Things to consider when considering an ADU

How to know if an ADU makes sense for your property

May 5, 2023

ADUs are becoming increasingly popular because of the variety of ways in which they can be optimized to save money and increase your income. 

If you’re in need of extra space for an office, an alternative to a retirement home for aging parents, or rental property as a source of passive income, an ADU may be an investment you should consider.

Determining whether or not an ADU “pencils out” is the diligence that every Developer and Real-Estate Investor does before moving on a project. However, it’s uncommon for most homeowners to consider all the factors that go into Real-Estate Investment so we’ve made a simple outline to help you get started.

Factors to consider

1 - Zoning Regulations

Check your local zoning ordinance to determine whether or not ADUs are legally allowed where you live, because an illegally built prefab will not be insured or hold resell value. Appraisers will not assign the proper value for your ADU if it hasn’t been permitted.

You will also need to consider regulations in regards to how your prefab should be built. For example, zoning ordinances and neighborhood rules may limit your prefab’s square footage, the style, the number of stories, the placement of the entrance, or even the color of the paint.

To help you know what you can build, hire a licensed contractor or use a ADU company to help get you a site analysis.

2 - Financing your prefab

Interest rates (in 2020) are still surprisingly low and no one can predict what factors might increase those rates in the next few years.

One advantageous way to finance your ADU without interest is through co-investing. Co-investing allows you to tap into your home’s equity by letting you convert existing equity to cash for you to spend on your ADU. Unlike a loan, this does not require monthly payments, fees, or interest charges. Instead, you are given a cash payment in exchange for an option to purchase a percent of your home’s equity in the future. There are no payments until you sell your home. This option is appealing to homeowners that have a low interest rate on their primary home and don’t want to spend the additional monthly interest.

Another way to finance your ADU is through a home equity line of credit (HELOC). A HELOC gives you a revolving credit line to cover large expenses (such as an ADU) or consolidate debt from loans. HELOCs tend to have lower interest rates which may also be tax-deductible.

A Cash-Out Refinance loan is a product that allows you to pull out up to 80%-90% of the equity you have in your home - you are paid the difference between the mortgage balance and the home’s value. How it works is that it replaces your existing mortgage from your primary home with a new loan. You must have equity built up in your house to pull cash out.

If you don’t have enough equity in your home for a Cash-Out Refinance, renovation loans are another option to consider when planning how you’ll finance your prefab. A renovation loan gives you funds for fixing up your home, in the form of a personal loan or a mortgage. You can also begin refinancing your ADU after construction, to get a better rate since you’ll have added the new value of the home and will consequently increase your equity.

3 - Return on Investment

A house creates more wealth for homeowners than any other asset. If you plan on renting out your ADU, calculate return on investment (ROI) to help estimate your monthly cash flow. ROI is a measure used to evaluate how much there is to gain from an investment, by dividing the return of an investment by the cost of the investment. ROI is measured as a percentage and this allows you to compare the return of different investments before investing.

Real-Estate investors will often gauge their investment on a simple 1% rule. The 1% states that you should be earning 1% of your total property value, in your rental income per month. So if your property is valued at $350k, you would want close to $3,500/mo in rental income. This is a number that is hard to hit for most investments but the 1% rule can give you a good signal of whether you are making a wise investment.

In terms of resell value, you should also check to see if appraisers in your neighborhood count ADUs as square feet. If your ADU is counted as square footage, multiply the new square footage by the current cost per square feet of your primary home.

Note: if you are thinking about investing in and ADU, you should also consider what your money would do in the a brokerage fund or a retirement fund. You can get help from a financial advisor to help compare the ROI from your ADU to what you could make by putting your money in the market.

4 - Tax costs and benefits

Building a prefab could potentially raise your property tax if your rental income is also taxed, so it’s important to know what tax bracket you’ll be in with the added income.

There are also a number of tax deductions you may qualify for. A mortgage interest tax deduction is based on the interest rate of your mortgage loan and this will most likely be your largest deduction. You may also qualify for deductions because of the cost of repairs, maintenance, deferral of capital gains, and your mortgage insurance premium if you took one out.

5 - Comparables

There are several software tools that can help you find out what your projected rental income will be (see Airdna). These tools will give a free estimate for your property. It’s a good idea to get as much data as you can that is relevant to your property. Make sure to ask neighbors that are renting or check local rental websites to see the costs, square footage, and bedroom / bathroom counts.

Other Benefits and Considerations

As housing costs rise, an increasing number of retirees and working-class Americans are in need of affordable housing and prefab homes tend to have lower than average rent. Prefab ADUs cost about 10-20% less to build than traditional homes and can be a great guest house for a loved one.

The time it takes to build a prefab ADU is much shorter than the amount of time it takes to build a traditional home. The spend of construction directly translates into saved costs: interest rates during construction and with no one renting the home, you delay your income.

All in all, ADUs can pave a way to wealth creation unlike many investments that are currently available. We hope this guide can help while you consider adding significant value to your most powerful asset, your home.

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