Reasons to Build an ADU

Chapter 04: Why Build an ADU?

There are many benefits to building an Accessory Dwelling Unit (ADU). The following lists some of the reasons stated by homeowners we’ve interviewed.

Increase Monthly Income

You can boost your income with an ADU if you live in a City where rents for 450sf – 1,200sf apartments or comparable units are high enough to support the new debt and increased property tax assessment from your new Accessory Dwelling Unit. To figure this out, you will need to run the numbers. First, you will need to get estimates for construction costs of your project. Construction costs should be divided up by Hard Costs and Soft Costs. Hard cost estimates come from your Contractor and consist of building materials and labor. Soft costs include other services and fees that you will be paying that include architects, engineering and permit fees.

In chapter 2, we looked at an example of property owners in Pleasant Hill, California who are realizing a positive cash flow after debt payments of $686/month by financing their unit with a home equity line of credit at 5%. Their project yield (total annual net income divided by total cost of the project) is 11.50%. Compare that to typical multifamily apartment project yields of 5.50% for new construction and 4.50% if you were to buy an existing apartment building in the Bay Area.

Pro Tip: Our 2019 eBook includes a simple pro-forma analysis and contractor estimate, which you can use to calculate your numbers.

Keep Your Parents or Kids Nearby

Many people do not wish to rent their ADU out to strangers. It is estimated that 70% of families that are interested in building a backyard cottage are for family members. Keeping aging parents close by is often a more desirable option than nursing homes, senior care facilities or rental apartments.

For many families, this allows them to assist aging parents, who are also able to assist with childcare and household duties. Renting a house or apartment elsewhere could add unnecessary risk to retirement funds - especially in high demand areas where rents are subject to large increases.

Senior citizens may consider an ADU as an alternative to mobile home parks. While at first, a mobile home park may appear to be an affordable option. However, space rents are also subject to rent increases. Instead of paying rent, homeowners may prefer to build an ADU instead of making a rent payment to a landlord. Financing the ADU, will increase the overall mortgage payment, but keep in mind a portion of the increase will be applied to the principal balance of the mortgage which creates home equity. In addition, it allows the homeowner to control an appreciating asset they can later pass on to their kids. For example, in the East Bay Area, we’ve seen new ADU rents averaging about $2,500.

The principal & interest payment for a 30 year fixed mortgage payment on $200,000 (average cost of an ADU) at 4.50% is only $1,013/month of which $263/month goes towards the principal balance of the loan and $750/month goes to the lender for interest. That is a difference of $1,750/month ($2,500 Rent - $750 interest = $1,750 Savings). After adding the extra cost of taxes and operating expenses for the ADU, you will still have significant savings that can be used towards long term care for aging parents.

We have also observed seniors making the decision to live in an ADU and renting the main house to their kids for a discounted rent. Living close by, it can be much more efficient to help parents with health care needs such as shopping, doctor visits, laundry and other home health care needs. The costs of home health care or nursing facilities has become prohibitively expensive in the U.S. and living close to the kids in an ADU can in many cases make sense.

ADU’s have also come into demand for parents who would like to help their children with a place to stay while they save up for the large down payment needed for California entry level housing. In the Bay Area for example, entry level home prices start at $800,000 to $900,000 in areas with schools rated 8 or higher. A 20% down payment would require $180,000 of savings plus enough income to support a mortgage of $720,000. Many parents in California are faced with watching their kids move out of state and having limited time around the grandchildren.

Increase Your Home Value and Equity

If you live in an area where homes are selling for in excess of $450 per square foot, you may be adding significant value and home equity to your home. Let’s take an example in Walnut Creek, CA. Homes in the 2,100 sf range are routinely selling for $500/sf and higher. There is value creation if your total construction cost for building your ADU (hard costs + soft costs) comes in at an average of $300/sf. You want to be careful and have a detailed market analysis of comparable home sales in your neighborhood to make certain you aren’t building too much square footage. If you add an 800 sf ADU to a 1,300 sf existing home with all-in construction costs of $300/sf, it would cost you $240,000 for the additional square footage you’ve just added. If you then turn around and sell the home at $500/sf, you’ve just created $160,000 in value ($500/sf x 800/sf ADU = $400,000 - $240,000 = $160,000 new equity). Your home will be re-assessed for taxes and your tax bill will increase. However, your home will now appreciate based off a larger home value as well. If your home appreciates at 4% per year, you could be realizing an additional $16,000 per year of appreciation. If you build a detached ADU, some appraisers do not give as much value to an ADU as they would for the main house. If you plan on selling your home in the near future, it may make sense to try to keep the ADU attached to the house with a door that attaches to the main unit. In this way, the appraiser is forced to value the ADU square footage the same as the house. Until appraisers start valuing ADU's based on the income capitalization approach (value is based on the income the unit produces) like they do for apartment buildings, detached ADU's may not get their fair valuation.

Realize Long Term Investment Benefits

There are 4 main investment benefits you could realize from building your ADU.

Appreciation - Your home will now be appreciating based on a higher home value. As stated above, if you’ve added $400K of value to your home, you are now controlling $400K more of real estate that is appreciating at 3-4% per year on average.
Principal Paydown – If you finance your ADU with a mortgage and then rent it to a tenant, a percentage of the mortgage payment will be going towards the principal balance of the loan. The extra principal pay down boosts the return on your investment and should not be overlooked. You may also pay down your mortgage much quicker if you apply the entire rent back to the mortgage which could save tens of thousands of dollars in interest by paying off your loan early.
Depreciation – If you use your ADU for business purposes or as a rental, you can depreciate that portion of your home and deduct the depreciation from taxes. (Consult with your tax advisor for personal advice.)
Higher Yields – Based on our pro-formas, you will see that most high cost areas in California show yields (net income of the ADU divided by Project Cost) in excess of 10%.

Naturally, choosing the right financing will have a big impact on the returns, as well. We'll discuss this in more detail in the next chapter.

Back to Chapter 3

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The 2019 Guide to Building an ADU in California
(Including Financing Options)

For homeowners who want to make the smartest investment when building a backyard cottage, granny flat, accessory dwelling unit, or garage apartment.