ADUs from an Investor's Perspective (Part I)

This is Part I of ADUs from an Investor's Perspective. You can find Part II here

Most homeowners are not professional real estate investors so I wanted to dive into a deeper understanding of how a professional investor would think about ADUs as an investment option. While investment isn't the sole reason that people build ADUs, it is commonly a large driver. To gain some perspective on how ADUs perform as a real estate asset, I interviewed a local real estate investor in Portland, Oregon, Dani Zeghbib. This is a complex topic, so this will be a multipart post. 

Kol: When you think about any residential real estate investment, what metric do you use to establish whether it makes sense to go for it? (eg. Cap rate, IRR)

Dani:  Well, there’s a short answer and a long answer.  

To avoid TLDR (Too Long Didn't Read), the short answer is: I look at my cash on cash return (COCR), capitalization rate (aka “cap rate,” which is essentially the interest rate I earn from net operating income relative to how much I spent to buy/renovate the property), and I compare that to cost of capital (i.e. arbitrage between the cap rate I earn and the interest rate I pay on the mortgage), target market (e.g. would this property attract the kind of tenant I’d want to manage), appreciation potential (e.g. is the property in the next “up and coming” neighborhood, based on my knowledge of the city and of the neighborhood), and how I might be able to add value (i.e. forced appreciation).  

There is also a very general metric that I call the 1% rule, meaning, do the gross monthly market rents equal at least 1% of the total purchase + rehab cost?  If I can get close to 1% in Portland, the investment is worth a closer look.  (For example, if a property costs $300,000, could I realistically earn $3,000 each month in gross rents?  This is getting increasingly difficult to find in Portland, but creative investors know where to look and how to add value to get close to that elusive 1%.)

IRR means “internal rate of return.”  This is a metric that many large scale real estate investors and/or developers use when they have a specific target date to exit the investment.  In a nutshell, IRR is the total rate of return I would receive, including the difference between the cost to build (or buy) a property and the price I sell it for later.  IRR is useful within the context of ADUs, however, because the homeowner is essentially a developer--adding value where there was none before.  

If a project is highly leveraged (i.e. if a significant portion of the cost is financed) there may not be much cash flow each year.  But if the plan is to treat the ADU like an investment and sell it, say, 5 years later, then any appreciation/equity increase over those 5 years is added to the total net income over that same time period to determine the IRR (which is a more complete picture of the developer’s “return on investment” than cash flow alone) once the property is sold.

IRR is a valuable metric because it can help determine whether a project might bring the developer her expected return. It can also help determine whether a project might lose money over that same period of time. As you can imagine, this is important to think about in advance! And while the true IRR can’t be calculated until the property is sold (or in some cases, refinanced), real estate investors use spreadsheets to help them get an idea of what the IRR will likely be given their predictions of the market over time.  

I haven’t used IRR because so far, I haven’t sold anything, nor did I have plans to when I purchased any of my properties.

If that wasn’t long enough, here is my “long answer:”

First, I’m a small scale real estate investor.  That means I own a handful of duplex and single detached units rather than large apartment buildings.  (From a mortgage banker’s perspective, properties of 4 units or fewer are considered “residential” real estate while buildings of 5 units or more are considered “commercial” real estate--even if they are residential apartment buildings.)  So far, I have only invested in smaller residential properties in Portland Oregon, so while some of the concepts I discuss apply to commercial real estate, I use them mostly in small scale residential real estate investing.  

Second, the long answer to your question (and to many questions when it comes to real estate investing) is, “it depends.”  Each property and every market is different.  Some properties may have more opportunities to add value than others, and for those, I may decide to deviate from any standard set of numbers that I might otherwise want to see for a “turnkey” investment (i.e. one that’s already renovated and move-in ready when I buy it).  

Third, every investor is different and has different goals. Some people nearing retirement may want to use real estate as a means for steady cash flow each month long term (i.e. buy and hold). Other folks who are looking to build up cash reserves (and who maybe have a higher risk tolerance) might want to buy, fix up, and quickly sell a building (i.e. flipping real estate).  For our purposes, however, I’m mostly talking about buy and hold investing, where the intention is to hold a property for a certain amount of time and earn income/cash flow from rents.

Because I’m in Portland Oregon (where, as in many West Coast cities, the relative cost of real estate is high), and because I have at least a couple decades before I’ll want to slow down, my strategy is to buy rental properties to which I can add value and “force appreciation.”  Typically here, I cannot earn the same rents (relative to purchase price) that I would be able to earn in many parts of the Midwest and southern United States. At the same time, property in Portland has historically appreciated in value at a much faster pace than real estate in the Midwest and South.  So if I were looking for straight cash flow--the highest monthly income relative to the cost to buy the property--I would likely not purchase real estate in Portland.  But I’m OK with lower cash flow (relative to purchase price) because not only do I believe that residential real estate here will appreciate faster than in “cash flow markets” like the Midwest, but I have also learned how to force appreciation by adding value where other people may not see it (e.g. by understanding zoning codes; by adding units, square footage, and/or desirable features like second bathrooms; changing the property’s use; developing the property; etc.)

If a prospective property/project appears to come close to the 1% rule, then (assuming the property is in a neighborhood I like, meaning: I think the neighborhood has a greater potential to appreciate more than other neighborhoods, and I’d live there myself) I put the numbers in my spreadsheet to find out the cap rate and cash on cash return.  (Tip: Never rely on sellers’ or Realtors’ numbers.  Always do your own analysis.  Even if you don’t have all the exact expenses, a conservative estimate is that 50% of gross rents will go to expenses like taxes, insurance, maintenance, and more.  If the building is new, that estimate can go down to 40% of gross rents.)  

If the cap rate is in line with or [ideally] higher than the neighborhood (cap rate varies per city and per neighborhood; experienced local real estate investors can tell you what the cap rate in your area is), then I look at my COCR.  I like to see that, after accounting for depreciation and taxes, I am earning a return of at least 11 or 12% on the amount of cash I invested in the project.  (Cash is typically in the form of a down payment and closing costs. Cash does not include borrowed money that wasn’t mine to begin with.)

Typically, if cap rate and COCR are where I want to see them, and I can get close to the 1% rule after renovating the property, then I don’t have to worry about arbitrage (i.e. the difference between the interest rate I pay to borrow and the interest/cap rate I earn from the investment). That said, I’m a relatively new investor, having purchased my first rental in 2012, when interest rates were low.  Today (December, 2017), interest rates are still historically low, around 4%.  The properties I buy tend to have cap rates of 5 or 6% (or I can increase income by making property improvements to then earn a higher cap rate).  There is a good chance that, once interest rates rise, I’ll need to take a closer look at arbitrage when evaluating real estate investments.  If the cost to borrow becomes 6%, and the cap rate is 4%, and the investor is highly leveraged, then that particular investment may not make very much sense.  Then again, it might, depending on the investor’s goals.  It depends.  

Kol: To make this conversation as simple as possible, let’s pretend that the developer/investor does not live on property. Let’s pretend Lia is the developer/investor, and she owns a rental property with a single family house on it.

She bought the investment property in 2010, and it’s in good shape. She bought it for $250,000 with 20% down ($50,000) and it’s now worth $300,000. It gets $2,000 in rent/month and her PITI is $2,000.

In 2017, she was decided to build an ADU. The 1BR ADU would cost $160,000. It would get $1500 in rent.

Would this investment make sense? Why or why not?

Dani: It depends.  

What are Lia’s goals?  Does she want steady cash flow until retirement?  Or does she plan to sell the property within the next 5 years?    

If she wants to sell the property sooner rather than later, where are we currently in the market cycle?  Has it been more than 7-ish years of solid appreciation without a market correction?  Is there any chance that the market could soften/flatten by the time the ADU is built, and is that a risk Lia is willing to take?  If she builds the ADU now, will she at least recoup 100% of that equity in terms of increased property value immediately?  Because if she decides to sell the property while the market is still appreciating, she doesn’t want to spend her limited investment capital on a property that is worth less than the cash it took to build it.  (There are much better investments out there.)

If she wants to hold the property, what is the cost of construction?  If, for example, the cost to build has increased alongside the cost to buy real estate, would a market correction bring the cost of construction down, making it potentially much less expensive to build that same ADU later (especially if she wants to hold that property for a while)?   

Is Lia financing the project, and if so, what is the cost of capital (i.e. interest rate)?  How long will she be borrowing/paying on the loan without income, and does she have the financial reserves to be paying out without earning income for that long?  Is the loan fixed or variable rate, and where is that rate likely to go within the next 5 to 10 years?  

What is the opportunity cost of this project, and how does that relate to Lia’s overall goals? For example, if Lia’s goal is to earn long term cash flow, how far could she stretch that same $160k on a different investment?  Could she get more cash flow by investing that cash in a different market?  On a different investment?  If so, then maybe the ADU would not make as much sense as investing elsewhere.  A lot of real estate investors who live on the East and West Coasts invest in properties in the Midwest and South for that reason: opportunity cost and cash flow.  

If I owned a house worth $300k that cost me $2k in PITI, plus expenses for maintenance, repairs, and my time managing the property on top of that, and market rent was only $2k, I’d drop that property like a hot potato. It’s losing money.  It would make more sense to sell that property (or live in it, if I liked it enough) and invest that cash elsewhere than hold it as a rental.  (That is, unless there were other factors that give that property value beyond the negative cash flow, for example commercial zoning or an unfinished basement to inexpensively add another unit and bring the cash on cash return/cap rate in line with my targets.)

Adding an ADU to the property might help the numbers on this property slightly, but it doesn’t erase the bad investment that is the underlying house.  (It’s “bad” from a cash flow and risk perspective.  I don’t want to lose money every month based on speculation that the property will increase in value.  First of all, I don’t have the income to offset monthly losses.  Secondly, it’s not a guarantee that I will be able to recoup my investment when it comes time to sell, or when I have to sell, after transaction and realtor costs are subtracted from the equation.)

If both units on that property are used as rentals (given the numbers you provided), then for me, that ADU would not make sense.  Even if the ADU cashflowed and had instant equity after being built, why build an ADU on a property with extreme negative cash flow when I could instead build an ADU on a property that’s already cashflowing?  It’s throwing good money after bad.  That $160k (combined with the $300k equity in the main house) would do much better elsewhere.  

Now, if instead Lia (or I) were living in the main house, that is a different situation.  The house that I live in is not an “investment,” and I don’t expect it to perform as one.  At that point, I’m evaluating the ADU based on its own merits, and whether I want my tenants right next door in my back yard. If at some point I don’t want to live next door to my tenants, I still need to consider whether the property as a whole (main house and ADU) makes sense as a rental.  If I move, I may decide that it doesn’t and might sell the whole property.  If I do that, I want to make sure that my ADU investment is actually an investment, and that it’s worth at least as much as I put into it at the time of sale, if not more.  

On a side note, speaking as an investor and an architectural designer, I would probably build a 2 bedroom ADU rather than a 1 bedroom.  In Portland, ADUs are allowed to be up to 800 square feet, which is enough for 2 bedrooms.  It doesn’t cost that much more to build a couple interior walls, but the return on that investment is high.  If Lia’s property is located in an area that can command $1500 for one bedroom, then she can probably get at least $2000 for two bedrooms.  If it costs $1000 to frame/drywall/paint a couple walls and it results in $500/month in extra income, that’s a good investment.  

If Lia has the cash, it would be worth building the ADU as a 2 bedroom 2 bath.  Designed well, this should not cost that much more than a 1 bedroom 1 bath with the same overall floor area. Two bedrooms with two bathrooms is going to be much more useful to a wider swath of renters than one bedroom one bath, and is going to make it easier to fill vacancies as well as command higher rents.  

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This wraps up Part 1 of this little series on ADUs from an Investor's Perspective. We'll dive into this in greater detail in coming posts.