Help me analyze whether or not to build a rear unit!

3 Replies

Hey BP,

Long post, thanks in advance to whoever sticks it out and reads it through!  If you don't want to read all the details.  Skip to the bottom for the TL:DR! 

Background info-

  • 1.Fiancé and I want to build wealth through real estate
  • 2.We look into purchasing our first home as a duplex in 2017
  • 3.Just barely priced out of duplexes in the ‘safe’ neighborhoods that we are comfortable with in Long Beach, CA
  • 4.Eventually opt for a quaint historic SFR on a large lot zoned for 2 (in hindsight for now, glad we bought when we did. The market has risen since then)
  • 5.Currently rent out the other bedroom for $800 per month. House hacking at its finest : )
  • 6.Just FYI- Long Beach ranked 8th nationally among the 100 largest US cities in month-to-month average rent increases and y-o-y from 2016 to 2017 with a 7.8% increase

I’ve contacted multiple planners from building and safety and have gotten the green light that a rear unit can be added as long as it passes through historical commission (yes I know this can be a headache) and as long as it meets parking requirements.

I currently have a short and sweet background in real estate appraisal for tax purposes but not so much for real world investing that have real ramifications. My question to all of you savvy investors is how I should be looking at whether or not it is worth building the rear unit. Like I mentioned before, we live in Long Beach, California so the prices/rents are on the higher side.

  • 1. Purchased a 2bed 1bath roughly 1150sf for 660k in 2017. Market has appreciated in our area shown by many market comps. Let’s say conservatively it’s worth about 700k.
  • 2.We would be looking at building a detached rear unit with res over a 2 car garage + storage. 2 beds 1 bathroom. Maybe 1.5 bathrooms if we can squeeze it in there. Looking at about 750-1,000sf of res. Side question- for a 2 bed, 1-1.5 bath, is there a huge noticeable difference between 750-1000 sf?
  • 3.I’m currently in talks with a few architects who have dealt with the local historical commission but they are both severely back logged and won’t be available for several more months to discuss more in depth. I’ve gotten rough estimates that in our area it might cost around $325 per square to build including permits, fees, arch, etc.

Analyze via Market approach?

  • -Was thinking about taking a simple market approach look at it. Assuming the market didn't crash, could we sell the newly built rear unit + front SFR as a duplex for more than we paid for the SFR + development costs? I've read/heard often times that people state to be careful about adding a rear unit because it doesn't always "add value" not everyone is looking to be a landlord and it might be "difficult" to sell the unit because people might not want the rear unit. I should mention in our sub market, rents are insane and 2-4 units get picked up fairly quickly with most "good" 2-4 units selling with less than 20 DOM.
  • -SFR= 670k
  • -new unit= 325k
  • -total cost= 995k.
  • -Unadjusted comps within the past year range from about 1 mil to 1.4 mil. (only one comp has a rehabbed unit that’s 2000 YB+, granted IMO it’s over improved but it still sold for 1.4 mil. Our rear unit would be 2019 YB and would probably garner the higher range)
  • -Could we sell it for more than we paid? Check, yes.

Analyze via Income approach

-Quick and dirty duplex comps in the area show a GRM of 15-18. If the back unit can get a GRM of anything substantially less than the market rate GRM then it's a good idea? Is that good logic?

If the rear unit say could get conservatively $2,600/month x 12 months = SGAI of 31,200

Cost to build= $325,000 / $31,200= GRM of 10.4

Or am I looking at that wrong because I’m only taking into account the “improvements” of the rear unit and not the 670k sales price of the front unit + land value?

Should I be evaluating the property as a whole? We will be living in the front unit but someday hope to move out and keep the duplex as our first rental. Should I be looking at the GRM of the whole duplex? If so, the numbers don't look as great.

Front unit= conservatively $2,900

Rear unit= conservatively $2,600

Both units SGAI= $66,000

Purchase price of $670k + cost to build $325k= $995k/ SGAI $66k= GRM of 15.08 which is at the lower end of the GRM range. Granted, my rents are probably pretty conservative but who knows.

Analyize via a DCF and IRR?

- How reliable is this to even try to estimate a 5 or 10 year holding period with rents/expenses/cap ex/vacancies?

I tried running an IRR with the first year being the 670k + 325k and both sides being rented out (even though we're living there).

Used the 2900 and 2600 rents respectively. 12% or 45 days worth for V&C. 5% repairs and 5% cap ex (comes out to $275 each). Using a lower repairs/cap ex since the back unit will be new. And the front unit has been remodeled with pretty much everything updated. Threw in 10% for property management. Included taxes, direct assessments, insurance, debt service. Even though LB had a 7% y-o-y rent increase. I used a 2% rental increase over the 10 year period with a reversion of $1,650,000 (I totally estimated that one based off a time trend over what I think it could sell for today. I don't think it's outrageous by any means, but what do I know). That gives me an IRR of 5.03%. I know some investors say anything between 8-10% isn't bad. "go throw your money in bitcoins or the stock market if you're only going to get 5%" I know some other investors won't even touch anything that isn't north of 15 or 20%. but hey we're just mom and pop starting out here.

initial-995000
year 1513
year 21400
year 32325
year 43255
year 54209
year 65181
year 76168
year 87180
year 98208
year 109261
reversion1650000

Cash-on-Cash 

Let's assume the same numbers

SGAI= $66,000

12% V&C @ $-7920

Effective Gross= 58,080

Less op ex

-taxes (assuming assessed value somewhere in the range of 900k), DA's= 10,700

-insurance @ 900

-repairs 5% @ 3,300

-capex 5% @ 3,300

prop mgt 10%@ 6600 (even though we'll be managing it ourselves)

op ex at -24,694

NOI= 33,386

debt service ($2,460 monthly) @ -29,520

pre tax cash on cash return of $3,866

investment down on original SFR= 168k

NC cost of rear unit = 325k

all in cash amount = 493k

CoC of .78% ....

If you take out prop mgt of 6,600 (because we'll be managing it) its 2.12%...

Is it safe to say that COC is not as useful in sub-markets/properties where the properties don't necessarily cash flow great and lots of the upside rests in the rental growth and appreciation?  Thus a metric more like IRR is perhaps a better indicator of value (if you're somehow able to guestimate each years income stream and reversion value?....ha)

I should also mention that we are going to be applying to become a mills act historic property which should slash our property taxes by about 60-70%. When we build the rear unit it’ll be strictly based off the front unit via some percentage/math equation. But still that’s something I’m not taking into account and it’ll just be icing on the top.

Also if you’re going to ask me where we’re coming up with the 325k to build and why we just didn’t buy a duplex/triplex in the first place. Well, originally we wanted to build on our own time frame at our leisure. We we’re thinking we’d probably be able to save up enough $ in about 3-5 years. Unfortunately, LB is going through some general plan and zoning changes and thus have moved up our time line considerably in order to make the cut-off date of being down-zoned.

I guess the answer is also, what is it worth to me? What percentage yield do we want? If this is our "first" attempt at REI then go for it because we'll learn a lot? Stay away, sell your SFR for a profit in a few years and then purchase a duplex that hopefully we can afford then?

TL:DR- how would you analyze whether or not to add a second detached income unit on a large SFR lot zoned for 2 units in a decently desirable "hipster" area that has seen high y-o-y rental growth although technically doesn't cash flow that great because we're in a 'good' neighborhood in southern California? 

Thanks BP!

@Keazy Moto , well done in getting in when you did. My question is: how hard would it be to officially turn it into two lots? Or are you stuck with it only ever being able to be sold off as one? If it can be separated, I'd be tempted to get the plans approved, then sell the land, with permit in place. My reason for suggesting this is: because you'll have to pay retail for every detail anyway, perhaps the real profit is in the appreciation you'll already be getting by splitting off the land?

But yes, I do believe it's "safe to say that COC is not as useful in sub-markets/properties where the properties don't necessarily cash flow great and lots of the upside rests in the rental growth and appreciation - Thus a metric more like IRR is perhaps a better indicator of value".

Interesting idea about the "mills act historic property". Good luck... 

@Brent Coombs thanks!  yeah... unfortunately we can't subdivide the plot. so it wouldn't be able to be sold off as two separate parcels.  

yeah i think the mills act will save us about 4-5k per year in property taxes.... thank you!

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