Building an ADU.... cash-out refi OR am I missing something???

Question

Building an ADU.... cash-out refi ??? • -----Just SOLD a Flip Property in April, long-story short my GC got me busted with the City and had to sink another $44k into the project so broke-even. -sigh. Ready for something more long-term and steady income. • • ----I do have a 'rental' in Joshua Tree House.... but in it for the long-term equity not income . • ----*Primary*: I just bought 1yr ago, June 2023 rate 6.623% - I have enough land to add an ADU. Estimated equity is $230,000. At first thought DSCR since the ADU will be a mid/long term rental, but those rates are most likely 9-12%. Doubt I want a HELOC because I can't pay it back right away -plus I technically don't qualify. My original loan just transferred to "Mr.Cooper" mortgage. He did a soft check and said my debt to income would not qualify me for a HELOC... but a cash-out refi with an FHA at 6.5% would be okay with around $100,000 cash-out which would put my debt to income around 56% Since I literally just bought my house hitting the 30yr reset isn't a big deal... especially if rate is micro point lower. My mortgage would go up $781 for the next 30years, the ADU income would more than cover & I hope to pay extra principal to cut my loan time -it's just I was hoping to pay off ADU within 5.5yrs- so that I can collect 'all' ADU income at that point . My Tax advisor suggested I keep the ADU under my personal funds and not my LLC or Corp. -Whatcha Think! Any suggestions I'm missing -or ideas- OR Just go with refi... and that extra $100k is only 6.5%. (plus, I get $1500 credit in processing fees)? Thank you for any insight or guidance....Sherrie Wilson

AJ Wong · Answer

HI Sherrie, ADU's are generally a great return on investment..I'd double check the DSCR and FHA rates though...A DSCR cash out client was just quoted the high 7%'s to very low 8%'s and FHA have improved tremendously this past week...on purchase quote today FHA rates were in the high 5%'s..check in with @Joseph Chiofalo Good luck!

Dan H. · Answer

>ADU's are generally a great return on investment

I could not disagree with this more in southern CA for hands off ADUs added in SF zoned areas.  It will likely add value less than 50% of its cost.  This creates an initial negative equity position.  From an accounting perspective there is no return until the negative equity position has been recovered making it one of the worse returns on investment.  Recovering this negative position can take many years.  This is many years before the first true return. In most jurisdictions it will make the primary rent controlled.  The expenditures occur long before any income.  The effort is likely more than a brrrr, but brrrr can achieve infinite return.  There is the challenges of financing.  There is the detraction from existing SFH.

Calculate the cash flow using the 50% rule and you will likely show negative cash flow for the ADU when financed at high LTV.  Note if your ADU has 1% rent to cost ratio, the property tax alone will be a ~10 expense ratio.

Building small units in small counts is expensive development.  Building larger units and/or larger counts results in significant savings in development.  It is a big reason ADU additions of SF zones areas cost more than the value that they add.

OP 5% maintenance and 5% cap ex is not nearly enough.  Your JT investment is negative cash flow.  Use 50% rule as quick verification, but at your estimated cash flow at the allocation for maintenance/cap ex is wrong.

What is best choice for OP?  I think in near term JT prices are likely to fall.  Hold it long enough at high enough leverage and it may do ok.  I would consider exiting if you could do so without a loss.

ADU addition, no way! Have you looked to purchase property with an existing ADU so someone else has suffered the initial negative equity and you purchase with buyer financing?

You may be a little gun shy of value adds after losing money on one, but they can provide a good return when done correctly.

Good luck

Jerome Morelos · Answer

@Dan H. I definitely agree with Dan. You’re better off finding a property with an existing ADU than building/converting one. ADU valuations are still low because there’s not enough comps. They value it about 60-70% of the cost to build, sometimes less  (in my area). However, more and more ADUS are being built so I can foresee valuations increase in the future.

Joseph Chiofalo · Answer

Hi Sherrie,

There may be a few routes for you to best utilize the equity in your current home.

How is your credit?  Some lenders have flexible terms on helocs or a fixed second mortgage.

Rates have improved a little so entertaining a cash out refi could be an option as well.

Ko Kashiwagi · Answer

Hi Sherrie,

DSCR rates are likely close to 7-9% range. However, DSCR requires you don't live in it so this is not an option on the primary. Also, how would you qualify for FHA refinance but not the HELOC? They both have DTI requirements. Alternatively, do you have equity in the Joshua Tree House?

Building an ADU.... cash-out refi OR am I missing something???

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