An Accessory Dwelling Unit (ADU) is typically a one or two-room living unit designed as a separate dwelling from the single-family home located on the same lot. ADUs can sometimes be referred to as guest house, carriage house, or granny flat. These spaces are completely habitable with features such as a kitchen and bathroom. ADUs can be a money maker for homeowners looking for short-term cash flow and long-term investment.
In California, prior to 2016, legally converting or building an ADU was met with a host of local regulations to the point that an ADU didn’t make financial sense. Today, due to relaxed ordinance changes in California statewide legislation, homeowners in single-family neighborhoods are now able to legally build, convert or permit second dwellings on their property. These units are quickly becoming a popular way to offset a mortgage with rental income and increase home values.
The math is relatively easy to figure out. Just compare the cost of permitting an existing structure or building a new ADU with the amount of anticipated rental income over the years. The costs to build new can vary based upon the square footage of the unit or type of ADU. On average, construction is nearly $150,000—though the median is $86,500 according to analysis from the County of Santa Cruz. Garages and other previously built structures can be converted to ADUs for residential use, which is a way to save money. Just note, permitting takes time and it’s best to hire a consultant to walk you through the process. Bottom line, an ADU is an investment upfront, but it will payoff in the long term. Here are five strategies for a return on investment.
#1: Rent the ADU to a Tenant:
The first place to look for income is to rent out the unit. This will mean guaranteed, monthly income as long as the unit is rented. Screening applicants carefully for a reputable tenant is important because they will be residing on the main house property and potentially sharing common space.
Step one is to obtain a copy of the prospective tenant’s credit report. A signed authorization to check credit will allow access to a credit report from any of the three credit repositories of Experian, Equifax and TransUnion. It’s just as important to get references and contact information from the applicant’s current and previous landlord(s). Once all that is complete, ask for a deposit, which typically means the first and last month’s rent. A legal California approved lease agreement that clearly spells out the details of the agreement, how much the rent will be, when due and other details is also key. This monthly, passive income is “mailbox money” and properly priced, not only will it generate steady income it can also offset your mortgage.
#2: Rent to Short-term Occupants:
Short term rentals are permitted in most jurisdictions. A short-term lease could be attractive to those who need corporate housing or are moving from out of state. More common options include Airbnb, VRBO, or Homeaway, common services for vacation rentals, and allow you to charge higher rates over a shorter time frame. Short term rentals have increased in popularity over the years and are fast becoming a vacation rental of choice for travelers Be sure to check with your local planning department to make absolutely certain that local laws admit of this option.
#3: Build a Space for a Home Office or Studio:
An ADU is also a perfect solution for those in need of a home office or a studio in which to work. There are many folks throughout California who work from home, but don’t want to pay for a separate office. If you are an employee, there may be a company reimbursement plan. Additionally, if you have partners or folks who would split the space, they might be willing to pay rent on the unit. For example, if one person only needs the studio part-time, it could be rented out for the unused hours. Square footage that is dedicated solely for work may also be an income tax deduction come tax time. Be sure to consult with your tax advisor for details on how and when this deduction can be taken.
#4: Create a Housemate Dwelling:
This is a perfect situation for baby boomers who want to create additional space for their grown children or aging parents/grandparents. It keeps their relatives in their own dwelling and is much more affordable than a separate apartment or assisted living. This is also a good option for millennials looking to purchase real estate together as friends.
#5: Increase your Property Value:
The big payoff will be when it comes time to appraise the home and there is both a habitable dwelling on the property with permitted square footage and a rental property to consider.
How much more value can an ADU add to the value of the home? A property appraisal can help with that question. A market appraisal is one which compares similar properties in the neighborhood. When placing a value on a property that has an ADU, the appraiser needs to find other homes in the area that also have an occupied ADU. Depending upon the neighborhood, there can be several homes with ADUs and the appraiser can then arrive at a fair market value of the entire property, including the ADU. In areas where there are few homes with an ADU, the appraiser can take the income approach and compile a comparative market analysis taking the net rental income from the ADU. This additional revenue adds value to the property and is listed as such on the final appraisal report. The addition of a ADU will ultimately make the property listing more attractive to buyers and add additional value when it’s time to sell the property.
If you’re thinking of ways to improve the value of your home while generating monthly passive income, an ADU might very well be your best solution.