Rehabbing and adding ADUs in OC?

[Dylan S.]

Our company is looking to jump into SFR investments and want to look for properties in the OC area with value-add potential to either rehab or add an ADU/convert a detached structure to an ADU. Ideally, we'd like to buy an oversized lot and build a separate ADU on underutilized space and/or convert a detached garage. Then the goal would be to either sell it off or keep it as a rental for a long-term hold. I know certain cities have different ordinances/rules for building ADUs. Which cities are best to execute this strategy? Has anyone had experience adding ADUs to properties in SoCal? How does that impact value? Was the cost to build worth the additional rent/value the property sold for?

[Joe Homs]

@Dylan S. I've lived in the OC pretty much my entire life. We used to call them "Granny flats." This was a great purpose for them, but I do not recommend them for a value-add at all. They will run you around $200-$300K to build. If you make $30K a year from rents it will take you 10 years to pay off the ADU. The appraisers also find it very difficult to give you the value you are looking for.

Good Investing...

[Dylan S.]

Quote from @Joe Homs:

@Dylan S. I've lived in the OC pretty much my entire life. We used to call them "Granny flats." This was a great purpose for them, but I do not recommend them for a value-add at all. They will run you around $200-$300K to build. If you make $30K a year from rents it will take you 10 years to pay off the ADU. The appraisers also find it very difficult to give you the value you are looking for.

Good Investing...

 Yes, that was my concern that the cost wasn't worth it in terms of value. In that case, it may make more sense to convert existing components of a home (attached/detached garage) into additional rentable space rather than building an additional structure. Have you seen that strategy work in Orange County area? By converting an existing garage into additional rentable space, would this add more value upon sale?

Or we could simply look into flipping a home. I see you have done that before in OC, do you see that strategy still working in today's market? We'd likely be able to purchase a fixer home with little debt. Looking in Costa Mesa, Garden Grove, Orange areas of OC.

[Joe Homs]

@Dylan S. I would just stick with flipping.  Thats what we do and have about 20 projects in the pipeline now.

Good Investing...

[Dan H.]

The cash flow can appear good on garage conversion ADU additions, but the value being added by ADU additions in SFH areas is even lower than this amount.

ADU additions in SFH areas are typically getting values of between $50k and $100k which is less than these additions cost for a hands off addition. This results in a negative equity position typically between $50k and $100k.

Now some hypothetical numbers that are in the range of expectations. $150k 2/1, 600' large garage ADU addition that adds a value of $75k. Start with a negative $75k position. Financed $120k (80% LTV) at 8.5%, 30 year with no secured loan (not a heloc). Rents in nice area, $3k/month. Use 50% rule, expenses are $1.5k/month. P&i $923. Cash flow $577/month, not horrendous. $75k (initial negative equity)/$577 (monthly cash flow in this hypothetical case) = 130 months (10.8 years). The first profit in this case happens in year 10 (almost year 11).

Note this is the biggest issue, but other things to consider is no revenue until ADU is built and rented. The ADU detracts from the primary unit. If the primary unit is over 15 years old, in most areas in CA the primary unit is now rent controlled (which I believe is not what was intended by the 15 year exemption but is the way most jurisdictions are applying the 15 year exemption). ADU additions are a lot of work. Likely more than a large rehab, but with a BRRRR I can (and always have) achieve infinite return.

A big issue adding a small amount of small units is expensive development   

In general, adding an ADU (even via garage conversion) in SFH zoned areas is one of the worst RE investments.

Note adding ADUs to 5+ unit properties is different. These properties are valued on cap rate and NOI. This may be able to work if the ADUs can be added at a low enough cost that the NOI and cap rate provides a value high enough to justify the effort and risk. Note one of the syndications I am an LP uses this strategy and a very friendly local ADU law as their sophisticated value add.

good luck