ADUs from an Investor's Perspective- Part III

This is Part III of ADUs from an Investor's Perspective. You can find Part I and Part II here. This is a complicated topic and it seems that there isn’t one right answer.

In the first two posts, I’ve interviewed one investor’s perspective on whether ADUs are a good investment.

This third installment is written by an investor who builds and holds ADUs on some of his residential properties. Arthur Donaghey is a real estate investor, general contractor and landlord in Portland, Oregon. He has built and manages four ADUs. All of them generate positive cash flow every month.

Here’s Arthur’s take on whether ADUs make financial sense:

Should you build an Accessory Dwelling Unit? It all comes down to the numbers.

Let’s use an ADU my business partner and I built two years ago as an example. All the costs listed here are real, but I’ve rounded off some numbers for simplicity.

We decided to build a detached ADU in the backyard of a rental house we own in North Portland. The rental income from the original house on the property pays the mortgage, property taxes, and insurance. So the building site in the backyard is free. That means what we had to consider was the cost to build the ADU, the cost to maintain it each year, and the potential rental income.

The ADU we built is an 800-square foot, two-bedroom home with a bath and a half. It’s completely separate from the main house.  It was designed by an architect. I am a licensed general contractor. I built the house and we paid my company the 20% general contractor fee.

The ADU is not a cheap rental. It's a nice home with a full kitchen, lots of storage, air conditioning, a deck, and a private fenced yard. The total cost to build the ADU was $185,000. That is about $230 per square foot—and that number includes design fees, engineering, permit fees, and all construction costs.

Our taxes went up $2,000 per year after we built the ADU. The liability insurance for the ADU is $25 per month.

We now rent the ADU for about $1,900 a month. After paying all expenses we have about an extra $870 per month.

So, if we had $185,000 cash available and the annual rent was $22,800 and our property taxes went up $2,000 per year and we paid $300 each year for insurance, then the return on our cash invested would be about 11%.

For comparison purposes, let’s assume that you could invest your money in the stock market and expect a return of about 7% per year, on average.

That 11% return would go down if there are vacancies or repairs. The repair costs are minimal because the house is brand new, but rentals tend to turn over every year or two. Let's say that this unit rents for one year and is then vacant for one month, and that we spend $1,000 on repairs or improvements when it is vacant. So, our income in the next year would drop to $17,600. That gives us a return of about 9%.

That 9%-11% return is before depreciation. The IRS allows us to depreciate investment real estate, which reduces the taxes we pay on the rental income. So, our actual rate of return could be higher.

If you are considering building an ADU you probably already know that owning a rental requires work and risk. You have to become a landlord or hire a property management firm. I manage this property and the others that we own. If you build an ADU in your backyard, then you are living next to your tenants. If the water heater breaks you have to pay for it. You also need to set aside money for things like repainting the outside.

Rents in Portland have been going up, but sometimes they go down. If the rent drops from $1,900 to $1,200 per month, and you have a month’s vacancy and you pay $1,000 in repairs, the return on your investment would drop to about 5%.

If you don't have the $185,000 for the construction budget you will need to finance the construction. If you have equity in your home, your lender might allow you to use that as your down payment; we have built ADUs where that is the case. But if you don't have enough equity in your home the bank could ask you for a 25% down payment. That would be about $46,000. If you invested that much cash to build the ADU, you would have to borrow about $139,000. At 6% interest over 30 years, the Google mortgage calculator estimates that would cost you about $835 per month.

Let’s run through those numbers even further: If your rental income is $1,900 and your mortgage goes up about $835 per month and your property taxes go up about $170 per month and you pay $25 per month for insurance, then your net cash every month would be about $870 per month or $10,400 per year. That would be a return of about 22% on the $46,000 you invested. That return could be increased by depreciation and decreased by vacancies, repairs, and lower rent.

By building this ADU you will have committed to increasing your mortgage and taxes and insurance by about $1,030 per month. So the rent needs to stay above $1,030 for this investment to break even each month before vacancies and repairs. If you invest $46,000 cash and borrow $139,000 to build the ADU, with current rents about $1,900 per month, you could pay for your taxes and insurance plus set aside $200 every month to pay for vacancies plus $200 every month to pay for repairs or improvements and still have $470 extra cash each month. That would give you a return of about 12%.

If you choose to build your ADU in your basement or your attic or attached to your house, the construction costs will be lower. The rents will probably be lower, too. But the financial decision-making process is the same.