How are ADU's currently being appraised in Los Angeles? After SB 9 was passed.

Question

I'm an investor based in Los Angeles and I'm planning on building a detached 2 bed 2 bath ADU (garage conversion) on my home to house hack, and eventually will rent out both units.  I have done this once before (in Cypress Park, Los Angeles), and had some issues getting a fair appraisal.  The first appraisal only gave me I think 50k in value for the ADR/garage conversion.  I waited for better comps, and got it reappraised once it was being rented out, and I could provide proof of rental income to the appraiser, and it appraised for much more.  But this was back in late 2020 when the market was appreciating very quickly.   My question is if anyone has experience more recently after SB 9 passed, if appraisers are actually valuing ADU's for their actual worth?   How can an appraiser only add 50k to the value of a home that has an added 2 bedroom 2 bathroom 850 square foot detached ADU that rents for 3700 a month?  The ADU brings in almost 50k in rental income every single year.   I mean that makes no sense at all.

I would love to hear from Appraisers, or any investors that have dealt with this more recently in Los Angeles, or in California.  I know in the past getting fair comps with ADU's was more difficult.  But I'm hoping since ADU's are getting more common, and since SB 9 is providing more clarity on the subject, that ADU's will start to get appraised more realistically.  If not I'm wondering what formula Appraisers use when factoring in rental income in terms of adding value to the home.  It seemed like the last time I had success, it was the rental income that helped the appraiser give fair value to the ADU.

Thanks,

Wade

Dan H. · Answer

If you pay $250K for a $100K asset (ADU additions often add value far below the cost of the addition), there is no return until the negative position has been recovered.  This is different than paying $250K for an asset valued at $250K which has a return if in produces income.

If there is no return, there is no comparison to items that produce a return.

I agree that if you are owner occupied for the duration required of SB9, that is likely a better approach than an ADU.  I only use the word likely because of the lack of track record, but it would seem very likely.

As for expenses, you should allocate maintenance/cap ex even when new based on cost and expected life span.  Maintenance/cap ex should not be zero as the lifespan of the components starts when placed in service.  Example if an asphalt roof lasts 20 years and has a cost of $10K, then the estimated cost associated with the roof is $500/year (this is likely a little high, but I wanted to use simple numbers).

As for low vacancy rate, the vacancy in low vacancy markets is not mostly from time to find tenant.  It is more from unit turnover time and new tenant providing appropriate notice.  This results in most tenant turnovers approaching or slightly exceeding 1 month even when you identify the tenant in the first hour on the market.  I had 2 units turnover since April.  Both will exceed a month of vacancy even though my market has a very low vacancy rate.

I agree that BRRRRs are challenging at this time and is why I have not purchased in 1.25 years (but I purchased $4M in Dec 2021).  I think RE syndications in the last decade have produced outstanding returns, but I believe we are in a more challenging RE market.  I would be leery of any RE syndication that has as its primary value increase either improving management or rehabbing units.  Look for syndications that are using more sophisticated value adds or have a preferred position.

Good luck

Dan H. · Answer

The value of properties with less than 5 units is unrelated to the income (rent, NOI, etc).  It is based on comps.  The fact that you had incoming rent should not have changed the value from an appraisal.  What I suspect happened is that there were higher comps of homes wiht ADUs than were available for your initial appraisal post adding ADU.

ADUs likely will not ever value at the same as the hands off cost because more buyers want SFH than want "duplexes" (SFH with ADU is not really a duplex but it has the sane disadvantages as a duplex for occupants).  If someone wanted an ADU, they can add an ADU at the hands off cost.

In addition, PSF is significantly based on land cost.  The land did not increase in value.  For example my home appraised in Dec 2021 as $630 PSF (it would appraise for more now).  The home costs no where near $630 PSF.  The majority of that value is the land value.  This implies that it is unreasonable to expect the ADU to add the same PSF as the primary structure would by itself because the land and its value is now shared.

The market will dictate the value assigned to ADUs especially when more comps are available, but to expect the market to ever fully reflect the hands off cost to add an ADU is unrealistic for the reasons cited.

Good luck

Wade Barnett · Answer

Thanks so much for all that info Brad.  Very insightful!  And I did go back and read your other comment in the other thread as well.  Thanks.  I will message you directly to get mores info thanks so much.  Everything you said makes sense to me.  The one thing I keep hearing that doesn't make sense to me is why there aren't "buyers" or investors going after homes with permitted ADU's and offering more than a similiar home without one.  I mean in LA finding a property that gets great cash flow in an A or B class neighborhoods with historically amazing appreciation is extremely difficult.  And homes with ADU's offer exactly that, for the most part.  Especially if it's a larger ADU, the cash flow if fantastic.  Maybe it's just the early innings of this game and they will in the future.    I digress...

As for SB9, from my understanding, the difference would be that you could build a detached, or attached unit, and get it permitted as a "duplex" rather than an ADU.  And since the second unit is permitted as a Duplex instead of an ADU, then the square footage would be included in the appraisal as a second primary dwelling.  The verbiage in SB9 says "up to two primary units on the parcel" and goes on to say the primary unit is not the same as an ADU.  I guess currently a lot of times they value ADU's like pools, or workshops or other auxiliary bonus structures.  And under the SB9 permit that would change the secondary unit to a second "primary unit."  Have you come across that type of permit?  I know it's a very new bill, but from what I've read that seems to be the case.  And if you live at the property for 3 years you could even consider a lot split and sell the two homes separately if you meet the guidelines.

If I were to get my property changed under SB9 to a duplex with two primary units do you think the value would go up?  I know that's a loaded question, sorry, you don't have to answer that.  But if two detached three bedroom two bathroom homes on one large lot in a great neighborhood permitted as a duplex produced greater income than a 5 unit apartment building, doesn't the cost valuation approach make sense?   I know that wasn't the way to value it before SB9, but the laws are changing and it seems like the approach to valuing these newly permitted properties will eventually change as well.  I mean all of these strategies used to be illegal, and now the state is encouraging them.  I guess at this point this is just conversation, because it will take a few years for these types of properties with become apart of the average buyers lexicon.  But will the affordability crisis I wouldn't be surprised if it happened faster than we think.

Brad S. · Answer

@Wade Barnett

Hey Wade, not sure if you saw my response to another thread a few days ago, but, essentially, it's not totally that the ADU's are not being valued correctly (which is sometimes the case), but, it's more of not enough data reflecting the market value of those ADU's. We, as Appraisers, reflect what the market values, not the other way around. So, when there are sales comps with similar ADU's then the appraiser has evidence telling them how the market values them.

Generally speaking, we, the Appraisers, do not set values, we report them. We look for market data that reflects how much the market (i.e. Buyers/Sellers) "values" certain property characteristics, and then we use different techniques to form an educated opinion, based on that market evidence. So, essentially, the willing Buyer and Seller are telling us where the value is. The challenges are when there is not enough straight forward evidence of that. Like when there are not enough sales with ADUs, in an area, to reflect how much the market is valuing them.

But, what you are talking about is a residential neighborhood, where most properties are typically used and bought for residential/owner-occupied purposes. So, generally, they are not being purchased for their income potential, even their ADU income potential. Therefore, the income approach is not a good indicative approach to value. So, that ADU income has a specific value to YOU, but not to the typical buyer in your market, at least not until there is enough data to prove otherwise. When more ADU's are built and properties with them are sold, the ADU values (to the market-"Buyers") will show up in their sales prices, which , in turn will be reflected in the Appraisals, etc. But, even then, those sale prices are most likely not going to be based solely on income, since most buyers are not purchasing them for their investment returns.

And, unless I'm missing anything I don't see how using SB9 would change that, for 2 units. You still end up with the same result and use.

Now, with that said, I did find a few recent sales with ADU's in your area, between 1.1m-1.6m. So, it looks like there is pretty good data for you to have a general idea of value with the ADU.

Feel free to contact me directly, I'm happy to discuss it further offline.

Wade Barnett · Answer

I agree Tony, the appraisals will get better with time.  Especially in high cost of living areas.  Thanks.

Tony Ngo · Answer

Appraiser give value based on the COMP.  Rent rate doesn't affect the value as it only use for lender to measure the amount rent to be use to for borrower to offset the liability of the property.  There will be more comp come into market.  The appraiser can provide the better value soon.  Agreed that you need to have good appraiser to help you justify it.  May some appraiser in BB can charm in to help on how they come up the value based on some guideline..

ADU purpose for investor is to generate income.  It's good for long term hold as you can think of borrowing example of $250K pay off in 10-15 years.  Can the collected income able to pay off that monthly amount.  It's investment and it take time to grow.

Wade Barnett · Answer

250k minus an appraisal adding 100k is 150k.  So it would be 24% return.  If you're collecting a 24% return immediately on the investment I wouldn't say that's a negative position.  You are getting paid immediately. It's like getting a 24% dividend, you just can't withdraw the initial investment immediately.  It will be brand new construction so no major maintenance expenses for a number of years.  The $3000 number is deducting property taxes, insurance, gardener, and utilities.  Vacancy in this area is basically non-existent.  The rent will be around $3600 total.  And the rental income has better tax advantages than the S&P.  I don't fully trust syndicators.  That's just me, maybe one day I will.  Thanks for your discussion, it has really made me think about this more.  I think I will purse an SB 9 duplex permit more before going with an ADU.  Simply for the advantage of including the square footage in the appraisal.

With current market conditions, I don't think perfect BURR's will exist for the next couple years in this market.  I think the market will go down through 2024, not drastically but some, so I'm not going to play that game.  Too risky.  I'm chasing the cash flow for now, and the addition, through SB 9 or with an ADU seems like the best option.  I'm curious since you seem to have a lot of experience in SoCal, what type of deals or you looking into currently?

Dan H. · Answer

A $250k ADU will not produce close to $3k income after properly allocating for expenses.  If trying to optimize return, your purchase would use leverage and be less than $250k.

A $250k investment that has less than $250 worth by accounting has $0 income until recovered.  It is subtle but I will use example.  Spend $250k to obtain $250k has revenue minus expenses equal profit.  Spend $250k to obtain $100k value has no profit until it recovers the -$150k initial negative position.  This kills the return on many ADUs.

ADUs unlike many investments has capital expense for many months prior to any revenue.  Cost of money has this lower the return.

Adding ADU even hands off is a lot of work.  I think it rivals/exceeds BRRRR, but the projected return is a fraction of even a decent BRRRR and a good BRRRR produces infinite return.  $36k on $250k investment (that did not have initial negative position) is 14.4%.  Many syndicators regularly beat this.  S&P 500 lifetime approaches 10%.  Both these options are more passive.

Some things for you to consider.

Good luck

Wade Barnett · Answer

My main goal is to capture the cash flow on the rental.  My goal is to buy and hold.  The ADU will produce the greatest amount of cash flow for the investment in this area.  $3000 a month of tax sheltered income on a 250k investment seems good to me.  Even if they only give me part of the cost to build in the appraisal.  I am looking into getting it permitted through SB 9, and not permitted as an ADU.  I've just started researching this, but from what I'm reading if you permit the additional unit through SB 9 as a duplex, they will include the square footage of the addition into the appraised valuation.  This would solve the issue of the square footage not being included in the valuation of the primary.   I agree with you that the appraisal process on a home with an ADU is definitely risky if your trying to pull equity out.  I know when non investors hear "duplex" the demand is lower.  But on this particular lot with such a big distance between the additional unit and the primary, it makes sense to me.  A lot split under SB 9 is also a really interesting option as well.  SB 9 will change the game in California.

Wade Barnett · Answer

Thanks for your response Peter.   I've heard more recently that if you get the additions (ADU) permitted through SB 9 as a duplex, and not permitted as an ADU, that the square footage of the addition is included in the valuation of the primary, thus raising the appraisal.  I know SB 9 is super new so there probably haven't been many sales reflecting that yet.  But do you know if that is the case?  It seems like that would solve the problem with ADU additions getting sub par valuations.

How are ADU's currently being appraised in Los Angeles? After SB 9 was passed.

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