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Four things to Know Before Building an ADU on Your Residential Investment Property

The local and state government have made it extremely attractive to construct additional dwelling units (ADU’s), also known as Granny Flats, on a property with a single-family residence by loosening the density restrictions.

The additional square footage created with an ADU can help increase the value of a single-family residential property, both owner-occupied and investment rental property. However, in this article, I am focusing on residential investment properties with ADU’s.  

I have arranged numerous construction and permanent loans on single-family homes with ADU’s as investment properties and would like to share some insights I have learned along the way.

There are four things to know before building an ADU on your residential investment property (non-owner-occupied):

1.  Understand how the Property will be Valued –

A single-family residence with an ADU (up to four units) is appraised differently than a multi-family 5+ units. An appraiser will focus on the sales approach to value when appraising 1-4 units, similar to how a single-family residence is valued, rather than on the income approach to value, which is how an apartment is valued.

Therefore, the valuation for 1-4 units will be based on comparable sales in the neighborhood rather than the income approach to value using a cap rate.

Values will vary from neighborhood to neighborhood. It is important not to over improve the property for the neighborhood when it comes to 1-4 residential rental units. The ultimate value will not be based on how much rental income you receive on the property, but on what other comparable sales have sold for in the neighborhood. Knowing how the property will be valued before you start will help determine the amount of financing you will be able to obtain upon completion.

2.  Make Sure the Units are Permitted –

The units must be permitted to maximize your property value.

If the unit is not permitted, the ADU will be treated as additional square footage only and will not be compared to other sold properties with permitted units, thus reflecting a lower value.

3.  Know the two Basic Constraints in Determining the Maximum Loan Amount for a Conventional Long-Term Lender

Every conventional lender has a minimum debt service coverage ratio (DSCR) the property must meet and a maximum loan-to-value (LTV) ratio requirement that determines the maximum loan amount.

The lowest minimum debt service coverage ratio I have seen is 1:1, which is that the gross market monthly rental income, needs to cover the monthly mortgage payment, taxes, and insurance (PITI). More conservative conventional lenders will often accept 75% of the gross market rental income in calculating the DSCR.

A typical maximum LTV ratio for the conventional take-out loan (not the construction loan) is 75% for 1-4 residential units.

4.  Know Your Return on Investment –

Adding an ADU to an existing property can provide the opportunity for a profitable return on investment. Especially since the land cost has already been incorporated into the original price of the single-family home, and it is usually just excess space not utilized to its highest and best use.

Whether the return on investment is acceptable will depend on the cost to construct the ADU, the achievable rental income, the loan amount financed, the interest rate, and amortization obtained on the loan.

Appreciation and tax benefits affect the overall return on investment, but I am leaving out these factors and focusing on how the cash on cash return is calculated.

The cash-on-cash return is determined as follows: Net annual cash flow (gross rents less operating and management expenses, and debt service) divided by the net cash investment (cash investment less the loan amount).

For example, an investor owns a single-family residence and adds two ADU’s to the property, converts the garage to a studio, and adds a detached 2BR/2BA unit in the rear of the property. I am excluding the single-family residential rental income from the calculation to simply the assumptions and illustrate how the cash on cash return is calculated specifically on the ADU’s.

Construction costs and rents can vary with the quality of improvements and location etc. Therefore, I would like to focus on the concept of how the return is calculated and not whether my estimates are correct or not.

Assumptions:

  • Cost to convert two-car garage to a studio (480 sq.ft.) and construct a detached 2BR/2BA (800 SF) ADU using $150/sf for the garage and $300/sf for the detached unit.  Total cost approximately $312,000.
  • The loan amount estimate is 75% of the total cost or $234,000.
  • Cash out of pocket investment is $78,000.
  • Studio rent $1,200/mo.
  • 2BR/2BA unit $2,100/mo.
  • Total gross rent from two ADU’s only $3,300/mo.
  • Management and operating expenses 25%
  • Net Rent = $2,475/mo.
  • The loan amount is estimated at $234,000 or 75% of cost using a conservative current market rate of 3.50%/30 year amortization monthly payment of $1,050/mo. (P&I) (Full Doc. Borrower or qualified mortgage)
    • The actual loan amount will be determined by the overall appraised value of the property and the lender’s underwriting constraints LTV ratio and DSCR. However, to keep it simple in this example, I used 75% of the total cost as it pertains to the ADU’s.
  • Net annual cash flow $17,090 ($2,475 Net Rent – $1,050 Monthly P&I  = $1,425) x 12)Calculation:  (Net Annual Cash Flow of $17,090)/($78,000 net cash out of pocket investment) = 22% annual cash on cash return.
    • Note that the land cost is not included in the net out-of-pocket cost. Due to the fact, it is a sunk cost whether the ADU’s are built it or not, and even if the land cost was included, it would decrease the cash on cash return only slightly, but regardless it would still be an excellent return.

It is important to know how your single-family residential investment property with 1-4 units will be valued, underwritten when getting a loan, and whether it will provide you an acceptable cash on cash return.

ADU’s provide an excellent opportunity to increase the value of a single-family residence and provide an excellent cash-on-cash return if constructed and financed at acceptable costs and loan terms.

If you want to add an ADU or want more information on how an ADU is financed, call me at 702-379-3468.

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