HELOC for ADU exit strategy

[Michael Ramos]

I am in the beginning stages of my first investment property. I am currently going through the planning of a garage conversion ADU. I live in the primary residence which is a 2 bedroom 1 bath 1000sqft. I have a HELOC in place for 45k along with some cash saved up to covert the garage into a 1 bedroom one bath ADU at just over 400sqft. Expecting 1200-1500/ month for the ADU and house hack. Current mortgage is 2,400.

My plan is to reappraise once ADU is complete and refi into a fixed rate to get out of HELOC. After doing some more reading I have seen people post about not getting much added value from ADU's due to lack of comps. I am looking for alternative exit strategies for HELOC. Thanks.

[Dan H.]

Originally posted by @Michael Ramos:

Thanks I will look into that. Added value would be great but it's not going to be a make or break for me due to the cash flow it will create. Correct me if I am overlooking something being a beginner. The current plan is to house hack and save up for a bigger house for my family as a primary residence and then use cash flow and hopefully by that time greater equity to continue my portfolio. If I didn't do the adu I would only be able to move on by selling the little equity I have now and have no portfolio started. 

The issue is in many markets the value of the ADU addition is more than $50K less than the cost of the ADU addition. This is an issue for a few reasons: 1) The initial cash flow goes to recover the negative position. The negative position can consume years of cash flow before it is recovered and the first true return is achieved. 2) ADUs having value significantly below the hands on costs of the ADU addition means that there is no easy way to extract the value. Lets say that you can refi at 75% LTV and the ADU cost $100K (very cheap hands off ADU) but has a value of $50K as set by the appraiser. You get 75% of the $50K value or $37.5K. This implies $62.5K of value is trapped in the property. 3) the larger the trapped amount of investment, the lower the leverage and the lower the return. For example if I have $20K invested in a $200K property and it appreciates $10K, I have make 50% from that appreciation. But if instead I have $100K invested in the $200K property, I have made 10% from a $10K appreciation. The same thing happens with cash flow. Leverage can increase risk, but it provides the means to optimize the return from every dollar invested.

Do not discount the impacts of a negative position from an ADU addition. Make sure you have some idea of the value of the ADU versus the costs. Research Figure.com and see if it provides any benefit in the value of the ADU in your market. The research you are doing now will help you make an educated decision and hopefully avoid any significant surprises.

Good luck