It’s Time to Consider Investing in ADUs

October 29, 2021 | Erin Behan

Accessory dwelling units offer more space and endless possibilities. 

ADUs or accessory dwelling units, are secondary units of housing on a single-family residential lot. They offer homeowners the ability to maximize the potential of their property by increasing the square footage. As such, they are viewed as a potential solution to housing affordability in places like California. 

Given the huge potential upside, ADUs are becoming increasingly popular across the country. Investors can generate additional streams of income on a single property, while homeowners also have much to gain. 

What is an ADU?

ADUs get called all sorts of things, including granny flats, in-law suites, back houses, carriage houses, and garage apartments.  Fannie Mae, the leading source of mortgage financing in the United States, defines it this way:

“An ADU is typically an additional living area independent of the primary dwelling that may have been added to, created within, or detached from a primary one-unit dwelling. It must provide space for living, sleeping, cooking, and bathroom facilities and be on the same parcel as the primary one-unit dwelling.”

To qualify as an ADU, the space must be smaller than the original home, and it must have an entrance from the outside directly into the ADU. The kitchen needs to be fully functioning with cabinets, a countertop, a sink with running water, and a stove hookup. In other words, it can operate as its own home independently.

Different types of ADUs

ADUs come in all shapes, sizes, configurations, and finishes. In general, they fall into one of three categories: interior, attached, or detached. They usually look something like the following: 

  • Converted basement ADU
  • Converted garage ADU or converted over the garage ADU
  • Space added to, or bumped out from, an original home
  • Detached new construction, sometimes prefab

Sometimes ADUs can be beneficial beyond adding space or flexibility to a property. For instance, in California, an investor who doesn’t live on the property can add an ADU and rent out both the ADU and the main house. This also opens up possibilities for flippers who want to buy a single-family home and add an ADU—although this process may take longer than some flippers prefer. In some cases, it may be possible to build an ADU that’s legally structured as a condominium and sold separately from the main house.

Laws vary by state and jurisdiction

Recently, some states such as California, Oregon, and New Hampshire have relaxed restrictions on building ADUs as a way of addressing the affordable housing crisis. Rules on ADUs can vary by state, city, and municipality. Such rules might specify a minimum or maximum size, or require them to be located near public transit to allay parking concerns. 

The loosening of restrictions around ADUs in California offer tremendous upside to investors.  It has made additional income generation easier than ever. With added units, investors can rent by the room or an entire unit on the same property with little additional hassle. Given the cost of an ADU compared to purchasing a new property, this can be quite lucrative.  

Before jumping in, be sure to do your due diligence. As their popularity has increased, books and blogs on ADUs have popped up to follow the ADU movement. A complete list of changes are available in the California Handbook on ADUs and on the state information page for ADU and JADUs. Builders who specialize in ADUs can also be a good source of up-to-date information. 

Pros and cons of ADUs

Investors might want to convert space into an ADU or build a freestanding ADU unit for a number of reasons. Likewise investors might want to buy a property with an ADU as they may make the property more flexible and potentially valuable. To better weigh the pros and cons, we’ve created a list below:

Pros

  • May increase the overall value of your property.
  • Give investors the ability to generate additional income on a property.
  • May be able to be built in such a way as to subdivide the land and sell both units and property separately.
  • Provide an affordable alternative for renters who want a small footprint.
  • Offer flexibility of use such as guest houses, rental properties, or more space.
  • Help to reduce sprawl in cities.
  • Are environmentally friendly, as they are built on a smaller footprint and use less energy than larger homes.
  • Require relatively low costs to build since they are small and the land is already owned by the homeowner.

Cons

  • Don’t always raise property value.
  • May take away space from the main home and property.
  • ADUs that are rented to tenants or used by family will reduce the sense of privacy in the main house.
  • Are not legal in every area, either to build or rent.
  • Cost money to convert or build, anywhere from $45,000 to $100,000 and up.
  • May be difficult to get financing for.

Overall, ADUs offer high upside for those looking to create new sources of income for a fraction of the cost of other options. To many investors, the flexibility of ADUs are their best feature. Investors can get two rents from one property. Or, ADUs can be used by the primary owner as a home office or guest suite. They can also house renters or an elderly relative or caregivers. Their use may change over time—a bonus to aging owners or investors who like flexibility. 

Are ADUs good investments?

There are many reasons to be optimistic about ADUs as an investment. However, just how lucrative they are depends on a number of factors. As you begin to consider your next steps, there are three final pieces of advice that you should keep in mind:

  1. ADUs need to be legal to build where you live, so it’s important to do your research. Non-permitted work is never a good investment, and it will always cost you in the long run. To ensure that you’re conducting business legally, consult a real estate lawyer to gain clarity.
  2. If you plan on renting it as a vacation rental, rules vary greatly by town and city. Be sure to review regulations for short-term rentals and determine a winning strategy where you live before investing in an ADU.
  3. Keep the end goal in mind. ADUs are a good investment if the numbers pan out. That means it’s important to run numbers on how much it will cost to build. You should also be clear on your strategy for renting the unit and estimate rental income ahead of time. Be sure to add in any long term additional costs like taxes or utilities as well as how else you could invest that money or equity in other properties or investments. These are great ways to make decisions about which approach fits your investment goals.

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