I've read a lot of recently about accessory dwelling units (ADU's) being heavily promoted by municipalities on the west coast. The ADU is a secondary small home built on properties with enough space in the back or side area of the existing single family home.
The goal is that the homeowner can utilize the secondary home as a rental, or perhaps move in to the ADU and rent out the primary residence. Multi-generational families in one home can benefit from ADU's by putting some family members in the ADU, thereby enabling more individuals to live in the estate more comfortably.
Most of the articles I've read have been for cities attempting to solve the shortage of housing through the creation of smaller/affordable housing. Most legislature for ADU's provides for expedited and reduced permit costs through the county or municipality.
I've seen some of these smaller she-shack builds in Seattle, but these smaller units seem to be used by the current homeowners as home offices. The homeowner seeking a second smaller home on his or her property will have lots of options. However, understanding the costs and risks of the ADU build is equally important. I'll run a negative scenario for you to consider.
Is an ADU a good investment for you?
As with many questions in real estate and investing, the answer is- it depends.
The analysis is like every other financial decision you need to work through, in my opinion it’s a simple math formula:
-How much will the ADU cost you?
(Let's say 150k)
-How are you going to pay for it.
(Home equity loan at 5%, or maybe a rich Uncle)
-How much rent will you receive per year?
Let's say you can guarantee $1,200 dollars rent per month for your newly built ADU minus additional fees, utility bills and other new taxes, which takes it down to $1,000 dollars profit per month. Now, let's say your municipality puts a rent freeze in place, meaning you can no longer increase the rent on your tenant- who for the sake of argument is on public assistance and is guaranteed your property for life. In this low profit scenario, your rich uncle inheritance works out, and so you fund a $150k build with cash. In this scenario you need 12.5 years to pay yourself back your Rich Uncle investment dollars.
-What’s the opportunity cost for that money?
Well, let's say your rich uncle inheritance of 150k showed up 12.5 years ago, and instead of building your ADU back then, you decided to invest this money. Using historical S&P500 returns, if you had invested 150k twenty years ago, not counting for inflation you would now have 450k using dividend reinvesting for that same time period. This is a 200% return. Accounting for inflation, the actual or Real amount is 236k, which is a 157% return.
In this worst case example, you spent 150k, which pays you back in 12.5 years, and at the end of this period you have a small cash positive rental that does not appreciate the way a single family home does. However, you now have a rent income of $1,000 dollars per month, as you have already paid yourself back your invested 150k.
The S&P 500 fund investment return of 236k (including inflation) to 450k (excluding inflation) seems like a better return using my doomsday conditions applied to the ADU.
I recommend running your own scenarios accounting for different tax/legal limitations on the ADU, and varied investment returns to determine if your math formula ends up in your favor.
Given the unknowns of ADU's, I would make sure to factor in your actual need for this secondary home, and it's impact on your net worth during your lifetime, and your children's estate planning scenarios.
Seattle Article on ADU's.
Note that I am not a financial or legal professional, nor am I licensed to sell securities, or any other financial instruments. Given this statement, I strongly recommend that you consider this blog as entertainment value. Although, I sincerely hope that I can motivate you to learn to build your own financial knowledge and wealth.
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