Garage to ADU conversion?

[Adam Watanabe]

Hi there! My wife and I recently purchased a single family home with a detached ADU outside the Sacramento, CA area. We just started medium-term renting the ADU through Furnished Finder and it's been an incredible experience. We barely notice our tenant and his rent covers about half of our mortgage. You might say I'm a little hooked and am considering other real estate investments. One idea would be to convert our attached 450 sq ft garage into an ADU to rent. It would cost around $100-120K and could rent for around $2K a month. This would be nearing the 2% rule which seems pretty good especially in today's market. Not to mention, we would be building equity into our house and it would cover the other half of the mortgage.

The other option would be to look for a property to purchase out of state to BRRRR. I would most likely try to find a multi-family to update, then hire a property manager to takeover. I wouldn't get near the rate of return as I would on the ADU, but I would be diversifying my housing investments.

Thoughts and comments would be much appreciated. Thank you!

[Dan H.]

Quote from @Bradley Buxton:

@Adam Watanabe

Converting a garage is not the best idea for the exit of a property. Many people still want garages for primary residences. By having a garage converted, you limit the value of the home and the buyer pool to investors. At 120k/2k that is 60 months or 5 years on the return. @Dan H. has some good insights on ADU conversions.
Generally, it would be better to put the $120k towards the down payment of another property so you can gain the equity even if the cashflow is breakeven. 

thanks for the tag.   To the OP, I regularly check ADU addition underwriting.  I encourage accurate and conservative underwriting.  On an ADU addition, the most important aspect of the underwriting is to KNOW the value that will be added by the ADU.  In the absence of sufficiently comps, expect a very poor valuation.  

I suspect the cost to convert an 450' garage to an ADU will approach $150k. The issue is it will likely add ~$75k of value resulting in an initial negative $75k (a value subtract). This initial negative position needs to be recovered before any cash flow is obtained.

I am also a bit skeptical that a 450’ unit can achieve $2k rent in Sacramento.

Using 50% rule (expenses other than mortgage is 50%) on a financed ADU, 8% 30 your loan at 80% LTV.

$2000 - $1000 (50% rule) - $881 (P&i) = $119/month
$75k/$119 = 630 months to recover the initial negative equity. This is 52.5 years.

Let’s use OP’s $120k with $45k initial negative position.
$2000 - $1000 - $704 (P&i) = $296/ month
$45k/$296 = 152 months or 12,7 years to recover the initial equity.

Building a single smal, unit is very expensive development.

Here is a list of why adding a single ADU in single family zoned areas 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 than building a single ADU.
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 an 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.

Good luck