ADU Garage Conversion or Short Term Rental

[Alex Ballesteros]

I recently purchased my first property in Compton, CA back in November... 2 bd 1 bath, 4,400 S.F lot with a 2 car detached garage (approx. 480 S.F). The property is a "fixer-upper" and in order to maximize rents it will need about $60K in renovations, and I am also considering converting the garage into an ADU. I will be self-managing the project (not using a GC), therefore, the total cost of construction + adding finishes, etc will run me anywhere from $80 - 100K & I would be financing the ADU with cash. On the other hand instead of doing the ADU, i am wondering if I would be able to find a deal and do a STR with the same budget, and how that would kind of play out in return to the ADU.

Let me know what you guys think on this... pros, cons? Why you would choose one option over the other ?

[Dan H.]

I believe adding an ADU is one of the worse RE investments.

What is not clear to me is whether the property makes is a good candidate for a BRRRR. Typically, if I do a value add of $60K, I expect at least $120k of added value. ADUs in most markets do not add as much value as they cost. This implies that if you decide to add an ADU, do it after refinancing post the $60K renovations.

Here are reasons why I believe adding an ADU is not the best RE investment:

1) The value added by the ADU addition is often significantly less than the cost of adding the ADU. Search the BP for ADU appraisals to encounter numerous examples. This creates a negative initial position. This negative position can consume years of cash flow to recover. Make sure you know the value the ADU will add to the property before building the ADU.
2) the financing on an ADU is typically far worse than for initial investment property acquisition or is often not leveraged (HELOC, cash out refi, etc). Leverage magnifies return.
3) The effort involved in adding an ADU is comparable or larger than a rehab associated with a BRRRR. However if I do a BRRRR I can achieve infinite return by extracting all of my investment. Due to item 1, adding an ADU can require years to start achieving any return (once the accumulated cash flow recovers the initial negative position).
4) Adding an ADU is a slow process. It can take a year or more to complete an ADU. During this time you are not generating any return from the money invested in the ADU. This amounts to lost opportunity because if you had purchased RE, at the closing it can start producing return.
5) ADUs detract from the existing structure whether this is privacy, a garage, or just yard space.
6) this is related to number 1, but there are many more buyers looking to purchase homes for their family than there are RE investors looking to purchase small unit count properties. This may affect value or time required to sell.
7) Adding an ADU does not make the property a duplex. For example in many jurisdictions I can STR units in a duplex but cannot STR an ADU (some jurisdictions will let you STR if you owner occupy). Duplex have different zoning that may permit additional units. Duplex can always add additional units via the ADU laws.
8) Related to number 1, purchasing a property with an existing ADU is cheaper than buying a property and adding an ADU. Why add an ADU if it can be purchased cheaper?

Good luck