You may have heard that California has made building an Accessory Unit (ADU), also known as a guest house, granny flat, casita, additional unit, or in-law suite) much easier on most residential properties across the state. But… is an ADU a good investment? Whether you’re a professional investor or a homeowner looking for your first opportunity to earn rental income, the answer will depend on a number of factors, and we want to give you some ideas while you think it all through.
There are several ways in which rental property investments earn income. ADU Investors earn regular cash flow, usually on a monthly basis, in the form of rental payments from tenants.
Building an ADU can be a great way to build long term wealth. Real estate investing can be both satisfying and lucrative. Properties with ADUs in big cities are priced 35% higher than units without one.
On average, in Southern California, we see the property value rise by 100x the monthly rental value. For example, if you rent the newly constructed ADU for $2,500 a month, the property will have a forced appreciation of $250,000. See study from PORCH here.
ADU’s commonly known as guest houses, granny flats, in-law suites are a great and easy way to add significant square footage to you property!
Then, you will want to understand the anticipated effect of the ADU on the property value and also on the potential rental income for the property, as well as the additional tax breaks.
For instance, if you are building an ADU on your primary residence, you will also enjoy an important tax deduction when it comes time to sell the property. On the sale of a primary residence, you may exclude up to $250,000 (or $500,000 for married couples filing jointly) of your capital gains from taxes. So unlike a separate investment property that does not count as your primary residence, when adding an ADU you would enjoy a tax shelter when it comes time to sell the property.
As in real estate more broadly, the value add of an ADU will be determined by the comparables in your area. One study from Porch showed that in large cities, a property with an ADU is typically priced 35% higher than a home without an ADU.
Constructing an ADU on your property typically increases the resale value of the property, since the house will be appraised with other homes with ADUs. An appraiser will use the value of properties with ADUs to determine the value of your own. Properties with an ADU sell for a premium since they include an income-producing unit and more square footage of livable space on the property.
While we are still early in the adoption of ADUs on a wide scale, it is becoming easier to find properties sold with guest houses. New appraisal guidelines are also making it possible for appraisers to include ADUs as part of their assessment of a property, which should start leading to more consistent valuations for ADUs.
A permitted ADU may be added to your title insurance report and will invariably increase your property’s value, both for the increase in square footage and as an income producing property. A tiny home or an unpermitted ADU will not be picked up on a title report and the property owner will only realize the value of the income production from renting the unit.
ADUs have the potential to produce a great return on investment by cash flowing, forced appreciation, tax breaks, and loan paydown! A 1000 square foot 3 bedroom / 2 bathroom ADU that costs about $400,000 to build can be rented for $3,500-$5,000+ per month in much of Southern California
When thinking about your true return on investment, be sure to budget for maintenance costs, taxes, and insurance. In this example above, that’s still close to $40,000 per year in your pocket. Unleveraged cash-on-cash returns would easily hit 10%+ on the full build cost of the ADU. You could also finance the construction; at a rate of 5% in the above example, you would still net $1500 monthly ($18,000 annually) if you financed all of the construction and came out of pocket just for design & permits (about ~$22,000). That’s an ROI of 82% on your invested capital in the ADU project.
There are many reasons to start the process now! Don’t wait!
