How ADUs Can Expand Your Real Estate Investment Portfolio
Rental properties can be lucrative for property investors but purchasing properties in today’s competitive market is still difficult. With property prices up nearly 20% over last spring in some areas, bidding wars are still common, and months of effort involved in just a single property purchase, it is no surprise some investors are waiting for the temperatures to cool.
But investing in a new rental property is not the only way to add to your real estate investment portfolio. It is possible to add on to existing properties in a way that will drive prices higher and add additional income streams. Accessory dwelling units, or ADUs, have a lot to offer. They are relatively affordable, easy to add, and quick to build. ADU’s are opening the door for a new and exciting opportunity. However, as with all investment avenues, ADUs are not for everyone. From local ordinances to reducing the size of the current property, there are plenty of factors to keep in mind when considering an ADU investment strategy.
What Is an Accessory Dwelling Unit?
An accessory dwelling unit (ADU) is a secondary housing unit built on a property that already has a primary housing structure. It is truly an accessory; it supplements the property that exists rather than replacing it or expanding it.
Even if you have never heard the term ADU before, you may still be familiar with the concept. Guest houses, pool houses, and granny flats are common forms of ADUs; essentially, they are a way to expand the capabilities of a property, whether to house a family member or serve as a source of passive income.
There is only one real expectation to classify a property as an ADU: an ADU must be able to serve as a stand-alone residence without any reliance on the main property. In most cases, they are standalone structures, but can also be attic or basement conversions, but they must offer all the amenities needed to live independently, like a kitchen, bathroom, and private entrance. For example, a converted garage with a bathroom and bedroom but no kitchen legally cannot be considered an ADU. The same is true for a basement apartment that can only be accessed from inside the primary property.
ADUs won’t be right for all properties. The zoning laws in some areas can make building a challenge, and small lots may not be physically capable of sustaining another housing unit. But if it is an option, the investment benefits may be worth considering.
The Growth of ADUs
ADUs are on the rise, so getting in early by adding on to fix and flip properties or expanding rental income capabilities can be a great way to ride out the uncertainty of the current real estate market.
Not only can ADUs raise property values and create an additional source of revenue, but buyers are also on the hunt for multi-generational housing – a plus for whenever you are ready to sell. Currently, Gen Y makes up nearly 40% of the real estate market, and they are the most likely demo to have newly aging parents in need of housing. Gen X is second in terms of share of current buyers, and they are more likely to have adult children in need of a place to return between college and careers. With 12% of buyers investing in multi-generational housing in 2021, more space for loved ones or tenants is a priority.
The rise in ADUs nationwide demonstrates this trend as well; in 2000, just 1.6% of properties had ADUs on the property. Today, that is up to 7% and continuing to grow.
Types of ADUs
ADUs are not one size fits all; they come in a few different forms, providing extra flexibility for investors to consider depending on local laws and property limitations. The two main options? Detached and attached structures.
Attached structures are, as the name implies, connected to a property rather than standing alone. Attached structures can be external or internal.
External attached ADUs are ADUs added externally onto a property, like an apartment built onto the back of a house or a converted attached garage. This can be a good option when there is not enough space to allow for a detached build. Most properties can accommodate an attached external ADU.
Internal structures refer to something like a converted attic or basement that is located entirely within an existing property. These type of ADUs can be a little harder to establish due to the need for a separate private entrance.
Detached structures, on the other hand, are not connected to a main residence. These are standalone buildings that simply exist on the same property. Sometimes, these are converted spaces, but most often are new construction designed to serve this specific purpose. Some homeowners build these units to generate income or to house a loved one when emergencies arise, but regardless, detached ADUs add extensive value.
The Pros and Cons of Adding ADUs
ADUs offer compelling potential, especially in California that have more people trying to become homeowners than available inventory. But before hiring a contractor, it is important to keep the pros and cons in mind – just like with every real estate investment opportunity.
There is lots to love about ADUs. These are the biggest pros to expanding rental holdings in this space.
- Passive Income: Perhaps the biggest pro for rental property real estate investors, building an ADU provides another unit to rent out in exchange for income. If local laws are followed, this effectively turns a property that once allowed for a single source of passive income into one that allows for two. Further, this income opportunity will be available as soon as construction is complete. There is no need to go through the lengthy purchase process normally required to add a new rental unit to your portfolio.
- Increasing Property Values: Based on the rise in ADU construction and the interest in multigenerational housing, one thing is clear – buyers want properties with flexible housing options. According to one 2021 study, housing with ADUs in cities with tight housing inventories can sell for as much as 35% more than properties without. Even if you plan to rent the unit out and this is not an immediate priority, chances are good you won’t hang on to your current holdings forever. Once the time to sell does come around, it will be easier to turn a healthy profit.
- Appealing to Renters and Buyers: Renters and buyers can both find something to love about a property with an ADU. Renters with minimal demands who do not want to live in a large apartment complex will love the private nature of a detached ADU, while those who need housing for extended family will be willing to pay top dollar for a property that suits their unique needs.
- Fulfilling Housing Needs: Housing inventory is at an all-time low, especially in California. And, with housing prices rising beyond what many people can pay, the single-family rental space is very big right now. With the addition of an ADU, you can not only do your part in relieving inventory pressures but take advantage of a growing space in many communities.
- Easy to Manage: ADUs are simple housing units, usually no more than 1,000 square feet, so they do not require a ton of upkeep, especially when added to a property you are already managing. You likely already have contacts, like maintenance services, in place for the existing unit, so adding another space will not be a significant addition to your workload.
- Customizable: Adding an ADU is more like building a new property than it is buying an existing property. When you handle the design work, you can make sure the addition has all the features you need to command top rental dollars.
ADUs have plenty of pros, but they are not without drawbacks. As with any investment, be sure you understand the downsides and your own risk tolerance.
- Problems with Zoning: Not all areas of the country are easy places to implement ADUs. While many cities throughout California make adding an ADU relatively painless, this is not true everywhere. Complying with zoning from the start can require a lot of time and research, and inadvertently going against area ordinances can mean steep fines or, in worst cases, the required removal of your new investment unit.
- High Costs: Any new construction comes with costs, and ADUs are no different. The costs of building an ADU are like any free-stranding housing unit. Keep in mind that you will need to run gas, water, and electricity to your new unit, which can be a big undertaking depending on the property in question. While there are companies that offer prefab ADUs for purchase, this will not work for everyone.
- Higher Property Taxes: In some areas, ADUs can result in higher property taxes. You may need a new assessment, and you may see a large one-time increase, plus future compounding increases.
- Reduced Outdoor Areas: ADUs will, by nature, take up space on a lot. For larger lots, this may not be a problem, but for smaller lots, this can really cut into usable outdoor space. This may not be an issue for some buyers or renters, but it will hurt property values for others, particularly homeowners who would prefer a deck, patio, or yard to an ADU.
Tips and Tricks for ADU Investments
For those new to the ADU space, it is important to understand the difference between building an ADU and purchasing a rental property or fix and flip. Keep these tips and tricks in mind before jumping into this compelling investment space.
- Understand Local Laws: Construction of all kinds is heavily governed by state and local ordinances. Even if you know the rules for general construction, that does not mean you know the ins and outs for ADUs; some areas have lots of hoops to jump through. Consider reaching out to government planning resources to understand the full scope of permits and zoning laws.
- Prefab or Custom Design? Before getting started, weigh your construction options. While custom designs can be appealing, working with established providers can result in a faster, easier process at a lower price point. At minimum, always choose design resources that have experience in working with ADUs.
- Arrange Financing: Work with a lender like Westpark Loans that can get you the cash you need to add an ADU to an investment property.
For those who do not want to buy rental property in the current competitive market, expanding into ADUs can be an excellent way to bolster your portfolio. While ADUs will not be right for everyone, they offer a compelling avenue for savvy real-estate investors.