To ADU or to Purchase Another?

Question

Hello BP community!

New investor here and excited to engage with the community. This year I purchased my first Investment Property in Kern County and its currently being rented. I have some additional capital put away to convert the garage into an ADU to create a Mid-Term Rental but was wondering if it would be a better ROI to use that capital to purchase another investment property? To convert garage into ADU or purchase additional? What would you do?

Dan H. · Answer

Your estimate seems low, but even at that cost, it will not add that value.   You will be lucky if it adds $50k of value.  Building small units in small counts is expensive development.  Add the financing challenges and that you existing structure likely will become rent controlled.

Here is a list of why adding ADUs 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. 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 n 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.

I believe you are typically far better purchasing a different property with conventional financing than adding an ADU.  If you want an ADU, buy a property with an adu.  You will likely achieve a better return than adding an ADU.

Good luck

Marisela Arechiga · Answer

Rick, thank you very much for your input! The rental is currently cash negative and our thought is by converting the unused storage unit it would bring cash flow into the positive. We are General Contractors and part of why my cost for the conversion is so low is because we have the resources to pay at cost and the property is located in a county with lower labor costs than other parts of California. Definitely appreciate your insight!

Gregory Schwartz · Answer

How do you plan to finance the ADU? Have you analyzed whether it will genuinely add value? From my experience, when I dive into the costs associated with building an ADU—including construction expenses and financing options like hard money loans—it often doesn’t make financial sense. The combination of high costs and the after-repair value (ARV) frequently leads me to conclude that buying a new rental property is a better use of capital.

Dan H. · Answer

the issue is the $200K investment does not add any where close to $200K of value in most single family zoned areas.  If it adds $100K of value then the initial negavie equity is $100K.

Now for the cash flow, $200K for $1800 rent is not going to produce decent cash flow with ADU financing.  It falls short of the 1% rule which with current rates is not sufficient in most markets to have achieved real cash flow after properly allocating for sustained expenses.  So this is likely cash flow negative if financed with a typical ADU addition financing (which is worse terms than RE acquisition.

But lets ignore that this is likely negative cash flow and say it makes $200/month.  It is a lot of work for $200/month to build an ADU then manage it.  In my market most LTR PMs are charging more than $200/month to manage individual units.

But let's ignore the work involved in building and managing the unit.  $200/month divides into the $100K initial negative equals 500 months to recover the initial negative equity.

Let's double the cash flow to $400/month.  250 months to recover the initial negative equity so over 20 years.

Let's reduce the negative equity position to $50K (which likely is less realistic than expecting $400/month cash flow at that rent point), you are at over 10 years to recover the initial equity position.

Now let's do it with all cash, no financing.

The 50% rule state $900/month cash flow.  900 * 12/200K = $5.4% or about half of lifetime return of S&P 500, or what can almost be achieved with a zero work, zero risk CD.

I see no way that someone who understands the numbers will call this a good investment.

Note just because an investment is better than most other investments in a market does not imply something is a good investment.  that is the logic you attempted to use versus running some numbers.  The other opportunities are worse than the poor investment.

The RE market is challenging everywhere.  I have an accepted offer on a luxury cabin.  It is a nice cabin, but it will not produce good return.  It may be challenged to out produce the lifetime S&P.  I am purchasing it anyways.  the profit is far less than I typically achieve but this is an awesome cabin (it was owned by a country music star in the past).  I will be proud to add it to my RE portfolio even if the overall return may be single digit.

Best wishes and be sure to do thorough and conservative underwriting on any RE investment.

Alan Asriants · Answer

My partner is building an ADU for under 200k in 3 months. Will rent for $1800/m. Seems pretty solid to me, no?

I get the point about removing privacy, not gearing to a family for resale, etc. But it can really help offset costs and pretty good return on investment at that value.

200k in philly puts you in Class C real estate at best, and you likely have to update it somehow.

I think there is value in ADU as long as it is legally done and can be legally rented.

On the sale side a benefit can always be an in law suite. I think its a matter of how you build it and its functionality.

You will need the cash to build it and I doubt banks will be favorable with lending terms. I guess I am just comparing it more to people who buy out of state with cash.

Marisela Arechiga · Answer

Dan, thank you very much for your very thoughtful input. Chewing on every bit.

Rick Albert · Answer

$85K seems extremely low for a garage conversion. Typically it is at a minimum $100K but likely closer to $150K and that's with no addition. An independent sewer line alone can be as much as $10K. My hunch is that's $85K for the garage itself before plans, permits, engineering, sewer line, electrical panel, etc.

The thing with ADUs is it is for cash flow. I have an ADU on my property and it was the best thing I did. But I did it pre inflation so the total cost was around $75K at the time.

The question is really about opportunity costs. Can you use that $85K towards another property that would generate the same or more cash flow. Even if it is slightly less cash flow, you now have a second appreciating asset. Plus the challenge with mid term is you are generally on the hook for things like internet, utilities, etc. That can hurt your cash flow and could equate to the same as a traditional long term hold without the headache and management.

I'm not saying don't do it, I'm saying you have to look at all options.

Marisela Arechiga · Answer

Thanks for your input! In my analysis the cost for an ADU in kern county would run about $85K and I have saved about 75% of that right now.

To ADU or to Purchase Another?

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