cash flow or appreciations (in California)

[Jason Phu]

HI everyone,

My goal to purchase an investment home now is to keep it long term and eventually it will become my place to retire (goal to retire in the next 10 years). At the moments, I'm looking at 2 properties both in California:

-  First one is a beautiful, bigger home, completely high-end upgraded, in a higher value area with a good school district, and of course it comes with a higher cost to buy, rent can only cover the monthly expenses (mortgage, insurance, tax, etc), this one is expected to have higher appreciations in the long term.

- Second one is a decent remodeled home, smaller, in a lower value area, I can get it without financing (pay cash), so it will cash flow (about $2200/moth after all expenses such as tax and insurance), it also has a potential for an ADU, but future appreciation is not as great as the first property due to location.

Which one I should go for? and why?

Appreciate your input!!

[Jon Schwartz]

@Jason Phu, California's a big state -- and LA is a big market, if that's where you're buying -- so we'd need a little more information about where exactly these two homes are, but here's my two cents as an LA investor/realtor:

Most CA markets are appreciation markets, which means -- to me -- that you'll always do better focusing on appreciation over cashflow. The high-appreciation asset will gain more value monthly than the low-appreciation asset that spins off some cashflow.

That said, are you sure the first home will appreciate more over time? Often, it's the transitioning neighborhoods that offer more potential appreciation. Is the second home in a neighborhood that's likely to gentrify in the next decade? That's an important consideration.

Additionally, adding an ADU to a property forces appreciation, especially if you have a one- or two-decade timeline. The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

And lastly, are you sure it's best to buy the less-expensive property in cash? You'll cashflow, but you'll also be tying up a lot of capital. What if you bought the second property with a loan such that it was also cashflow-neutral? Then maybe used your saved funds to do the ADU conversion right off the bat?

If you want to discuss the options you're considering in more details, please feel free to message me!

Best,

Jon

[Bjorn Ahlblad]

There is no way to know if the next 30 years will be like the last thirty years. It is important to make sure you have enough cash available to make it through the dips and never be forced to sell. 

Today the landlord tenant laws are against you so you have to make sure tenants are screened really well and you must inspect at least annually. And then there is the horrible state income tax. 

I would go for the more expensive property-or maybe two properties. You can't make money in California REI unless you have money to start with and I am not saying it is a good idea, I really have no clue. All the best!

[Christie Gahan]

You really need to find an accountant that loves tax strategy.  You need to look at your income to know if you could benefit from tax strategy there. 

I don't like the expensive house because the remodel is done.  For tax purposes, you might get a big tax advantage to buying a house and doing the remodel and a Cost Segregation Study. 

Also, the property you could pay cash for.... maybe not the best idea either.  If your income is high, a lot of cash flow / income just goes to Uncle Sam.  It might be better to put a large down payment so the property will cash flow enough.  At retirement, you can think about paying it off and living in it.

[Matthew Kwan]

It depends what you are trying to achieve right? Do you value cash flow or appreciation more?

Numbers are more doable in the Midwest where you can acquire units for a lower cash and might get 1% or more of return. However, the rents are slightly lower and could potentially wipe out your monthly cashflows with one major repair.

As for higher appreciation market like West/East Coast, it's more expensive, but rents are higher due to a strong labor market, there will be a certain amount of demand for those markets, but the downside is that you will need to be creative by adding more values for the property. It could be adding an extra bedroom, parking space, or kitchen where you can maximize the potential rent of the property.

@Albert Bui @Carlos Valencia

[Dan H.]

Quote from @Jon Schwartz:

@Jason Phu, California's a big state -- and LA is a big market, if that's where you're buying -- so we'd need a little more information about where exactly these two homes are, but here's my two cents as an LA investor/realtor:

Most CA markets are appreciation markets, which means -- to me -- that you'll always do better focusing on appreciation over cashflow. The high-appreciation asset will gain more value monthly than the low-appreciation asset that spins off some cashflow.

That said, are you sure the first home will appreciate more over time? Often, it's the transitioning neighborhoods that offer more potential appreciation. Is the second home in a neighborhood that's likely to gentrify in the next decade? That's an important consideration.

Additionally, adding an ADU to a property forces appreciation, especially if you have a one- or two-decade timeline. The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

And lastly, are you sure it's best to buy the less-expensive property in cash? You'll cashflow, but you'll also be tying up a lot of capital. What if you bought the second property with a loan such that it was also cashflow-neutral? Then maybe used your saved funds to do the ADU conversion right off the bat?

If you want to discuss the options you're considering in more details, please feel free to message me!

Best,

Jon

 >The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

The property income does not correlate to value unless there is more than 4 units. So additional income does not equate to additional value. In my market, JADUs are regularly being removed when selling a property to achieve top price even though they can generate income. I have seen crazy claims from ADU developers including attempts to indicate a value based on income. When challenged on it you get either a back down or indicating they were referring to cases with more than 4 units. I had one in the last couple weeks on this forum of a ADU vender stating that value can be based on income. When I challenged his assertion, he indicated he was referring to more than 4 units but this was conveniently left out of his initial post.

I also do not know whose expectation is that ADUs will appraise better in the future. maybe ADU venders are stating these are the expectations. The reality is ADUs, casitas, mother-in-law suites, etc have existed for decades, much longer than the fairly recent state level ADU laws some of which are already 5 years old. I cannot think of a single reason, with the poor valuations that have existed for decades, that the poor valuations will be changing any time.

ADUs have poor valuations, have always had poor valuation, and seem likely will continue to have poor valuations.  

[Jason Phu]

@Jon Schwartz, Thanks!! I like your suggestion of the second property with a loan instead of cash, and add ADU. For me, an ADU always a plus to a property in value and income. The concern is that I don't see the neighborhood is a safe/growing one.

[Allan C.]

@Jason Phu you haven't provided sufficient info so you're going to get a lot of incomplete responses. Also, cash flow by buying a property unleveraged is a meaningless metric. Lastly, as mentioned above, ADUs often do not add value on a SFH in CA.

One factor that you didn't mention is property tax basis. That is by far the biggest impact when buying CA real estate, so have you factored that cost into your NOI comparison?

Also, do you want all of your eggs in one basket or do you want to diversify your risk? Generally I’d prefer to purchase 2 properties instead of one, but it also depends on what your goals are for portfolio size.

[Andrew Lax]

If it doesn't cash flow it's speculation. 

[Jon Schwartz]

Quote from @Dan H.:

Quote from @Jon Schwartz:

@Jason Phu, California's a big state -- and LA is a big market, if that's where you're buying -- so we'd need a little more information about where exactly these two homes are, but here's my two cents as an LA investor/realtor:

Most CA markets are appreciation markets, which means -- to me -- that you'll always do better focusing on appreciation over cashflow. The high-appreciation asset will gain more value monthly than the low-appreciation asset that spins off some cashflow.

That said, are you sure the first home will appreciate more over time? Often, it's the transitioning neighborhoods that offer more potential appreciation. Is the second home in a neighborhood that's likely to gentrify in the next decade? That's an important consideration.

Additionally, adding an ADU to a property forces appreciation, especially if you have a one- or two-decade timeline. The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

And lastly, are you sure it's best to buy the less-expensive property in cash? You'll cashflow, but you'll also be tying up a lot of capital. What if you bought the second property with a loan such that it was also cashflow-neutral? Then maybe used your saved funds to do the ADU conversion right off the bat?

If you want to discuss the options you're considering in more details, please feel free to message me!

Best,

Jon

 >The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

The property income does not correlate to value unless there is more than 4 units. So additional income does not equate to additional value. In my market, JADUs are regularly being removed when selling a property to achieve top price even though they can generate income. I have seen crazy claims from ADU developers including attempts to indicate a value based on income. When challenged on it you get either a back down or indicating they were referring to cases with more than 4 units. I had one in the last couple weeks on this forum of a ADU vender stating that value can be based on income. When I challenged his assertion, he indicated he was referring to more than 4 units but this was conveniently left out of his initial post.

I also do not know whose expectation is that ADUs will appraise better in the future. maybe ADU venders are stating these are the expectations. The reality is ADUs, casitas, mother-in-law suites, etc have existed for decades, much longer than the fairly recent state level ADU laws some of which are already 5 years old. I cannot think of a single reason, with the poor valuations that have existed for decades, that the poor valuations will be changing any time.

ADUs have poor valuations, have always had poor valuation, and seem likely will continue to have poor valuations.  

Dan, I've seen you attack ADUs as an investment vehicle here and on other posts, and I think you've maybe lost touch with what's happening with ADUs -- at least in Los Angeles.

Just to share some boots-on-the-ground information with you:

Appraisals are beginning to account for the real value of an ADU because ADUs are very attractive to traditional homebuyers. You suggest that only an investor would buy a house with an ADU; in fact, since work-from-home took off four years ago, homes with ADUs have been in huge demand in LA. Add to that the ridiculous affordability crisis, and a lot of buyers are all too happy to buy a house with an income-generating unit in the back. So homes with ADUs sell for more, and the appraisals have followed pricing for four+ years now.

I personally know an investment group that targets neighborhoods, mostly in the San Fernando Valley, where comps with ADUs are outperforming non-ADU comps so that they can refinance out the value created by their ADUs. They incorporate ADUs into all of their BRRRR projects. And JADUs, too!

You seem to think that JADU's owner-occupancy requirement is a dead end. In Los Angeles, the owner who builds the JADU must sign a covenant stating owner-occupancy, but there's no enforcement. I've personally transacted on a house + ADU + JADU that was rented to three separate tenants. And we financed it!

You seem to think homes with a JADU aren't financeable. Technically, you're correct, but like I said, I've gotten around this. Just remove the oven from the JADU kitchen during the appraisal.

Anyway, back to ADUs...

You seem to think that income isn't a factor for appraisal or value. Firstly, conventional loans now allow for ADU income to be counted as borrower income for financing. Secondly, residential multifamily in Los Angeles reconciles the sales comp approach and the income approach on appraisal. Thirdly, selling a house with an ADU collecting rent significantly boosts the value for traditional homebuyers. I recently sold one of my duplexes in a bidding war; the highest bidders were all traditional buyers looking to occupy the vacant unit. They couldn't afford a single-family home in the same neighborhood, but with the income generated from the other unit of my duplex, they were more than happy to pay top dollar. (And I know this example is of a duplex, not a house + ADU, but I've seen the same bidding wars over homes that have rent-collecting ADUs.)

Speaking of ADUs versus duplexes -- you make the point that adding an ADU doesn't turn a property into a duplex. Why is this a negative? It's better that the parcel maintain it's single-family zoning so that an SB9 strategy can be executed in the future.

What else...? You had so many objections to ADUs, and they were mostly so baseless...

Oh, yes! The long time is takes to build an ADU, "a year or more," according to you. Yes, it can take more than a year to build an ADU, but it's much more common -- in LA, at least -- to finish an entire ADU project in six months. ADUs are so popular here that an whole cottage industry has sprung up around the quick and inexpensive conversion of garages. There are designers who focus on ADU layout, drafters who just draw ADU plans, and contractors who just pump out garage conversions. Prices have fallen as a result. I recently saw a garage conversion quote of $120K -- fully executed by a GC, no DIY.

You also seem to think one's capital for an ADU has to sit unused for a year. Where did you get this idea? During permitting, all you're out-of-pocket is the drafting and permitting costs. You don't pay your GC until he starts work, and a garage conversion is done in three months.

You also have a problem with ADU financing, which traditionally comes from a HELOC. Yes, HELOC financing isn't as cheap as owner-occupant or even investor financing, but the leverage can still be worthwhile...

...because the fundamental cap rate of an ADU is SO FREAKIN' HIGH. That's why ADUs aren't the worst investment in LA, but the best. Look, a garage conversion costs $150K and collects $1500/month. Let's put expenses at 15% since it's a new build, and you're looking at a 10.2 cap rate. In Los Angeles!

In LA, when we're assessing small multifamily, we usually look at the gross rent multiplier (GRM) instead of cap rate. The above example has a GRM of 8.3. That's about half the GRM you'd get in LA's worst neighborhoods (and the lower the GRM, the better the buy).

ADUs aren't perfect, but they're still an amazing investment in Los Angeles, especially for homebuyers or homeowners looking to get started.

[Jon Schwartz]

Quote from @Jason Phu:

@Jon Schwartz, Thanks!! I like your suggestion of the second property with a loan instead of cash, and add ADU. For me, an ADU always a plus to a property in value and income. The concern is that I don't see the neighborhood is a safe/growing one.

Will you share what neighborhood it is?

[Jason Phu]

Quote from @Jon Schwartz:

Quote from @Jason Phu:

@Jon Schwartz, Thanks!! I like your suggestion of the second property with a loan instead of cash, and add ADU. For me, an ADU always a plus to a property in value and income. The concern is that I don't see the neighborhood is a safe/growing one.

Will you share what neighborhood it is?

first one is in Eastvale, 2nd one is in Fontana

[Jason Phu]

Quote from @Andrew Lax:

If it doesn't cash flow it's speculation. 

at a certain point, I agree with you. But it also depends on the market. CA is mostly appreciation, that's why housing price in CA is so crazy.

[Andrew Lax]

Quote from @Jason Phu:

Quote from @Andrew Lax:

If it doesn't cash flow it's speculation. 

at a certain point, I agree with you. But it also depends on the market. CA is mostly appreciation, that's why housing price in CA is so crazy.

Buying on speculation at the top of the market would probably not be my go to plan .... 

10 years ago with the market conditions and low rates maybe.  but not now. 

If it doesnt throw off 10% ROI I would think long and hard ...

Not saying there are not deals out there that make sense ..

Just be careful relying on appreciation only... 

I am an old dog and seen many lay to waste thinking this train will keep rolling forever 

just be careful buying on a hypothetical appreciation number - markets dont run forever 

[Andrew Syrios]

I don't like relying on appreciation, especially in a relatively flat market like ours and California seems to have a large number of problems, affordability issues, consistent outmigration, etc. I would go with the cash flow property

[Jason Phu]

Quote from @Andrew Lax:

Quote from @Jason Phu:

Quote from @Andrew Lax:

If it doesn't cash flow it's speculation. 

at a certain point, I agree with you. But it also depends on the market. CA is mostly appreciation, that's why housing price in CA is so crazy.

Buying on speculation at the top of the market would probably not be my go to plan .... 

10 years ago with the market conditions and low rates maybe.  but not now. 

If it doesnt throw off 10% ROI I would think long and hard ...

Not saying there are not deals out there that make sense ..

Just be careful relying on appreciation only... 

I am an old dog and seen many lay to waste thinking this train will keep rolling forever 

just be careful buying on a hypothetical appreciation number - markets dont run forever 

Great point!! Thanks

[Jason Phu]

Quote from @Jon Schwartz:

ADUs aren't perfect, but they're still an amazing investment in Los Angeles, especially for homebuyers or homeowners looking to get started.

in CA, houses have larger lot with ADU potential or houses that have ADU always attract more buyers, in some cases people are willing to pay more for those properties.

[Jason Phu]

Quote from @Allan C.:

@Jason Phu you haven't provided sufficient info so you're going to get a lot of incomplete responses. Also, cash flow by buying a property unleveraged is a meaningless metric. Lastly, as mentioned above, ADUs often do not add value on a SFH in CA.

One factor that you didn't mention is property tax basis. That is by far the biggest impact when buying CA real estate, so have you factored that cost into your NOI comparison?

Also, do you want all of your eggs in one basket or do you want to diversify your risk? Generally I’d prefer to purchase 2 properties instead of one, but it also depends on what your goals are for portfolio size.

 Yes. Tax has been factored into the number, but I'm not convinced about 
"ADUs often do not add value on a SFH in CA." It may not be obvious now, but I believe it will soon down the road when SB9 is applied

[Dan H.]

Quote from @Jon Schwartz:

Quote from @Dan H.:

Quote from @Jon Schwartz:

@Jason Phu, California's a big state -- and LA is a big market, if that's where you're buying -- so we'd need a little more information about where exactly these two homes are, but here's my two cents as an LA investor/realtor:

Most CA markets are appreciation markets, which means -- to me -- that you'll always do better focusing on appreciation over cashflow. The high-appreciation asset will gain more value monthly than the low-appreciation asset that spins off some cashflow.

That said, are you sure the first home will appreciate more over time? Often, it's the transitioning neighborhoods that offer more potential appreciation. Is the second home in a neighborhood that's likely to gentrify in the next decade? That's an important consideration.

Additionally, adding an ADU to a property forces appreciation, especially if you have a one- or two-decade timeline. The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

And lastly, are you sure it's best to buy the less-expensive property in cash? You'll cashflow, but you'll also be tying up a lot of capital. What if you bought the second property with a loan such that it was also cashflow-neutral? Then maybe used your saved funds to do the ADU conversion right off the bat?

If you want to discuss the options you're considering in more details, please feel free to message me!

Best,

Jon

 >The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

The property income does not correlate to value unless there is more than 4 units. So additional income does not equate to additional value. In my market, JADUs are regularly being removed when selling a property to achieve top price even though they can generate income. I have seen crazy claims from ADU developers including attempts to indicate a value based on income. When challenged on it you get either a back down or indicating they were referring to cases with more than 4 units. I had one in the last couple weeks on this forum of a ADU vender stating that value can be based on income. When I challenged his assertion, he indicated he was referring to more than 4 units but this was conveniently left out of his initial post.

I also do not know whose expectation is that ADUs will appraise better in the future. maybe ADU venders are stating these are the expectations. The reality is ADUs, casitas, mother-in-law suites, etc have existed for decades, much longer than the fairly recent state level ADU laws some of which are already 5 years old. I cannot think of a single reason, with the poor valuations that have existed for decades, that the poor valuations will be changing any time.

ADUs have poor valuations, have always had poor valuation, and seem likely will continue to have poor valuations.  

Dan, I've seen you attack ADUs as an investment vehicle here and on other posts, and I think you've maybe lost touch with what's happening with ADUs -- at least in Los Angeles.

Just to share some boots-on-the-ground information with you:

Appraisals are beginning to account for the real value of an ADU because ADUs are very attractive to traditional homebuyers. You suggest that only an investor would buy a house with an ADU; in fact, since work-from-home took off four years ago, homes with ADUs have been in huge demand in LA. Add to that the ridiculous affordability crisis, and a lot of buyers are all too happy to buy a house with an income-generating unit in the back. So homes with ADUs sell for more, and the appraisals have followed pricing for four+ years now.

I personally know an investment group that targets neighborhoods, mostly in the San Fernando Valley, where comps with ADUs are outperforming non-ADU comps so that they can refinance out the value created by their ADUs. They incorporate ADUs into all of their BRRRR projects. And JADUs, too!

You seem to think that JADU's owner-occupancy requirement is a dead end. In Los Angeles, the owner who builds the JADU must sign a covenant stating owner-occupancy, but there's no enforcement. I've personally transacted on a house + ADU + JADU that was rented to three separate tenants. And we financed it!

You seem to think homes with a JADU aren't financeable. Technically, you're correct, but like I said, I've gotten around this. Just remove the oven from the JADU kitchen during the appraisal.

Anyway, back to ADUs...

You seem to think that income isn't a factor for appraisal or value. Firstly, conventional loans now allow for ADU income to be counted as borrower income for financing. Secondly, residential multifamily in Los Angeles reconciles the sales comp approach and the income approach on appraisal. Thirdly, selling a house with an ADU collecting rent significantly boosts the value for traditional homebuyers. I recently sold one of my duplexes in a bidding war; the highest bidders were all traditional buyers looking to occupy the vacant unit. They couldn't afford a single-family home in the same neighborhood, but with the income generated from the other unit of my duplex, they were more than happy to pay top dollar. (And I know this example is of a duplex, not a house + ADU, but I've seen the same bidding wars over homes that have rent-collecting ADUs.)

Speaking of ADUs versus duplexes -- you make the point that adding an ADU doesn't turn a property into a duplex. Why is this a negative? It's better that the parcel maintain it's single-family zoning so that an SB9 strategy can be executed in the future.

What else...? You had so many objections to ADUs, and they were mostly so baseless...

Oh, yes! The long time is takes to build an ADU, "a year or more," according to you. Yes, it can take more than a year to build an ADU, but it's much more common -- in LA, at least -- to finish an entire ADU project in six months. ADUs are so popular here that an whole cottage industry has sprung up around the quick and inexpensive conversion of garages. There are designers who focus on ADU layout, drafters who just draw ADU plans, and contractors who just pump out garage conversions. Prices have fallen as a result. I recently saw a garage conversion quote of $120K -- fully executed by a GC, no DIY.

You also seem to think one's capital for an ADU has to sit unused for a year. Where did you get this idea? During permitting, all you're out-of-pocket is the drafting and permitting costs. You don't pay your GC until he starts work, and a garage conversion is done in three months.

You also have a problem with ADU financing, which traditionally comes from a HELOC. Yes, HELOC financing isn't as cheap as owner-occupant or even investor financing, but the leverage can still be worthwhile...

...because the fundamental cap rate of an ADU is SO FREAKIN' HIGH. That's why ADUs aren't the worst investment in LA, but the best. Look, a garage conversion costs $150K and collects $1500/month. Let's put expenses at 15% since it's a new build, and you're looking at a 10.2 cap rate. In Los Angeles!

In LA, when we're assessing small multifamily, we usually look at the gross rent multiplier (GRM) instead of cap rate. The above example has a GRM of 8.3. That's about half the GRM you'd get in LA's worst neighborhoods (and the lower the GRM, the better the buy).

ADUs aren't perfect, but they're still an amazing investment in Los Angeles, especially for homebuyers or homeowners looking to get started.

 >Appraisals are beginning to account for the real value of an ADU because ADUs are very attractive to traditional homebuyers.

I go to a fair amount of RE meetups and see the posts on BP about ADU appraisals and it does not match what I hear or see. In the last 2 weeks, I analyzed two ADU addition properties. I should have rejected the first immediately as it was not hands off, but a flipper and was requested by someone considering adding an ADU to their property in the same vicinity. So, it is not the case of what I describe as the hands off ADU addition. I could not determine a value on the ADU, but the flipper did great. They declared a value add expense with the state of I believe it was $750K (something close to that) so they did a lot more than the ADU addition. These expenses reported to the state are often under reported even in the case of flippers. In the case of flippers the underreporting is in case they need to resort to plan B and keep the property longer than intended (rental). The flipper sold for a delta of over twice his declared expenses and I suspect made significant money on the his ADU addition (but was not hands off). The other request came from someone that had originally thought his ADU refi value was OK. I analyzed the average appreciation in his market since his fairly recent purchase and the value of the house without the ADU. The owner originally had not accounted for any market appreciation since the purchase. It ended up he got a value of between $40K to $75K for an ADU addition that cost basically double the high end of that value.

>You suggest that only an investor would buy a house with an ADU

I do not believe I ever suggested such a thing. I did imply the buying pool is smaller than for SFH. I do not believe that is debatable.

>You seem to think that JADU's owner-occupancy requirement is a dead end. In Los Angeles, the owner who builds the JADU must sign a covenant stating owner-occupancy, but there's no enforcement. I've personally transacted on a house +ADU + JADU that was rented to three separate tenants.

If I am taking the risk of breaking a deed restriction, I expect the associated discount.  I purchase these types of properties off market.  They are not a problem until they are.  I recently got multiple red tags on a property for unpermitted work that was completed by previous ownership.  Sometimes you get away with it and sometimes you do not but it is risk.  To me the vast majority of off market purchases require either work and/or have risk.  This type of risk should not be a retail sale at a retail price.

>You seem to think homes with a JADU aren't financeable. Technically, you're correct, but like I said, I've gotten around this. Just remove the oven from the JADU kitchen during the appraisal.

As indicated I am correct.  Next I have heard of sub-to appraisals that require more than the removal of an oven for illegal units.  It is a risk and you can see my above post about these risks.  Retail purchases at retail prices should not have such risks.

>You seem to think that income isn't a factor for appraisal or value.

Correct when less than 5 units.

>Firstly, conventional loans now allow for ADU income to be counted as borrower income for financing.

This is unrelated to RE value which is what you are responding to and I used to have this on the list but removed it recently when ADU income can help qualify for the loan. This used to be an advantage for true MF RE, but is no longer.

>residential multifamily in Los Angeles reconciles the sales comp approach and the income approach on appraisal.

No. The income approach is used for reference only and not a basis of the value if using conventional F/F financing. If the value based on both approaches is significantly different, the cost basis is not used at all. Only the comps are used in the obtaining value. I had a case of this 3 years ago. The income basis put the value at over 2x the value of comps (it was a true over 1% property in San Diego which you can imagine the value income approach showed). The comp value was used as the value. No average of the two value; no deviating of comp value for such a great income property. You also see this with STR appraisals.

>selling a house with an ADU collecting rent significantly boosts the value for traditional homebuyers.

For some, including a high percentage on this forum, yes but those buyers are a smaller pool than buyers looking at SFH. In addition, they are looking to make an ROI (all RE investors should be) which often results in the lower value than the emotional purchases of the SFH purchase.

>Speaking of ADUs versus duplexes -- you make the point that adding anADU doesn't turn a property into a duplex. Why is this a negative? It's better that the parcel maintain it's single-family zoning so that an SB9 strategy can be executed in the future.

I agree that you can often find ADUs in nicer areas than true Multiplex, but these areas do not typically place a high value on the ADU. These ADUs in nicer areas are good for the house hacker who wants to live in nicer area and have a rental. This is especially true if they are purchasing the property with the already existing ADU (getting likely larger than usual ADU discount because of their often poor valuation in nice areas without the effort of adding the ADU). Advantages of duplex include ability to add ADUs, no extra STR restrictions, and they in general appraise better than SFH with ADU. As for SB9, if you have the right property and the ADU was added in the correct location (so at least 40% of the property is dividable), then you could use SB9. Note this was the case without the ADU also.

>The long time is takes to build an ADU, "a year or more," according to you. Yes, it can take more than a year to build an ADU, but it's much more common -- in LA, at least -- to finish an entire ADU project in six months.

Can you site a source showing a majority finish 6 months?  I believe it is possible if all goes near perfect which is unlikely.  I admit my year or longer is without knowing how long it is taking on average which is why I say "it can take a year or more" (my statement is true as I know of cases that took over a year).  I have high confidence that the average is more than 6 months in LA and elsewhere in So Cal.  For those who have added ADUs in So Cal, I invite you to say how long it took from start to finish.  During the build process, money is spent but income waits for the unit to be rented after completion.

> I recently saw a garage conversion quote of $120K -- fully executed by a GC, no DIY.

I believe that but there has always been a price range. I believe the $120K is at the lower end of the hands-off cost range and a more expected cost to be close to $140K and more if the garage slab needs significant effort to be usable for the ADU. I usually use $140K as the cost but have always realized some will cost less and some will cost more.

>You also have a problem with ADU financing, which traditionally comes from a HELOC. Yes, HELOC financing isn't as cheap as owner-occupant or even investor financing, but the leverage can still be worthwhile

You miss why I do not like HELOC for ADU additions. It is because it basically is unleveraged by the asset (the ADU) financed (it is leveraged by the existing property). When I use HELOC, margin, etc. rather than a loan that leverages the value of the asset, I expect a significantly greater return on that money. I recognize that my expected return is different than many of the members of BP, but the most successful of investors do not consider a loan on one asset to purchase another asset (whether it is stock via margin, home equity via HELOC, borrowing from 401K, etc.) to be the same as leveraging the value of the financed asset in the financing. It is subtle but think about it. Think how I could use $120K HELOC to add an ADU or I can use the same $120K to purchase an $600K SFR investment RE at 80% LTV. I hope the example illustrates why HELOC to finance ADU is not optimal not even addressing the risk of a variable longer term loan (I do not use variable on longer loans) or additional interest rate (these are secondary issues but I would have issues with HELOC even if the HELOC were fixed at the same rate as a new RE purchase loan (but HELOC are typically variable with worse terms than RE purchase loan).

Good luck

[Rhyna Orillaneda]

Quote from @Jon Schwartz:

Quote from @Dan H.:

Quote from @Jon Schwartz:

@Jason Phu, California's a big state -- and LA is a big market, if that's where you're buying -- so we'd need a little more information about where exactly these two homes are, but here's my two cents as an LA investor/realtor:

Most CA markets are appreciation markets, which means -- to me -- that you'll always do better focusing on appreciation over cashflow. The high-appreciation asset will gain more value monthly than the low-appreciation asset that spins off some cashflow.

That said, are you sure the first home will appreciate more over time? Often, it's the transitioning neighborhoods that offer more potential appreciation. Is the second home in a neighborhood that's likely to gentrify in the next decade? That's an important consideration.

Additionally, adding an ADU to a property forces appreciation, especially if you have a one- or two-decade timeline. The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

And lastly, are you sure it's best to buy the less-expensive property in cash? You'll cashflow, but you'll also be tying up a lot of capital. What if you bought the second property with a loan such that it was also cashflow-neutral? Then maybe used your saved funds to do the ADU conversion right off the bat?

If you want to discuss the options you're considering in more details, please feel free to message me!

Best,

Jon

 >The additional income you'll get immediately raises the value, and even though ADUs aren't appraising well now, the expectation is that that will change in the coming years.

The property income does not correlate to value unless there is more than 4 units. So additional income does not equate to additional value. In my market, JADUs are regularly being removed when selling a property to achieve top price even though they can generate income. I have seen crazy claims from ADU developers including attempts to indicate a value based on income. When challenged on it you get either a back down or indicating they were referring to cases with more than 4 units. I had one in the last couple weeks on this forum of a ADU vender stating that value can be based on income. When I challenged his assertion, he indicated he was referring to more than 4 units but this was conveniently left out of his initial post.

I also do not know whose expectation is that ADUs will appraise better in the future. maybe ADU venders are stating these are the expectations. The reality is ADUs, casitas, mother-in-law suites, etc have existed for decades, much longer than the fairly recent state level ADU laws some of which are already 5 years old. I cannot think of a single reason, with the poor valuations that have existed for decades, that the poor valuations will be changing any time.

ADUs have poor valuations, have always had poor valuation, and seem likely will continue to have poor valuations.  

Dan, I've seen you attack ADUs as an investment vehicle here and on other posts, and I think you've maybe lost touch with what's happening with ADUs -- at least in Los Angeles.

Just to share some boots-on-the-ground information with you:

Appraisals are beginning to account for the real value of an ADU because ADUs are very attractive to traditional homebuyers. You suggest that only an investor would buy a house with an ADU; in fact, since work-from-home took off four years ago, homes with ADUs have been in huge demand in LA. Add to that the ridiculous affordability crisis, and a lot of buyers are all too happy to buy a house with an income-generating unit in the back. So homes with ADUs sell for more, and the appraisals have followed pricing for four+ years now.

I personally know an investment group that targets neighborhoods, mostly in the San Fernando Valley, where comps with ADUs are outperforming non-ADU comps so that they can refinance out the value created by their ADUs. They incorporate ADUs into all of their BRRRR projects. And JADUs, too!

You seem to think that JADU's owner-occupancy requirement is a dead end. In Los Angeles, the owner who builds the JADU must sign a covenant stating owner-occupancy, but there's no enforcement. I've personally transacted on a house + ADU + JADU that was rented to three separate tenants. And we financed it!

You seem to think homes with a JADU aren't financeable. Technically, you're correct, but like I said, I've gotten around this. Just remove the oven from the JADU kitchen during the appraisal.

Anyway, back to ADUs...

You seem to think that income isn't a factor for appraisal or value. Firstly, conventional loans now allow for ADU income to be counted as borrower income for financing. Secondly, residential multifamily in Los Angeles reconciles the sales comp approach and the income approach on appraisal. Thirdly, selling a house with an ADU collecting rent significantly boosts the value for traditional homebuyers. I recently sold one of my duplexes in a bidding war; the highest bidders were all traditional buyers looking to occupy the vacant unit. They couldn't afford a single-family home in the same neighborhood, but with the income generated from the other unit of my duplex, they were more than happy to pay top dollar. (And I know this example is of a duplex, not a house + ADU, but I've seen the same bidding wars over homes that have rent-collecting ADUs.)

Speaking of ADUs versus duplexes -- you make the point that adding an ADU doesn't turn a property into a duplex. Why is this a negative? It's better that the parcel maintain it's single-family zoning so that an SB9 strategy can be executed in the future.

What else...? You had so many objections to ADUs, and they were mostly so baseless...

Oh, yes! The long time is takes to build an ADU, "a year or more," according to you. Yes, it can take more than a year to build an ADU, but it's much more common -- in LA, at least -- to finish an entire ADU project in six months. ADUs are so popular here that an whole cottage industry has sprung up around the quick and inexpensive conversion of garages. There are designers who focus on ADU layout, drafters who just draw ADU plans, and contractors who just pump out garage conversions. Prices have fallen as a result. I recently saw a garage conversion quote of $120K -- fully executed by a GC, no DIY.

You also seem to think one's capital for an ADU has to sit unused for a year. Where did you get this idea? During permitting, all you're out-of-pocket is the drafting and permitting costs. You don't pay your GC until he starts work, and a garage conversion is done in three months.

You also have a problem with ADU financing, which traditionally comes from a HELOC. Yes, HELOC financing isn't as cheap as owner-occupant or even investor financing, but the leverage can still be worthwhile...

...because the fundamental cap rate of an ADU is SO FREAKIN' HIGH. That's why ADUs aren't the worst investment in LA, but the best. Look, a garage conversion costs $150K and collects $1500/month. Let's put expenses at 15% since it's a new build, and you're looking at a 10.2 cap rate. In Los Angeles!

In LA, when we're assessing small multifamily, we usually look at the gross rent multiplier (GRM) instead of cap rate. The above example has a GRM of 8.3. That's about half the GRM you'd get in LA's worst neighborhoods (and the lower the GRM, the better the buy).

ADUs aren't perfect, but they're still an amazing investment in Los Angeles, especially for homebuyers or homeowners looking to get started.

I did a permitted garage conversion by GC. 1B/1B. Spent $70,000 thru HELOC from my primary home here in San Jose, CA. Rents $2,000 now. It could generate more if I do MTR from Travelling nurses etc., but felt I did not have time. Since everything is brand new, there has not been any maintenance or repair issues. I could still build another JADU as long as it's owner occupied.