Thoughts on ADU's in California

[Kody Thompson]

Any of my fellow investors in California utilizing ADU's? Why or why not. Looking for your input to make some big decisions.

[Dan H.]

Originally posted by @Matthew Forrest:

I built an ADU at my SFH and it was a great investment to improve income, but so far it has been tough to realize the value in terms or equity/appreciation. Personally I think ADUs are useful, but they will be best used on multifamily properties that are valued based on the net operating income.

This is true in our San Diego County market. The ADU is being valued by appraisals at less than the hands off cost of adding an ADU. This implies 1) There will need to be market appreciation to be able to extract value via a refi or selling 2) It is cheaper to buy a property with an existing ADU than to add an ADU.

In many areas there is issues hitting the 1% rule with a new ADU. To word it differently, a 1200' new ADU that costs $250K is not bringing in $2.5K in rent in some areas. 1% is often considered the "safe" cash flow ratio with a high investor LTV (80% LTV), but I believe in my market, and other high rent markets, it is conservative. In my market, 0.75% ratio with 80% LTV cash flows using my conservative expense estimates. The point is that some new ADU may not be achieving initial positive cash flow.

If you build a hands off ADU in most areas of Imperial County (just to use one area of many possible examples), it will not achieve rent to provide initial positive cash flow. The best ADU investments are where the rents are highest. Think class A areas where 1200' units rent for far above $2500/month.

I believe many people who are building ADUs are not running their own numbers. There is a local ADU specialized site that lists an ARV for adding an ADU that used cap rates to determine the prices. Where did they get a cap rate to use seeing that cap rates are for 4+ units? In addition, cap rates have a range that is based on many items including number of units (and none of the number of units are 2 or 3 units). The more units, the lower the expenses per unit. There is no appropriate cap rate to use for a SFH with ADU and/or JADU. If they used appraisals, it would show the ADU added less value than what they charged to develop the ADU. So they, to put it as politely as I can, fudge the use of cap rates to reflect a unrealistic value that helps them get people that want to pay them to develop ADUs.

If you build an ADU:

• Run your own ARV. Do not use the developer's ARV.
• Realize that it is likely to add an initial value as great as the cost of the ADU.
• Realize that it is likely cheaper to purchase a property with an existing ADU.
• Run your own conservative cash flow estimates.

ADUs can be a good opportunity, but do not believe everything the marketing people indicate.  Do you due diligence.

Good luck