Remodeling and Developing Triplex into 4 or 5-plex

[Anton Gerondine]

Hi folks, first timer here!

My wife and I have entered the market this year with our first purchase. We're located in Berkeley, CA, and own a parcel that has a 1000sqft house (2bed/1bath) in the front and a 2x800sqft unit (1bed/1bath each) building in the back. We're occupying the house and plan to keep the property for 5-6y, after which we would either move and hold it or sell it. In the meantime, we're wondering if it would make sense to (1) remodel the house to increase its size to 1100 sqft and turn it into a 3bed/2bath, (2) turn a detached garage on the parcel into a 2bed/1bath ADU and (3) build a JADU under the main house (or finish and expand the house downstairs). Doing all 3 scenarios here would cost about 1M$ to 1.2M.

The numbers are:

- Purchase price: 1.5M$

- Current mortgage: 65% LTV, 2.55% 30y fixed

- Property taxes: estimate 25k$/y

- Current rental income from two 1bed/1bath units: 2200$/m each

- Previous rental income from the 2bed/1bath house: 3600$/m

- Property mgmt: 12%

- Quote for garage ADU conversion: 500k

- Quote for remodel: 400k

- Quote for JADU: 300k

- Estimated rental income from ADU conversion: 3500-4000$/m.

- Estimated rental income from remodeled house: 5000-5500$/m.

- Estimated rental income from JADU: 2500$/m.

Concerns we have:
- There's no comp in the area that sells for more than 2.5M for a setup like this. This price range is all low range commercial rental around us.

- I'm not sure we can rent the JADU in 5y when we move abroad. I think JADUs need to be adjacent to an owner-occupied unit?

- Moving beyond 4-plex turns into commercial mortgage loans, which I think will reduce the pool of potential buyers.

- If we play to hold, I'm not sure if the rental income will make this a worthy enough investment, but I could be wrong.

What do you think of this situation here? Our heart wants to go ahead with the work, but I'm not sure if the math makes sense. And I'm not sure if we should do all the work, or just some parts of it. To note is that Berkeley has very low housing supplies and a strong rental market driven by UC Berkeley.

[Jon Schwartz]

Originally posted by @Anton Gerondine:

Hi folks, first timer here!

My wife and I have entered the market this year with our first purchase. We're located in Berkeley, CA, and own a parcel that has a 1000sqft house (2bed/1bath) in the front and a 2x800sqft unit (1bed/1bath each) building in the back. We're occupying the house and plan to keep the property for 5-6y, after which we would either move and hold it or sell it. In the meantime, we're wondering if it would make sense to (1) remodel the house to increase its size to 1100 sqft and turn it into a 3bed/2bath, (2) turn a detached garage on the parcel into a 2bed/1bath ADU and (3) build a JADU under the main house (or finish and expand the house downstairs). Doing all 3 scenarios here would cost about 1M$ to 1.2M.

The numbers are:

- Purchase price: 1.5M$

- Current mortgage: 65% LTV, 2.55% 30y fixed

- Property taxes: estimate 25k$/y

- Current rental income from two 1bed/1bath units: 2200$/m each

- Previous rental income from the 2bed/1bath house: 3600$/m

- Property mgmt: 12%

- Quote for garage ADU conversion: 500k

- Quote for remodel: 400k

- Quote for JADU: 300k

- Estimated rental income from ADU conversion: 3500-4000$/m.

- Estimated rental income from remodeled house: 5000-5500$/m.

- Estimated rental income from JADU: 2500$/m.

Concerns we have:
- There's no comp in the area that sells for more than 2.5M for a setup like this. This price range is all low range commercial rental around us.

- I'm not sure we can rent the JADU in 5y when we move abroad. I think JADUs need to be adjacent to an owner-occupied unit?

- Moving beyond 4-plex turns into commercial mortgage loans, which I think will reduce the pool of potential buyers.

- If we play to hold, I'm not sure if the rental income will make this a worthy enough investment, but I could be wrong.

What do you think of this situation here? Our heart wants to go ahead with the work, but I'm not sure if the math makes sense. And I'm not sure if we should do all the work, or just some parts of it. To note is that Berkeley has very low housing supplies and a strong rental market driven by UC Berkeley.

 Anton,

These are some exciting problems to work out!

Let me give you some general advice, then help with some back-of-the-napkin math.

Adding two units and creating a 5-unit property is risky not because the buyer pool is smaller (there are ample buyers for every property in CA!), but because it's unclear where lending will be in 5-6 years. Currently, stepping up from residential to commercial via ADU additions is a huge grey area (correct me if I'm wrong here, anybody!). Most commercial lender don't see this is a commercial property, and most residential lenders don't see this as a residential property. The issue will hopefully be cleared up before you want to sell, but you're taking on the risk that it won't be.

For these reason, I'd pursue the ADU, maybe pursue the addition, and ditch the JADU idea. You're correct that the owner must live on the property in order to rent out the JADU. That's clouds up the property's value on top of the residential/commercial confusion -- so just ditch the JADU idea, I say.

I would solicit more construction quotes, too. $500K for a renter-grade garage conversion is quite high. You could build a ground-up new structure for $500k! And adding 100 square feet and a bathroom for $400K?! You realize you'd be paying $4000 per square foot, right? That's highway robbery! Unless you're building your high-end dream home, you should not be paying this much, even in CA!

In terms of the math, let's look at return from rental income and return for equity:

For each item, calculate a year's return, and there's your approximate ROI

For the ADU conversion: ($4000/month x 12 months)/$500,000 cost = $48,000/$500,000 = 9.6%

That's before expenses, which will cut that number down by several points. If the ADU actually costs you $500K, it's barely worth it in terms of cashflow. If it costs $250K, however, $48K/$250K = 19.2%. Now we're talking about a solid return on investment!

For the home renovation, do the same math, but with the difference in rental income. Looks like this:

$5000-$3600 = $1400 in additional rent

($1400/month x 12 months)/$400,000 = 4.2%

If that renovation is going to cost you $400K, no way is it worth it! If that's a typo and the reno is actually $40K, which is closer to what it should be, the numbers are killer: ($1400 x 12)/$40,000 = 42%! That's a no-brainer! The ROI is HUGE.

In terms of comps, you should really be looking at the additional income you'll be generating and how that will impact the value. Residential multifamily is partially appraised by comps, partially appraised by the amount of income it generates. The more units, the more your potential buyers will just be looking at the income.

So the math is like this:

You bought a property that generates $8000/month for $1,500,000. Your purchase price was 15.6x the annual gross income, so this property sold at a 15.6 gross rent multiplier (GRM).

If you do the renovation and add the ADU, the property will generate $13,400/month ($2200 + $2200 + $5000 + $4000). Assuming the neighborhood doesn't change substantially and still warrants a 15.6 GRM on its buildings, you should be able to sell the property for $2.5M ($13,4000/month x 12 months x 15.6 GRM).

So if you bought at $1.5M, spend $900K on the renovation and ADU build, then sell for $2.5M, you haven't really earned that much for your efforts.

So, yeah, these improvements don't seem worthwhile at the prices you've been quoted, but again, your quotes seem wildly high. You should be able to add a bathroom and 100 sq ft for under $100K and convert a garage for under $300K. At those numbers, the improvements make all the sense in the world.

Good luck!

Best,

Jon