Analyzing Pros and Cons: Building an ADU vs. Buying Rental Property in a Cheaper Mark

[Adam Sha]

I'm at a crossroads and need some advice from those with experience in real estate. I'm trying to decide between building an Accessory Dwelling Unit (ADU) on my existing property (secured permit) and investing in a rental property in a cheaper market. Each option has its pros and cons, and I'm hoping to get some insights from this community to make a more informed decision.

Option 1: Building an ADU

Pros:

1. Increased Property Value: An ADU can significantly increase the value of my primary residence.
2. Control and Proximity: I can closely manage and maintain the property since it's on my land.
3. Potential for Higher Rent: ADUs in bay area can fetch a good rental price.
4. Flexible Use: ADUs can serve multiple purposes – home office, guest house, or rental unit.
5. No Additional Land Purchase: Utilizing existing property means no extra cost for land acquisition.
6. Foundation improvements: I will get an upgrade for my foundation which increase house stability.
7. Time to recover investment: around 10 years if I rent it for $1700 - paying cash.

Cons:

1. Impact on Primary Residence: Construction can be disruptive, foundation is old, and having tenants nearby might affect privacy.
2. Time to cash: The rental income will be delayed by at least 6 months as I'm building the ADU.
3. Tenant risk: California is tenant friendly and eviction can be difficult.
4. Time sink: takes so much effort and time while working full time.

Option 2: Buying Rental Property in a Cheaper Market

Pros:

1. Time to cash is immediate is about 40 days from closing time.
2. Landlord friendly: which means eviction and rent control in Landlord
3. Diversification: Investing in a different location spreads the risk.
4. Property Appreciation: Some emerging markets might offer significant appreciation over time.
5. Established Rental Market: Easier to find tenants in established rental markets with a high demand.
6. Potential to build an ADU: i can build on the property land.

Cons:

1. Lower Cash Flow: Properties in cheaper markets often have lower rental yields because I have to pay taxes, insurance, CapEx.
2. Market Risk: Cheaper markets might be cheaper for a reason, with slower appreciation and higher vacancy rates.
3. I won't fix my foundation.
4. Tax and insurance: have to pay those for the property
5. time to recover investment is 20 years assuming 1k cash flow - paying cash.

I would love to hear your thoughts and experiences with either option. What else should I consider? Are there any hidden pitfalls or unexpected benefits I might have missed?

Thanks in advance for your insights!

[Dan H.]

Quote from @Adam Sha:

I'm at a crossroads and need some advice from those with experience in real estate. I'm trying to decide between building an Accessory Dwelling Unit (ADU) on my existing property (secured permit) and investing in a rental property in a cheaper market. Each option has its pros and cons, and I'm hoping to get some insights from this community to make a more informed decision.

Option 1: Building an ADU

Pros:

1. Increased Property Value: An ADU can significantly increase the value of my primary residence.
2. Control and Proximity: I can closely manage and maintain the property since it's on my land.
3. Potential for Higher Rent: ADUs in bay area can fetch a good rental price.
4. Flexible Use: ADUs can serve multiple purposes – home office, guest house, or rental unit.
5. No Additional Land Purchase: Utilizing existing property means no extra cost for land acquisition.
6. Foundation improvements: I will get an upgrade for my foundation which increase house stability.
7. Time to recover investment: around 10 years if I rent it for $1700 - paying cash.

Cons:

1. Impact on Primary Residence: Construction can be disruptive, foundation is old, and having tenants nearby might affect privacy.
2. Time to cash: The rental income will be delayed by at least 6 months as I'm building the ADU.
3. Tenant risk: California is tenant friendly and eviction can be difficult.
4. Time sink: takes so much effort and time while working full time.

Option 2: Buying Rental Property in a Cheaper Market

Pros:

1. Time to cash is immediate is about 40 days from closing time.
2. Landlord friendly: which means eviction and rent control in Landlord
3. Diversification: Investing in a different location spreads the risk.
4. Property Appreciation: Some emerging markets might offer significant appreciation over time.
5. Established Rental Market: Easier to find tenants in established rental markets with a high demand.
6. Potential to build an ADU: i can build on the property land.

Cons:

1. Lower Cash Flow: Properties in cheaper markets often have lower rental yields because I have to pay taxes, insurance, CapEx.
2. Market Risk: Cheaper markets might be cheaper for a reason, with slower appreciation and higher vacancy rates.
3. I won't fix my foundation.
4. Tax and insurance: have to pay those for the property
5. time to recover investment is 20 years assuming 1k cash flow - paying cash.

I would love to hear your thoughts and experiences with either option. What else should I consider? Are there any hidden pitfalls or unexpected benefits I might have missed?

Thanks in advance for your insights!

ADU comments:
- some items: ADUs in SF zoned areas add less value than the hands off cost of adding. So it is a value subtract.
- at 50% rule (which I suspect your expenses will exceed 50% of rent as property tax increase by itself is likely to be ~20%) and a rent of $1700 it will take a lot more than 10 years to recover. Initial cash flow goes toward recovering the initial equity position. This can take years. Then the cash flow starts recovering against investment.
- In many/most jurisdictions adding an ADU will make the primary unit rent controlled if built more than 15 years ago.
- no leverage. RE returns excel due to leverage. Without leverage there are more passive means to obtain similar return with similar risk.
- adding ADU is significant effort. I suspect more effort than BRRRR, but I can achieve far greater work with a brrrr.
- building small units in small counts is near the most expensive development possible.

OOS comments
- building and maintaining a quality team is not easy local, much more difficult OOS
- would you being paying cash? No leverage? See earlier comment on leverage.
- $1k cash flow is unlikely if properly allocating for expenses in these low cost areas on a single unit even if purchasing all cash. 50% rule is aggressive on these lower rent markets. If financed at high LTV, there will be negative initial cash flow.

I like the idea of value adds, but ADUs are not an optimal path. I am never in favor of a newby starting OOS. I also believe you are entering at a challenging time.

Good luck

[Travis Biziorek]

Adam, I've done both of these things and here are my quick thoughts.

Our ADU build here in CA is near completion. We're spending ~$300k and it's completely custom. We tore down our garage, expanded the footprint, and rebuilt. The lower level is 600 sq ft garage and then 450 more sq ft consisting of a 1/1 along with a mudroom. This part is the addition to our existing home.

Upstairs is about 1,000 sq ft 2/1 with a balcony. We'll operate that as a STR and expect it to generate $4,000 - $5,000 in gross monthly rents. This also gives us the flexibility to block it off for friends/family when they visit. We're also able to use the 1/1 behind the garage for that as well.

I expect the ADU to fully repay itself in 5 - 7 years.

Beyond that, I hold a 12-door rental portfolio in Detroit. My focus there is on doing value-add stuff. Essentially, buying a house for $50,000 - $60,000 and then doing another $20,000 - $30,000 in cosmetic renovation. The goal is to force some equity, refi out, and leave $5k-$10k in the deal (or less).

I started investing in Detroit in 2019. Today, I have zero dollars invested in any of those properties. It's all come out via refinances and cash flow. I've also experienced strong appreciation.

I'm not advocating for one over the other. I'm very glad I've done both. But obviously, most folks need to choose (at least initially). 

I would say the toughest thing with the ADU has been the length of time it's taken. We spent 10 months planning with architectural, structural, builder, city permits, etc. And now it's been about 6 months in the build phase.

Out of state investing has its own challenges. But you can start small with one deal and do more as you gain confidence. I have a ton of resources about the Detroit market I'd be happy to share.

Hope that helps.

[Bradley Buxton]

@Adam Sha

Look at the payoff schedule and if that timeline will fit into your portfolio goals. Will the added cash flow and equity move you closer to what you want to get from RE investing? You will have to manage a builder and bank time and energy for that.

Out of state investing takes different time and energy inputs by building a team and managing that team to move you closer to your goals.  

[Alecia Loveless]

@Adam Sha I was looking at adding an ADU at the cost of about $110,000. After consulting my realtor I discovered the ARV would only be about $60,000 and that it was going to take about 10 years to get my money back and likely 10 years to get the value of the property up consistent with what I had put into it.

I opted to buy a separate property with better cash flow.