Is Building an Accessory Dwelling Unit (ADU) a Good Investment?

Considerations when deciding whether to invest in constructing a rental unit on one's property.

Question

The rental market in my area is hot. I want to take advantage of it somehow. Constructing an accessory dwelling unit (“ADU”) is one option I have considered. Doing so seems more affordable buying a separate rental property right now. Is an ADU a good investment?

Answer

Even with ADUs gaining popularity, the value an ADU adds to a given piece of property is hard to calculate. This can make determining whether an ADU is a “good investment” difficult. You may not know whether it is a good investment until you sell the property (which may be many years down the road.) Determining whether an ADU is a good investment is also going to depend heavily on the investor’s (your) financial situation and goals.

Below is a list of questions to consider as you work through determining whether an ADU is a good investment for you.

1. Is the ADU lawful on your property? This initial inquiry is critical. If an ADU is not lawful, an appraiser is unlikely to assign it any value. This can be a problem if you ever need to refinance your property or when you sell your property, because lenders will not lend money if the underlying collateral is unlawful. Also, if an ADU is not lawful on your property, and you build one anyway, you will have to worry about a code enforcement action that results in you paying a fine and/or removing the ADU. If that were to happen, the ADU would certainly be a bad investment, so do your homework up front. The local zoning ordinance will provide you guidance on whether an ADU is lawful. Zoning ordinances are not always crystal clear, so do not hesitate to hire a land use attorney to help you determine whether an ADU is lawful.

2. If an ADU is lawful, is it feasible to build one on the property? When reviewing the zoning ordinance, look at what requirements the local government will require as a condition of permitting the ADU. Will you have to provide additional on-site parking? Are there setbacks that restrict where a detached ADU can be located? Is an attached ADU permitted, but not a detached ADU? If the zoning ordinance includes restrictions that make it so that you cannot lawfully build an ADU, you may need to seek a “variance.” However, variances add cost and complexity to a land use application, and there is no guarantee that a variance will be granted. Before incurring any costs related to your ADU project, it is important to determine whether it is feasible to build an ADU on your property.

3. How much will the ADU cost to build? A detached ADU may cost as much as a small house to construct. An attached ADU will likely cost less, but still be costly. Once you have a good idea of the scope of the project (for example, detached versus attached, as well as size) getting bids from several reputable general contractors with experience building ADUs will help give you a good idea of how much you will likely spend on construction. Your cost will not be limited, though, to the construction costs quoted by the contractor. You will also have to pay for building and land use permits and design (architecture), and you may have financing expenses (see below). It is also possible you will have to pay for professional services from an engineer, surveyor, or attorney.

4. How do you intend to finance construction of the ADU? Financing an ADU can be tricky. If you have the cash on hand, you are one step ahead. There are a couple of financing options available to help property owners construct ADUs. If you have equity in your property, you might be able to refinance and pull cash out to cover the construction expenses. If you do not have equity in your property, but have steady income from a job or other source, you might qualify for a renovation loan. Do your research and see which lender offers the best option for you. Financing construction of your ADU will add to your cost, since you have to pay lending fees and interest on the loan. To get an idea of what that cost will be, talk with your lender so you can better estimate your financing cost.

5. What are the rental rates for similar ADUs? Answering this question will help you determine what your monthly cash flow will be and whether you will be able to cover any financing required for the ADU, and otherwise meet your financial goals. Finding reliable data regarding rental rates can be a challenge. Some real estate agents specialize in investment properties, and as a result, are familiar with residential rental rates. These agents can be a good resource. You also can research online by looking at your local Craigslist and websites for local property managers to see what similar ADUs rent for.

6. Will there be tax consequences? The ADU may impact your property tax bill and you may have to pay rent on any rental income received. Talking to a tax professional can help you fully understand the tax consequences that may result from adding an accessory dwelling to your property.

7. Are there alternatives to constructing an ADU? If buying an investment property on your own is too expensive, is it possible to find a partner to invest with you? And if so, will doing so help you accomplish your financial goals? Or is it a better investment to place a tiny house on your property and rent it out? Ultimately an ADU may be your best investment, but be sure you have thought through the alternatives.

In addition to thinking through the above questions, you should talk to a financial adviser about whether an ADU is a good investment in light of your short-term and long-term financial goals. And for the reasons discussed above, before you start construction, it is a good idea to talk to a land use attorney about whether an ADU is lawful in your neighborhood and what the procedure is for having an ADU approved.

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