ADUs have changed the landscape of the California housing market, and they are quickly spreading nationwide. Because this is an emerging trend, many homeowners and investors aren’t yet familiar with the ADU concept or how it affects their real estate holdings.
In this article, we’re sharing all the details to bring you up-to-date on the ADU housing shift.
What is an Accessory Dwelling Unit?
An ADU (Accessory Dwelling Unit) is a separate housing unit added to an existing residential property. ADUs may also be called guest houses, in-law suites, casitas, granny flats, or gites.
Homeowners and investors can create ADUs by converting basement, attic, or garage areas into apartment-style living spaces or by building stand-alone structures next to the property’s main house.
What are ADUs Used For?
ADUs can serve a number of purposes, including:
- Rental units. Homeowners can house hack by renting out their ADUs as short-term vacation rentals or long-term rental units.
- Starter apartments for grown children. If your young adult is ready for their own space, but not yet fully independent, an ADU can be a good way to transition from home to their own apartment.
- Multi-generational households. Many homeowners want to keep aging parents close while still allowing them their own space.
- Guest house. Buyers who regularly host visitors may want to keep the ADU available as a guest house for comfortable accommodations.
- Multiple income streams from a single property. Real estate investors can purchase the property and rent out both the main house and the ADU to earn two separate income streams.
Why (and How) are Local Governments Incentivizing ADUs?
Many state and local governments are in favor of ADUs because they add housing units at a time when many communities are seeing extreme housing shortages (particularly for affordable housing). For this reason, governments are incentivizing homeowners and investors to build ADUs in a number of ways, for example:
- Streamlining the permitting process. The faster you can get your building permits, the sooner you can begin construction.
- Creating suitable financing options. Some local governments may offer favorable loan terms to assist property owners in funding the construction of ADUs.
- Offering tax incentives. Tax incentives could take multiple forms. For example, in many cases, interest on a loan taken to build an ADU may be tax deductible. Additionally, in states like California, where there are caps on annual property tax increases, an ADU does not result in a reassessment of the entire property. Instead, the assessment on your primary structure and land would remain under the existing cap for tax purposes, with only the value of the ADU being added to the assessed value. Additionally, if the property is held long-term, proceeds from the eventual sale would be taxed at the lower capital gains rate rather than the higher earned income rate.
Pros and Cons of ADUs
Building an ADU comes with several benefits, as well as a few potential downsides to be aware of. Here are the pros and cons of building an ADU.
The Benefits of ADUs
The advantages of ADUs include:
- Easing the housing crisis. The more units available, the more people we can house.
- Adding to the inventory of affordable units. Modest ADUs also increase the availability of affordable housing units.
- Promoting sustainable living. The future of real estate investing includes taking advantage of existing infrastructure (like the roads and utilities already extending to existing single-family residences), which is more sustainable than stretching infrastructure to new housing developments.
- Offering more flexible housing options for complex household structures. With blended families and multi-generational households on the rise, ADUs can comfortably accommodate more types of households.
- Increasing property values through forced appreciation. Building an ADU can increase the value of your home by more than the cost of labor and materials, instantly increasing your home equity.
- Offering passive income potential. Renting out the ADU gives you a chance to earn passive income from real estate as you collect rent payments.
- Creating potential tax breaks. There are many tax benefits of real estate investing, including rental property income tax deductions, favorable capital gains tax rates, and rental property depreciation.
The Potential Drawbacks of ADUs
In addition to the many benefits of ADUs, there are a few potential downsides to watch for, including:
- Knowledge of construction requirements. Whether you do the work yourself or you oversee a general contractor, understanding the construction process will minimize the risk of expensive mistakes.
- High upfront financial commitment. Labor and materials for an ADU vary widely depending on location, quality, size, and style. A 2020 study found that ADUs could cost anywhere between $20,000 and $440,000 with the average total cost coming in around $181,000.
- Disruption of construction. Construction naturally comes with lots of noise and a bit of a mess. Be prepared for this if you will be living onsite during construction.
How to Finance an ADU Build
In many cases, the cost of an ADU is too high for homeowners to finance the project with savings alone. So, homeowners often turn to financing to fund their ADU build.
Here are four financing options for constructing an ADU:
- Home equity loans (sometimes called a second mortgage). Home equity loans allow you to borrow against the current value of your home. If you qualify for a home equity loan, you could receive a lump sum that you’ll repay, plus interest, over a set number of years at a set interest rate.
- HELOCs (Home Equity Lines of Credit). Similar to home equity loans, HELOCs allow you to borrow against the current value of your home. However, HELOCs are a revolving line of credit, meaning that you receive a credit limit that you can borrow against at will during the pre-determined “draw period.” The amount borrowed will be repaid over the pre-determined “repayment period,” typically with an adjustable interest rate that fluctuates with changing market conditions over time.
- Construction loans. Unlike home equity loans and HELOCs, construction loans are typically not secured by your home. This means your home is not used as collateral. And this makes the loan riskier for the lender, which can result in a higher interest rate. In lieu of collateral, you should expect to provide a detailed building plan and construction timeline to provide some level of assurance to the lender. You may even need a well-qualified co-signer to provide further assurance to the lender that the loan will be repaid.
- Hard money loans. Hard money loans are offered by private investors or investment companies rather than traditional financial institutions. These are typically considered “loans of last resort” for those who don’t qualify for other loan options. Hard money loans typically require that the property be used as collateral for the loan.
It is important to take extra care when using your home as collateral for any loan type. If a loan is secured by your home, the lender could potentially initiate foreclosure on the home if you are unable to repay the loan.
How to Invest in ADUs Without Construction Experience or Loans
If you would like to reap the benefits of investing in ADUs without the hassle or high upfront expense of building an ADU, consider investing in a crowdfunded real estate that includes an ADU.
Gatsby Investment, for example, offers single-home flips with ADU builds. This unique investment opportunity combines the traditional fix-and-flip model with the ground-up construction of a new ADU to maximize return potential. And because Gatsby oversees the entire project, you don’t need any experience with real estate analysis, architecture, construction, design, or sales. You also don’t have to spend your own time and energy on the project!
Gatsby pools funds from multiple investors, allowing you to buy into a deal with as little as $10,000. And, with Gatsby’s extensive network of industry professionals and streamlined procedures, we can complete a project in just 6-12 months, allowing you to get in and out of a deal quickly.