the Denver Area. They probably don’t make sense in Littleton but they would in the Denver downtown core, given the traffic on 70 and other highways.

Originally posted by @Chris Lopez :

Tyler, you don't have the appetite for dealing with renters and driving around town? But you do have the appetite for a 12-month construction process!?!?  The construction is a much nigger time vampire. Hire a PM for the other rentals and you're hands-off.

It wouldn't take 12 months, far closer to 6. There are also the added benefits (outside of the ADU) of getting a fully remodeled yard and outdoor living space plus a two car garage, neither of which I have now. I believe the garage and outdoor living space to add considerable value to a home in Denver.

Back to finances:
Sure, I can hire a PM, but then am I really cash flowing more?  I think you're also not accounting for a significant factor — if the average house is selling for $550,000 in Denver, you're path asks me to onboard considerably more debt, and therefore risk (going into an economic downturn).  

I'm lifting my personal mortgage payment $650/mo, giving up $60K of cash, and bringing on a new mortgage of roughly $2,000/mo for $350,000 of new home (550-140-60). That's $2,600/mo of net new liabilities, versus just $600 with the ADU. I will have gone from a $350K mortgage to something closer to $750,000 in loans; roughly $250,000 higher than just building an ADU. Assuming roughly $800/mo per room for the 4ish rooms I bought — that grosses $3,200/mo against $2,600. So $600 of cash flow before taxes, and before PM... Also the increased debt will likely get hit with increases mortgage insurance to cover the bank's risk. I'm not sure I am cash flowing more in this scenario, but open to your perspective if you think otherwise.

I'm not sure I would qualify for that additional mortgage load to begin with.  The upside of course, is that from a leverage perspective I'm getting more assets which, in theory, appreciate.  That's the longer term play.


 

Originally posted by @Tyler Hardy :

It wouldn't take 12 months, far closer to 6. ...

I'm not sure I would qualify for that additional mortgage load to begin with.

A couple thoughts. If I were betting, it would be on the 12 month end unless you have extensive construction experience and have everything lined up from the word go. 

So the good thing about rentals is that you can use the income to offset the mortgage costs so your debt to income is not impacted.

Think about the leverage and run some numbers. In all likelihood, you will be at least 10x better off owning a few rentals than adding one ADU to your house. IMO owning 1 ADU would be much more headache than self managing 3-6 rental units. With the rentals you develop systems to handle situations. With one ADU you have to solve every problem and every time it's a new problem. If you are busy you should be much better at figuring out how to do the rentals with minimal time. Busy people tend to figure things out.

Just my 2 cents to ponder.

 

I agree with Tyler Hardy. Seattle has less than several hundred permitted ADUs because of the reasons he outlined. Another consideration is the covenant requirement. Does the owner have to live in one of the units so you wouldn't be able to rent both? Seattle now allows 1000 sf of ADU and 1000 sf of DADU on all City lots, space providing. When you do the math this is designed more for developers than the average home owner due to the expense and limitations due to the existing structure. It's perfect for a new McMansion with an ADU and DADU designed around this new use however. Many Seattle properties are now worth more for their development potential. From a development standpoint more structures on these parcels only means more demo expense.

What is your property zoned and what are the chances it will be rezoned in the future? Large portions of Seattle went from single family to various levels of multifamily zoning this year. We invested in century old homes on parcels that are now prime multifamily locations. If we would have invested in ADUs all of that would have been for nothing. Your area may be different but all of the above are things to consider.

$200K is a lot of money for a two car garage with only 500+ sf of living space. If you're going to do an ADU I'd max out the allowed living space first then do what you can for parking. This is just my opinion based on the return potential vs what I would enjoy personally.

Originally posted by @Bill S. :

So the good thing about rentals is that you can use the income to offset the mortgage costs so your debt to income is not impacted.

@Bill S. - I hadn't really considered this but I'm connecting the dots. This starts to make some more sense — though losing any rental income puts TWO properties at risk. Take $140K out from cash-out-refi, qualify the appraised rental income to the balance on the home value, and start that way. $140K is more than enough as a downpayment. Cash flow the property @ roughly same $ amount but with a much higher value in owned assets. The $60K I was planning to invest in cash to the ADU I could just simply build out a garage and landscape, perhaps even a small kitchen (not a large house). It could work, starts to bump up against my risk appetite (my wife and I just moved to one income as she is going back to school, so there is that).

 

...though losing any rental income puts TWO properties at risk. 

So the reality is that the risk is very low. Buy the right property (good tenants want a nice property) is the first step. Screen tenants (a vacancy is a blessing compared to a bad tenant) well is the 2nd step. Be on top of vacancies so you advertise and show while the current tenant is in place (see why tenant selection is key?) and you can easily go for a decade with no vacancies. You have to work at it and be on top of things and do it right but in reality, the risk is low. No risk, no reward.

You have to have reserves but if done right it's unlikely you will need them.

@Tyler Hardy - In short, yes you'll be cash flowing with a PM in place with the rental properties. Part of the issue might be how you're analyzing properties. First off, we're not buying $550k single family homes! We're buying 3/2 condos at $200k, single family homes at ~$300k and cash flowing multis at $400k+ plus. They all have much better rent to price ratios than what you laid out.

I agree with @Bill S. If you buy a good property and hold reserves (6 months of PITI), then you have a very high chance of success in the long run.

Looking at total debt load is not the best way to measure risk. If you want some reading, research DCSR (Debt coverage service ration). It's a lending guideline that commercial banks use to make sure it's a safe investment for them to lend on. It typically doesn't apply to buying small properties, but it's great concept to understand.

I bought a fourplex a few weeks ago for $850k. I put down $220k. It's close enough to use with your cash on hand on of $200k. Mine was not the deal of the century, but a good property at a low 6 cap.

Option #1: Build the ADU

You'll have $14,400 in annual income.

Option #2: Buy a fourplex (or similar)

you'll have $78,000 in annual gross income.

Fast forward into the future... when the mortgages are paid off, who's making more money? The Fourplex is.

Subtracting out all the expenses (including PM) on the fourplex leaves me about $55k Net Operating income (before mortgage expenses.) If subtracting out all the expenses so I'm as hands off as possible, the fourplex will make more money than the paid off ADU (even assuming zero expenses!)

That's what I mean by you'll be better off from a finance and investing perspective by buying rentals rather than building an ADU. Now, with the rentals, you don't get the personal benefits of the garage and workshop. This is where it comes down to how much is that worth to you?

If you really want to get into nitty-gritty numbers, let me know. I can walk you through the numbers and with 99.999% certainty, show you how you'll make more money buying rentals.

I don't mean to sound negative on ADU's, I just find many people get hyper-focused and excited about them, but should compare them to traditional investing.

Originally posted by @Chris Lopez :

If you really want to get into nitty-gritty numbers, let me know. I can walk you through the numbers and with 99.999% certainty, show you how you'll make more money buying rentals.

I don't mean to sound negative on ADU's, I just find many people get hyper-focused and excited about them, but should compare them to traditional investing.

Shot you a message on LinkedIn to connect. And to the second statement above, I agree. There is a unique value ADU's add the the right homeowner, and in many cases it appeals to my wife and I. Where we live is getting denser and this sort of development will be needed to keep with demand. But when push came to shove — I struggled with the $200,000 for 550sqft. Despite cashflowing the math wasn't screaming it was a good use of money. Thanks for letting my play devils advocate, but in the end, I agree with the statements above from multiple people. The sheer building costs of ADU's make them less than ideal as investments compared to other options.