Sell or upgrade?

[Anton Kharcheuka]

Hey everyone! I am relatively new in real estate and here is my situation. I have bought a 3bed/2bath house 2 years ago, and was renting out 2 rooms, while using 3rd room for living and as an office space. My total resulting expenses for that home including rent profit and bills are roughly $1200/month. Now I moved to another place and don't need that office room and home anymore and it is also a bit small for Airbnb rent. I am thinking to sell and I most likely will loose money since that home does not have much appreciation yet. I did a rough calculation that converting the garage into a 460sq/f studio ADU can potentially make the house profitable as a rental, $1800/month estimate. I am budgeting for roughly $40K renovation (I have some construction skills). I am not exactly sure if calculations are accurate and feel stuck with this decision, I would appreciate if someone could offer an advice or potential solution?

[Dan H.]

A hands-off garage conversion ADU is over $100, even doing much of the work yourself, it will be much more expensive than your estimate.

Single ADU additions in single family zoned areas are typically one of the worse re investments. There are many reasons but near the top of the list is their cost versus the value add. The issue is building a single small residential unit is some of the most expensive development.

Here is a list of why adding a single ADU in single family zoned areas in my CA market is typically a poor 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 by the ADU (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?
9) adding multiple ADUs or adding an ADU to a quad looses F/F conventional financing. This reduces exit options and affects the value.
10) Small number of small units is the most expensive residential development there is. This implies residential units can be built at lower costs and provide better return than building a single ADU.
11) adding an ADU to SFH can make the SFH fall under rent control. In CA currently only MF properties are rent controlled. If the house is older than 15 years old and an ADU is added, it can become rent controlled. Rent control laws are market specific. Make sure you know the impact that adding an ADU will have on any rent control.
12) investors seldom include the land value in the overall ADU costs. The reality is the land has value.

Good luck