My first multi-family..can someone with more experience evaluate?

Question

Hello I am getting into real estate investing. I am looking to use my VA loan on a "duplex" in Hawthorne, CA (near Space-x). Asking $895k, and I planned on offering $850k. The "duplex" is 3 bed 2 bath, but the master bedrooms to both units are walled off creating two 2 bed 1 bath units and two 1 bed 1 bath units (no kitchen in these. essentially a hotel room). There is room in the backyard to add an 600sqft ADU (which I plan to do and get permitted by the city). As the property stands now, the 3 car garage was converted into an illegal 1 bed 1 bath ADU (not permitted by the city).

Using the VA loan would allow me to put no money down (no PMI and at an 850K purchase price at 2.75% interest rate). I estimate the mortgage to be around $4400-$4500. Currently, all the rent money would be enough to cover the mortgage, however not covering all the costs like water, gas etc. I have about $130k in a brokerage account that I can use towards building the permitted ADU in the back, but this would essentially drain all my cash reserves.

Tenants come in place. They pay on time and have been there for years despite being on month to month lease terms. Breakdown of their rent is as follows: 2b1b-$1350; 2b1b-$1275; 1b1b-$600; 1b1b-$500; 1b1b garage unit-$950. Total rent collected is $4675. Expenses are water-$150, Sewer-$300, Gas-$40, Trash-$92. Total expense is $582.

After adding the ADU and making it a legal triplex, I would eventually want to turn the garage back into a 3 car garage, so I don't get in trouble with the city. The triplex in the area are going for between $950k-$1.2M.

I'm looking for advice from a seasoned and experienced REI. Does this seem like a good value add deal and house hack? Or is there too much risk involved? Thanks in advance.

Caroline Gerardo · Answer

The VA loan is restrictive on health and safety codes. Sounds like they rigged rooms without legal permits. After you pay for you appraisal it will note that all the "rooms" are removed and put back to single family meeting codes. You cannot close until the house is inspected and returned to a nice safe single family house. The Seller's agent will tell seller not to take your offer if it says VA because they should know that's a tangle and a long escrow that will cost the seller thousands of dollars. The seller is not going to accept a lower offer than what they list it unless it's all cash.  The VA will also require that the seller notify the tenants they must be out as you are going to owner occupy (VA will require this) and seller has to remodel to get it to code. Here is my suggestion: If you love this location and intend to occupy for 10 years make the offer with notes that seller has to bring subject to code and remove tenants, you will need to sweeten the price for them to do this. Will it appraise??? The ADU is a great idea for extra income. There are many companies in Southern California who can deliver a kit one for $80000. and you pay for permits and hook to existing utilities.

Dan H. · Answer

I am not a lender and have only a cursory knowledge of VA loans, but I have seen many appraisals come back with zero issues due to unpermitted work and unpermitted units.  I think it is a crap shoot, but your odds of it not getting subject to addressing the unpermitted units increases if the work quality appears to be what would be expected for legal units.  Your odds of not subject to also increases where unpermitted work is very common.  There is a market in San Diego where the properties with an illegal unit likely is greater than the number of properties without an illegal unit.  The purchasers in that marker are able to get conventional financing.

If the appraisal does not come back subject to addressing the illegal units, your plan may work out.  Hopefully you have contingencies to handle a subject to appraisal.

As @Jonathon Taylor indicated, in many/most markets the value of an ADU (as set by appraisal and/or selling) is less than the hands off ADU addition cost.  This implies that in these markets the ADU starts off with a negative position.  It also implies that there is no way to extract the investment until it appreciates over 30% (at 75% REFI LTV).  The COC on ADUs are typically one of the worse RE investments for hands off ADU additions.  Note with an active role or the right market this is not the case.  So it is important to research the value of the ADU in your market.  My understanding is that ADUs often value best where there is plenty of small multi units to use as comps.

Good luck

Jonathan Taylor · Answer

@Kevin Meyer you're going to run into issues with the unpermitted units as stated in the above comment. Being that the loan is collateralized with the property, those who will own the loan will want to make sure the property is legal and conforming to local building codes, being that it isn't, per your post, the appraisal will come back with legal and non conforming so this loan can't be sold on the secondary market. This property is a cash buy and maybe non conventional loan product route for those reasons.

As far as the plan, the costs of ADUs ground up are 100-150k and most appraisals do not value the sq ft as the same as the main house so you wouldn't be able to get the value out of the ADUs that you put into it. It would be a strictly cash flow move, which works for most folks if you have the cash to pay for the construction.

Kevin Meyer · Answer

Hi Caroline. Thanks for the response.

To provide more context: My offer of $850k was accepted and we are in escrow now. Still need to do the appraisal and inspection, which is where you see most of the issues coming due to the lack of legal permits and not being up to code. Let me know if you have more to add knowing this information. Thank you!

Dan H. · Answer

It often comes down to a lack of comps which results in the ADUs being valued much lower than the per foot value of the primary structure.  In many markets the ADU is valued over $50k below the hands off costs of the ADU addition.   The valuation of the ADU varies by market.  The owner who adds an ADU should be confident that there are comps to justify a value close to or greater than the costs to add the ADU.  it would suck to add an ADU, taking a garage or yard space, to achieve a valuation $50k+ below the costs of adding the ADU.

Cody L. · Answer

Very interesting.  Why is that?  It can't be THAT much to add a small 600-700 SF ADU.  And given you have the land already, and given homes sell for ~400+ / SF, while it might cost 150/sf to build, it would seem that adding an ADU would add more value than it's cost.

(not saying your wrong, but curious why you're correct...)

Bryan Cambra · Answer

Hi Kevin, I'm currently house hacking a Duplex in El Monte using a VA loan. The only issue that came up during financing regarding unpermitted units is that they couldn't be included in the unit mix. For example if it was functionally a 3 unit but only permitted as a 2 unit then your max loan amount would be capped at the 2 unit amount.

Given that you're using a VA loan, which unit do you intend to live in? Not sure how an eviction would work (even if it's legal) in the current environment?If you end up getting it I would consider just leaving that garage unit in place and wait until the city makes you change it. Stack the extra cash somewhere that earns interest so if they do come you'll have the cost paid for with cash flows. If they don't, then even better.

Justin Goodin · Answer

@Dan Heuschele great points

Justin Goodin · Answer

@Kevin Meyer Hope this works out for you! I do not have knowledge about VA loans. No money down? Can't beat that!

My first multi-family..can someone with more experience evaluate?

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