How to evaluate building an ADU vs. buying a SFR.

[Caitlin Bigelow]

I recently spoke with a friend who lives in North Park (San Diego) in a 3 bedroom 1 bath. They are considering putting an ADU in the backyard and renting it out ocassionally and using it for family and guest that come into town. She's worried that the permitting process will be too challenging and so she's trying to evaluate should she:

A. Build an ADU in the backyard now, she can pay for it all with cash. (~100K)

B. Wait 2-3 years and save for a downpayment of a SFR and skip the whole ADU hassle.

I thought it was an interesting question. I think her goal is more to have a comfortable place for family to stay, but if you were motivated by cash flow, how would you assess this opportunity? 

[Dan H.]

Typically because the land is already purchased the rent to cost is very good on an ADU compared to purchasing a new property. The rent to cost ratio has a direct correlation with cash flow; all things equal the property with the better rent to cost ratio will have the better cash flow.

For example a purchase of a SFR to quad in San Diego at a rent to cost ratio of 0.75% is good. This would mean that a property that was purchased for $500K would get at least $3750 in rent. Properties like this that do not present a landlord headache (i.e. decent area, not too high density, adequate parking, etc.) are not easy to find. If they are SFR they are below retail. Most of the duplex to quad you see that meet this rent to cost ratio have one or more items that disqualify it from it being something I would purchase.

However, seeing the land is already owned and it is to be better leveraged it seems to be fairly easy to achieve far better than a 0.75% rent to cost ratio on rented ADU buildings. Realize it is not really an apple to apple comparison because in the one case you are purchasing the land while in the second case you already have purchased the land.

Because the land is already purchased for the ADU, it is very unlikely that her investment dollar can produce better COC via a full property purchase than building and renting the ADU.

Good luck