All Forum Posts by: Justin R.

@Dan Heuschele - my son works for a contractor in San Diego that is focusing heavily on building ADUs in and around San Diego. They are seeing huge demand. I don't know that it's equating to a higher selling price, though, as some other posts have said. I think what's driving it is the high cost of housing, lack of affordable housing, the ability to rent out the units as a STR for side income, and of course the extra space to move family members onto the property. So it's driving value, but not necessarily resale value.

Many people are doing it, but if they are doing it hands off there are ways to obtain a better return in RE. The issue is the return is primarily set by cash flow. Cash flow of building an ADU is good compared to many San Diego properties, but still poor.

I suspect many of these people are unaware of some of the syndication returns.

I have seen investors doing ADU additions that seem happy with a return just better than lifetime S&P 500. Buy n hold RE is not passive. I would not choose it if my conservative projection was not at least double the lifetime S&P 500 and ideally much better than that.

Many of the ADU investors under estimate the long term expenses of an ADU. Their cash flow projection is not conservative. In particular, they typically underestimate maintenance/cap ex. The 50% rule is conservative, but I want my pro forma to be conservative. Anyone who is going hands off ADU addition should be aware what their return would be based on the 50% rule.

The next issue is the value of the ADU as set by both appraisers and purchasers are less than the typical hands off cost of a first time investor doing an ADU addition. This implies that at completion of the ADU, the investor that has done a hands off ADU addition has a negative return. The initial cash flow is needed to recoup this negative position. If the value is $50k less than the cost of the hands off ADU addition, the first $50k of cash flow goes to recoup this negative position. With realistic expenses used in the pro forma, this will typically be over 5 years if financed (and if not financed, the investor has a lot to learn about leverage associated with return).

In addition, the ADU is often either paid for via poorer loan terms (compared to conventional Fannie/Freddie (f/f)) or as a leveraged loan (HELOC, margin, portfolio loan, etc). These leveraged loans are of course limiting. Once it is tied up in an ADU, that presents few options for extraction, it is no longer available for use (implied by the tied up).

I can do a fairly poor job at a BRRRR and trap less than 10% of ARV using a F/F refi loan (at least for the 1st 10 properties - if you have 10 San Diego properties financing starts to be less of a problem). If I do a rockstar BRRRR, I extract all of our investment (as of this month all our BRRRR have had all money extracted). Likely the BRRRR is more work than hands off ADU addition, but a non owner occupied asset at less than 10% invested is incredible.

I have seen various pro forma for hands off adding ADU (purchasing RE with an existing ADU is different). When they depict realistic long term expenses, they have fairly lot expected return for the effort of buy n hold.

There seem to be many ways to obtain better return including buying a property with an existing ADU.

Not totally sure I caught Dan's whole point, but another way to say what (I think) Dan's saying is: actually building the ADU as a discrete action is likely a good investment. But, buying a property that doesn't work for investment and adding an ADU to it is unlikely *overall* to be a good investment.

I started in REI by adding units to properties and spent 8 years doing it - before and after ADUs came on the scene. At this point, with (property and construction and rent) prices where they're at, it just so rarely makes sense to further develop a property unless you're adding more like 3+ units to it. I'm building two smaller properties like this at the moment that barely work; there's numbers below in case anyone considering this strategy wants to compare their expectations to reality. It's easy to talk about generalities, but hopefully some hard, actual, current numbers will be helpful to someone. Note this is very much hands-on -- I'm a Developer for a living and while this involves other professionals hired to do what they're good at, there's no do-it-for-me option here. :-)

SFR --> 2 unit + ADU, City Heights

Purchase: $400,000
Consultants: $15,000
Permits: $25,000
Vertical Construction: $240,000
Site Construction: $12,000

SFR --> SFR + ADU, South San Diego

Purchase: $300,000
Consultants and Permits: $20,000
Vertical Construction: $120,000
Site Construction: $27,000

I'll leave the rest of the proforma as an exercise for those interested in it, but to spoil the suspense and get down to the numbers that really matter (these are for the "City Heights" one):

FCoC (measured as Year 2 free cash flow from rental operation / total capital remaining in property) is about 8.5%.
Earned ROI (Year 2 free cash flow + loan amortization) is about 16%.
Unearned ROI (Earned ROI + projected 2% appreciation from inflation or market appreciation) is about 28%.

Note these projects are under construction at the moment, so these are projections. While they will be off somewhat, I've been doing this long enough to know they'll be pretty close to actual.

Couple things to remember when thinking about this (or, "Justin's Soapbox"):

I had to spend 5 years fighting and making mistakes to learn this stuff, then quit my cushy day job before getting to the point where these become reality.
Once you operate rental property long enough, you understand actual CapEx costs. The reason I said FREE cash flow is because part of the cash flow is taken away and reserved for CapEx. "Cash Flow" minus "CapEx Reserves" equals "Free Cash Flow".
It doesn't matter how much you earn, it matters how much you keep. Choose strategies (like this) that help avoid paying tax on profits.
These projects are very interest rate sensitive. Low rates juice returns. Higher rates sap them. A 1% rise in LT interest rates cuts all three profit measures by about ~20%.
I'll say it till my face falls off: If you're new to REI, the purpose of your first investment should be to prepare you for your second and third ones. Whatever strategy you choose, focus on BUILDING AN ADVANTAGE over everyone else for your next project.

And one final thing on the topic of housing supply here in San Diego: I would encourage everyone to drive to your favorite urban area outside downtown and take a picture. Take the same pic again in late 2022. There is a wave of new supply coming, packing small units into new tall (5-7 story) buildings. The bigger projects we're doing are all getting re-designed right now to bump unit counts about +50%, and I know other Developers are too. I think we'll see stabilizing (and likely falling) rents for 1 bed and studio units throughout the urban areas over the next couple years. That's probably a good thing for society, and it's what the City wants (and needs). I don't know if that impacts ADU rental rates, but it's certainly more options for people on where to live.

Viel Glück!

You were clear that this is not a hands off effort. The implication being that the cost would be much higher doing this hands off and the projected return subsequently less (assuming they use similar cost estimates, but having seen your pro forma in the past it is my belief most new RE investors would not use cost projections as high as your (or my) pro formas).

You were also clear that you have a lot of experience. The person doing this for the first time is not going to be able to match these costs or the projected return (again using similar hold cost projections).

I suspect no matter what RE investment path is chosen, the efficiency/profit increases with experience, but I suspect this is more true of new development than other RE investment options.

In general, most RE investors will do better purchasing a property with an existing ADU than building their own. It is my belief that the hands off ADU addition produces one of the worse RE returns and often takes years to recover from the negative position of having paid more for the hands off ADU addition than the value as set by appraisers and buyers. Even $20k negative position will consume years of cash flow and most ADUs are being valued at more than $20k below the hands off construction costs. The investor must do their research on the projected ARV value after adding an ADU to determine how long it will take recoup the negative position.

Broadly, agree. It's true I'm executing at lower cost than a new investor would be (ignoring cost of my time). But aside from the construction costs obvious to anyone is the costs associated with the DECISIONS that are made. Every property can have an ADU built - which ones make most sense to do so? How big should it be built? Attached or detached? Should other work be done while the ADU is being done? Does it make sense to pursue additional dwelling units in addition to the ADU when considering the public improvements and fees involved? How should utilities be designed and handled?

People don't need super human knowledge to figure these things out, but looking back at all the lessons learned (and which a rising real estate market bailed me out of) I'm very aware of the difference between what you're calling a "hands off" approach and a "hands on" approach in terms of the outcome one will get.

This is not trying to dissuade people from doing it ... just advice not to think of it as a clean transaction where you are promised something, pay the money, and get what you're promised. :-)

2 Votes

Originally posted by @Dan H.:

Originally posted by @Bonnie Low:

I suspect many of these people are unaware of some of the syndication returns.

There seem to be many ways to obtain better return including buying a property with an existing ADU.

SFR --> 2 unit + ADU, City Heights

Purchase: $400,000
Consultants: $15,000
Permits: $25,000
Vertical Construction: $240,000
Site Construction: $12,000

SFR --> SFR + ADU, South San Diego

Purchase: $300,000
Consultants and Permits: $20,000
Vertical Construction: $120,000
Site Construction: $27,000

I'll leave the rest of the proforma as an exercise for those interested in it, but to spoil the suspense and get down to the numbers that really matter (these are for the "City Heights" one):

FCoC (measured as Year 2 free cash flow from rental operation / total capital remaining in property) is about 8.5%.
Earned ROI (Year 2 free cash flow + loan amortization) is about 16%.
Unearned ROI (Earned ROI + projected 2% appreciation from inflation or market appreciation) is about 28%.

Note these projects are under construction at the moment, so these are projections. While they will be off somewhat, I've been doing this long enough to know they'll be pretty close to actual.

Couple things to remember when thinking about this (or, "Justin's Soapbox"):

I had to spend 5 years fighting and making mistakes to learn this stuff, then quit my cushy day job before getting to the point where these become reality.
Once you operate rental property long enough, you understand actual CapEx costs. The reason I said FREE cash flow is because part of the cash flow is taken away and reserved for CapEx. "Cash Flow" minus "CapEx Reserves" equals "Free Cash Flow".
It doesn't matter how much you earn, it matters how much you keep. Choose strategies (like this) that help avoid paying tax on profits.
These projects are very interest rate sensitive. Low rates juice returns. Higher rates sap them. A 1% rise in LT interest rates cuts all three profit measures by about ~20%.
I'll say it till my face falls off: If you're new to REI, the purpose of your first investment should be to prepare you for your second and third ones. Whatever strategy you choose, focus on BUILDING AN ADVANTAGE over everyone else for your next project.

Viel Glück!

6 Votes

@Mark Kohn From a strict financial perspective, the only two things that matter at the end of the day are (a) total return on your investment and (b) tax responsibilities on that return.

(a) is measured by the IRR of an investment. If you're considering a type of asset to buy (SoCal SFR rental, in your case?) and don't create a proforma that projects the IRR (including the impact of cash flow, capex, amortization, rental rate changes, earned appreciation, and unearned appreciation), you're playing darts in the dark. There's people who play in the dark, and those that play with the lights on. Play with the lights on and you'll usually win.

Why is that so important? To calculate that IRR, you'll have to make assumptions about what will happen: When will the roof need to be replaced? When will rental rates increase? When will you get your first non-paying tenant? How much will it cost you to fix up the property? What direction will interest rates go? What will inflation do? Will demand for that type of home go up or down?

Lots of questions; do you know all the answers? Of course not. But it forces you to understand what you're doing. By thinking about all these up and downsides, and playing with spreadsheets to see how they each impact your total return, you'll be able to compare two investments (an SFR in SoCal, and a triplex in FL, for example). You'll see which variables drive your returns, which ones drive your costs, and where your risk is at. And, you can decide how confident you are in projecting each.

From there, you can move from asking the question you asked in this thread to asking more nuanced ones that impact those variables and from which you can actually act, "Do you think residential interest rates will continue to track the 10y treasury if it's forced higher?" or "Can I really expect tankless water heaters to last 20 years in practice?" or "What are some other ways ya'll generate more income from urban properties that have backyard space?"

Sorry this got long, but I hope it gives you a sense of where you should aim as you go from noob to sophisticated (if you choose to do so). Or, forget all this high brow stuff and just go with what has worked for others - even the Farmer's Almanac often gets it right because it recognizes that even if you don't understand why, you should often pick what worked in the past ... it's more likely than the alternative to work again in the future.

And is it ok to buy free cash flow-negative properties? Yes. But, I don't. ... Unless I'm going to tear down and develop the property. :-)

2 Votes

@Dave Chan Think you have good advice on this thread already - I'll specifically echo the advice to search your network for someone with experience, or find a way to get someone who has experience involved in your project. That could be as a friend, as a lender, a paid project manager, or ????.

In the small residential construction game, there's basically three general options:

1. Hire a "firm" to build something. They're often called "design/build" and have a whole operation, people, and back office. They'll package up everything for you - plans, engineering, permitting, construction, material selection - and do it for you. It's like hiring a party planner for your 50th birthday party. Pay, then just have fun. You'll pay, for example, $300/sf vertical cost for a 500sf ADU. Imagine: You go to their showroom every two weeks and they help you pick from the 10 flooring samples they have.

2. Hire a "guy" to build something. This is generally a small general contractor. Maybe a couple of employees who produce in the field. His wife may do the office work. This person probably hooks you up with a designer, a permit runner, an engineer(s), and will self-perform some of the build, maybe hiring subs for parts of it. It's generally not expertly managed and hiccups are to be expected. But, you'll pay probably $225/sf vertical. Imagine: He gives you the name of a flooring store and tells you to go pick any floor under $X/sf.

3. Owner/Build it. This is you acting as project manager, finding your own service providers all the way through. Hire your own subs. You can pay closer to $150/sf vertical at this.

You really just need to decide what sort of build experience you want to have and, if you're not paying cash for the project, what your lender will require. The cost of having your hand held through the project is very high, but can totally be worth it if that's what you want+need. The thing is you'll never make money long term by paying retail rates for your construction as described in #1. The more layers you cut out of the process, the closer you'll get to profit as an investor.

Other than that, I'd echo everything @Whitney Hill said. Except the permitting timeframe - at the moment it will be 2-3x that timeframe in City of SD, but that's super dependent on which municipality you're in.

2 Votes

@Brandon Pomerantz I don't think it's necessarily a good or bad idea ... it's just an option. You need to FIND a specific investment opportunity first and then compare that opportunity - including tax implications - to whatever opportunity your retirement accounts currently have.

If you find that really solid local deal, then the answer is "Yes". If you can't find a solid deal, then the answer is "No".

0 Votes

San Diego, California

Talk to Adit Shah (not sure why I can't @mention him here) - look him up in the BP search.

1 Vote

San Diego, California

@Dan H. is correct - if you attempt to permit the JADU right now, the City of SD will require a deed restriction placed on your property requiring owner occupancy.

As a general answer to @Matt L. Question #1: the cable company will only have 1 drop to the property and will split the signal for each unit. They're happy to take 3x the revenue for the same service. That's not an issue to do. I've done it many times over the past 10 years (the strategy you're describing is exactly what I did from 2010-2019).

On Question #2: you mean too much trouble to build the 3rd unit? That's totally your own call. I wouldn't personally want to live in a home with 2 unrelated people in the other two units. But, maybe you don't mind. It's certainly an income-generating endeavor. Don't underestimate the soft and hard costs of new construction (whether site built with sticks, component built, or manufactured) -- it's expensive.

1 Vote

@Shervin Esfahani I don't have direct experience building them myself, but I have some exposure to SRO uses and applying them to new builds. I don't know the lingo that you're using (a "conscious community", for example) so perhaps you're thinking about something other than this.

Big picture, I have thought along the same lines. At the moment I'm working on a new-built project (a largish urban apartment building) that has small units but devotes significant valuable space to indoor and outdoor common areas. It's an exercise to think about how to intentionally design those spaces to imagine what they'd be used for ... while keeping flexibility in case I'm wrong.

My interest is certainly in the same ballpark as you - namely, building communities and not just private spaces for people to live. There are many others with similar interests, to one degree or another.

I'm open to the space, have the projects where we could implement some of the concepts on a decent scale, but don't know enough to really apply it. So, I dunno ... thoughts?

1 Vote

San Diego, California

Originally posted by @Breanna Green:

Thank you all! You're correct, interest is $600/mo - not $1000, I just pay $1000 minimum as I'm trying to pay more than just the interest each month. Interesting POV and appreciate the insight with dividends options for Verizon. I have a very simplistic understanding of stocks to buy low and sell high, would like to know more about P/E, dividends, etc. that make a worthwhile purchase.

I'm not afraid of debt but haven't quite mastered the beast either (~ $1.2M in mortgage debt: primary which I just purchased and live in now because I was tired of renting, beach house which pays for itself, and now the cash out refi against my other home in San Diego) which puts me at overall NW ~ $2.2M). I'm with you to have the money grow and work for me, I still have a little bit of the conservative mindset which is why I default to houses. I'm playing with $70k in Etrade right now hoping to have some short sells but this is an entirely new endeavor for me as I usually go with the Warren Buffet buy and hold strategy (maybe not the best considering I'm 35). I'd like to take some more risk but don't want to fall flat on my face and spread myself too thin. I was offered a 6 month forbearance plan on my current primary which I'm considering since I was crushed on taxes, owing $12k. (Long story). Separate topic but any negative consequences for taking the forbearance?

I've invested in Fundrise ($5k) over the last year but it's had fairly measly returns. I appreciate your examples and this forum is most helpful! I don't really have anyone to bounce ideas off of that's an expert and not bias (financial advisors who earn 1% of my portfolio).

I hear you on the advice thing. Problem is anyone you talk to is going to favor whatever they know.

Go to your local Chase Bank branch and that advisor will want to put you in a managed blended portfolio of stocks and bonds. Nothing wrong with that.

Ask me and I'm going to tell you to invest in a real estate capital fund laddered with 30, 180, and 720 day access to capital.

Ask my parents and they'll tell you CDs are best and spending 1/30th of your saved principal each year until you die is the way to go.

If no one taught you how money works at some point in your life, you need to watch someone who did learn. It boils down to this: invest your money where you have an advantage. If you know a lot about pharmaceuticals, look at pharma companies or participate in venture backed early stage companies. If you are a lifestyle addict and voraciously follow People magazine or fashion, invest in companies where you know things before others do. If you're an Engineer and appreciate AWS before everyone else understands, invest in Amazon.

The people on BP have chosen to get an advantage in real estate. I'm about to buy a 2 bedroom house on a small lot with a parking lot in the back for $850k. 98% of real estate people here in SD will think I overpaid when they see it close. That's fine - they haven't taken the time to learn what I know. They don't have the advantage, so they won't get the income.

So, either pick something and build an advantage ... Or pay someone a management fee to use their advantage to make you money.

i know my abstract ramblings aren't prescriptive enough to act on. So, assuming you want to build a RE advantage, take a little money (say, $50k) and invest it with someone who's flipping houses ... Or building daycare centers ... Or entitling land ... Or kicking people out of apartment buildings so they can jack up rents. Use the access your investment gives you to watch and learn. See what problems they run into. Look at the financial statements. See which contractors they use.

Let your first investment pave the road for #2 and #3. Build your advantage.

Or... Don't stress about it, invest passively, and enjoy the returns (at LEAST 8% annual) so you can focus your life on whatever actually makes you happy.

Whatever you do, your money needs to he working every day. It was born to do so.

1 Vote

Originally posted by @Breanna Green:

Thanks Justin! So as if I invest the funds, how do you propose I pay off the variable loan? I have to pay at least $1000/mo for interest alone so typically try to aim for $2500/mo. And of course the mortgages come due and for the most part my tenants' rent takes care of it.

Unlearn how you think about debt. Instead of seeing it as an oppressive and dangerous wild animal that you have to kill for your safety, think of it as an animal that you need to tame and then use. Would you rather plow the field by hand or with an ox pulling your plow? Make debt your ox.

Here's the thing: Someone invested some money into a 'margin lending' product. You bought that product for $235k, and you're paying $587/m for it (assuming 3.2% interest rate). How do we make money? We buy low and sell high. Sell that $235k at a higher price (meaning, more than 3.2% interest). The difference is your profit.

The skill comes in figuring out how to sell it and what to charge.

Buy VZ stock - it'll pay you 4.3% in dividends right now. It'll pay you $10105 over the next year. You pay $7520 of that to your LOC. Your profit is $2585 over the next year.
Invest in MogulReitI (no affiliation - just an example) - it'll pay you 6% annually. You'll pocket $6580 over the next year.
Lend that money to a real estate developer for a project - it'll pay you, say, 13% annually. You'll pocket $23,030 over the next year.

I'm just giving some easy-to-explain examples. Of course they all have different things to consider, but the money you make at the end of the year is payment for your knowledge and skill in choosing and evaluating your strategy. The more you know, the higher your net risk-adjusted returns will be.

So to answer your question, "how do you propose I pay off the variable loan?". I don't propose that you do. As long as you've tamed the debt beast and are using that beast to plow your fields faster, never pay off that loan. Sleep well knowing that if the loan is called or the interest rate spikes, or your spouse starts arguing with you because they're listening to too much Dave Ramsey and don't yet understand, you can sell your investment and pay off the LOC within a fairly short order.

Don't fear the beast. Own the beast.

--Justin

Note: The numbers I'm seeing don't add up correctly, so I just made the following assumption:

The "personal loan" is actual a margin LOC in the amount of $235k. Currently at 3.2%, variable. This is $587 in monthly interest.

5 Votes

All Forum Posts by: Justin R.

Justin R. has started 16 posts and replied 1059 times.

Post: How are sale values of ADU's?

Post: How are sale values of ADU's?

Post: Noob question: Ok to buy negative cash flow but build equity?

Post: Building a Backyard ADU in SoCal - Cost?

Post: Take advantage of the CARES act w/ no penalty for rental instead?

Post: San Diego Density Maximization/Rezoning

Post: Rental property with both attached ADU and detached ADU

Post: Co Housing (CoHousing) or conscious community living San Diego

Post: $235k Question, Putting It All Out There

Post: $235k Question, Putting It All Out There