Help me analyze this. Would you buy a 600sqft home w/ ADU?

Question

Hi!I’ve been actively looking for a property the past year. I started looking at condos and the past six months and have transitioned to looking at duplexes or SFH with ADUs. I am a very conservative person in terms of finances and gets scared when there’s too much risk. I am a single income person and after looking at duplexes in the high 400-low 500’s, its been discouraging to proceed to say the least due to repairs needed to make the unit ready for rent while putting 20% down. I finally found a place that is well within my budget and close to my work. BUT it is a small home with a (unpermitted) garage conversion. I plan to live in the main house and rent the ADU once I get it up to code. It’s priced at 390k, 600sqft home with small lot <4000. With 20% down and room for repairs, the budget work for me but need help if it’s a sound purchase.Breakdown: Main house (I will live in it for a year or two) current market rent: 1400ADU rent: 1200Mortgage and interest with 20% down: 1315Taxes: 413Insurance: 100Property manager: 100 (thinking of managing it myself) Utilities: 120Vacancy: 60Cap expense: 60Repairs: 60All expenses:2228Potential income once I move out: 2400down payment: 78k, closing cost: 7,800 repairs, permits: 20k budget. from my calculation, it looks like cap rate is 2%. Will someone be able to enlighten me on that? So what I did was calculate the cash flow for the whole year divided by the money I invested. I hope thats correct. I’m wondering as an investment standpoint, would the property be good to buy right now or wait til next year? Also any experience on buying a small home, living in one, ease as a rental and it’s ease in resale? This property is in Southern California. Thank you in advance for reading this post!

Dan H. · Answer

I have a lot of concerns about your maintenance/cap ex numbers. You allocated $120 total for 2 units or $60/unit. To be blunt, that is about 25% of what I allocate per small unit. The 50% rule is conservative in high rent markets like coastal So Cal, but it is worth looking at. $2600 (rent) - (2600 * 0.5) (50% rule) - $1350 ( debt service) = -$50. As indicated this is likely conservative in your market. Rent to value ratio is $2600/($390000 + $7800)= 0.65%. It is a long ways from the 1% rule, but my pro forma show positive cash flow in my market (similar to yr market) pretty universally at 0.75% and on many properties at 0.7%. I suspect your property would start at about neutral cash flow. However, it would save you from renting a place and paying someone else’s mortgage, you would get equity pay down, the cash flow is likely to increase due to rent appreciation, the property is likely to appreciate. As for the timing, no one knows. My own belief is that the risk of a depreciation cycle is higher than it was a year ago (pre Covid). The free money interest rates are helping boost the market, but will that be maintainable? For a long term Hold, I believe there is more risk staying out of the market than there is of entering and having a depreciation period. All depreciation periods recover and typically in just a few years. I suspect it is not a bad purchase, but I question if you can do better. I believe you could do better. I do believe that this purchase is likely better than no purchase. Good luck

Matthew Forrest · Answer

I love @Dan Heuschele's response around timing and wish that I could so eloquently formulate my responses like that. @April Causapin I agree that doing something is better than doing nothing. You could probably do better, but don't hesitate to bring your deals to the forums. Thanks for sharing!

April Causapin · Answer

@Dan HeuscheleHi, Dan! Thank you! I apologize, the calculation was for one rental. I get a little too excited when I see a property I like and go to BP too fast to share my info and get some advice. Thank you for the last two paragraphs you wrote! It gave me clarity in making a decision regarding this property.

Matthew Forrest · Answer

@April Causapin I love that you're taking a look at investing and moving yourself further out the risk curve! In regard to your comment that you are "a very conservative person in terms of finances and gets scared when there’s too much risk," what are you considering as increased risk? In my opinion, a higher purchase price isn't necessarily more risk. To exaggerate, if you were choosing between a $1MM apartment building in Santa Monica that rents for $10,000 per month, and the the property you listed above for $400,000 which would you choose? From my perspective there is a lot more safety from a property that has better debt coverage and higher desirability. You might find in your area that you'll be taking less risk buying a larger house for $750,000 than buying your smaller house which I think you're concerned about having a small lot and interior square footage. For your cap rate calculation... the cap rate should be the (net operating income) divided by the original capital cost or the current market value. Your expenses should not include debt service. Basically the cap rate is going to tell you what the property would yield if you bought it cash. As far timing the market, I think it's so difficult to do that I don't even worry about it. I mitigate market timing risk by being in the market buying good properties every year for the rest of my life. To me, now is always the best time to buy.

April Causapin · Answer

@Matthew Forrest Thank you for your response! I appreciate it! To me increased risk is shelling out more money than I’m comfortable with. And I worry about purchasing something expensive because if the uncertainty of returns. And thank you for explaining how to calculate cap rates. For you, what are the qualities of a good property?