Everything You Need to Know About ADU - Accessory Dwelling Units
Warning! This is the most in depth guide ever written on ADU.
What is ADU?
Accessory Dwelling Unit, ADU, also known as Granny Flats, in-law unit, is a legal and regulatory term for a secondary house or apartment that shares the building lot of a larger, primary home.
ADU can be new construction, garage conversion, or conversation parts of the living space in the house.
Due to the lack of affordable housing in California, new legislation was made, And today virtually all single-family homeowner has the right to create an ADU and generate themself.
In California, ADU cannot sell separately (unlike Texas), however, they can be rented separately from the main house.
So what is JADU?
Junior Accessory Dwelling Units (JADUs) are small living units (up to 500 square feet) created out of space within an existing single-family home or an attached garage.
JADU is a legal and regulatory term unique to California and can be built as an accessory unit in addition to an ADU. The Difference between JADU to ADU
ADU & JADU Laws and Guidelines
ADU can be new construction, garage conversion, or conversation parts of the living space in the house and must function as a self-sufficient unit. This means it must have its own kitchen, a full bathroom, a separate electric meter, and a separate sewer line.
ADU laws on single-family property
As of January 2020, California allows virtually all single-family owners to build an ADU on their properties regardless of city or HOA (homeowner association) regulations. The state of California passed a series of laws that provide the absolute minimum benchmark that every city must meet. Again, those benchmarks are the absolute minimum. However, each city can choose to write more lenient guidelines. For this discussion, we will call that ADU state exempts ADU.
To be more specific, we will need to separate the new construction ADU and Converting the existing structure ADU.
What is the size limit for ADU?
As far as size goes, the state benchmark says; that a new construction state exempts ADU maximum size must be not less than 850 sqft or 1000 sqft for more than one bedroom ADU (2 and above). And for cities that didn’t establish their ADU guidelines, the maximum size will not be larger than 1200 sqft, which means that homeowners can choose to build smaller than 850 sqft (or 1000 sqft for 2bds), the planning department of the city must approve any project below 850 sqft as long as it meets all other requirements.
Example #1: 1600 Sqft house with 400 sqft garage
Same house as example #1 plus new construction ADU of up to 850 sqft for one bedroom or studio, and 1000 sqft for 2 bedrooms or more
What is the size limit for converting an existing structure to ADU?
It is a different story when it comes to an existing structure ADU. You can convert any permanent, permitted structure such as a barn, shed, garage, or part of the existing structure or main house without the size limit laws imposed on new construction. Furthermore, if you would like to expand the existing structure, even more, you can add up to 150 sqft without being subject to the size limit of the new construction. That means that if you currently have a 3,000 sqft barn, you can convert the bard to a 3,150 sqft ADU and the city can tell you nothing about it.
Example #2: 1600 Sqft house with 3000 sqft barn
Same house as example #2, only that the 3000 sqft barn converted fully to ADU
Same house as example #2, only that the 3000 sqft barn converted fully to ADU plus 150 sqft were added to the bard as new construction
ADU and percentage of the primary residence? True or false?
One misconception that people have is that there is a minimum percentage requirement for the total size of the house. Although it might be true that each city can enforce a percentage of the entire property, that only applies for units larger than the minimum benchmark of 850 sqft (or 1000 sqft for more than 1bds). That means technically if you own a 700 sqft house and you have an adequate size back yard to meet the required setbacks. (Scroll down for more information) you can build up to 1000 sqft (for more than 1 bds ADU) even if the city allowed only 50% ADU from the original structure. Amazing, isn’t it?
Example #3: 800 Sqft house with 200 sqft garage
Same as example #3 plus new construction ADU of up to 850 sqft for 1-bd or studio, and 1000 sqft for two bedrooms or more. as you can see, the ADU is larger than the main house
With that said, if you want to build more than 1000 sqft ADU, you will be subject to the city limitation even on existing structure conversion.
Go back to the 3,000 sqft barn example. In this case, the city had a 50% limit of the original structure. The main house must be larger than 6,000 sqft to convert the entire barn. If the city imposes a 25% limit to convert barn as a whole, the main house must be 12,000 sqft.
For a city with a percentage requirement, the owner could convert only from the primary house size or up to 1000 sqft, whichever is higher.
For a city with a percentage requirement, the owner must have at least 6000 sqft house to convert the entire barn to ADU
Heights and setbacks
What is the maximum height allowed when building new construction ADU?
As far as height goes, state-exempt ADUs can be up to 16 ft tall from the curb.
However, some cities and counties (Santa Barbara, for example) allow you to build up to 30 ft high or the height of the primary house. Whichever is less.
Can you build two stories ADU?
The short answer is no.
Due to the minimum height requirement of 7ft per floor plus the gap between the feet of 12-14 inches and the space for the roof.
However, the full answer is probably yes. Because the law says that the new construction ADU cannot be taller than 16 ft height from the curb, and it does not limit the floor count.
So technically, if you dig 2-4 feet underground, you'll create enough space for the two stories ADU.
What is setback?
A setback is a minimum distance in which a building or other structure must be set back from a street or road, a river or other stream, a shore or flood plain, or any other place deemed to need protection. In ADU terminology, setback means the distance between the ADU and the property line.
WHat is the minimum setback requirement for ADU?
Any new construction ADU must be built with no less than 4 ft rear and a side yard setback.
However, if you convert an existing permitted structure (such as a detached garage or part of the house), you don’t need to follow the setbacks requirement.
For example, the garage was converted to ADU and didn't need to comply with the setback requirement. However, the new construction on the second floor must yield to the 4ft setback requirement
You can build an ADU regardless of the building zone. The only zone that is important is the fire zone.
My Zone has changed to industrial or commercial, can I still build ADU?
Yes, it is possible to build ADU in any zone, as long as the house itself is a single or multi-family residence. Regardless of the change in zone
Can I build ADU in a fire zone?
You can convert the garage or any part of the house to ADU regardless of the fire zone.
You can also build a new construction ADU in a moderate fire zone, high fire zone, and very high fire zone.
You will not be able to build a new construction ADU if the property is located in a very high fire zone AND on a steep slope.
Please check the Fire Hazard Severity Zone map from the state fire marshal website to check if your house is in a very high fire zone. Click Here.
Do I need to make parking spots to the ADU?
There is a parking requirement for the new ADU and JADU of one space per bedroom. This parking space can be but not limited to cover space, uncover space, tandem space (parking one behind another), or a mechanical lift.
Although there is no parking requirement if the property is located within half a mile from a public transportation station.
Do I need to create new parking if I convert the garage to ADU?
In the case of garage conversion, the number of spaces that were removed due to the conversion needs to be replaced in addition to the new spaces that the ADU and the JADU require. However, there is NO parking replacement requirement if the property is located within half a mile from a public transportation station (bus station, train station, or metro station).
So what is JADU?
Junior Accessory Dwelling Units (JADUs) are small living units (up to 500 square feet) created out of space within an existing single-family home or an attached garage.
JADU is a legal and regulatory term unique to the state of California and can be built as an accessory unit in addition to an ADU.
Although JADU and ADU sound similar, the two couldn't be more different.
What is the difference between ADU to JADU?
JADU must be contained in the existing structure of the main house, which means it can be a converted living space such as a playroom, bedroom, etc. Or a converted, unlivable space that confides within the main house, such as an attached garage (conversion of a detached garage must be an ADU), conversion of the basement, or attic space.
Example #1: 1600 Sqft house with 400 sqft garage
You can choose to convert more than the garage alone to JADU. You can convert up to 500 sqft from the structure to JADU
Lastly, JADU does only need a kitchen, and can share the bathroom with the main house, needs only an electrical sub panel box and not a new meter, and can connect to the main sewer line of the house. All of those will reduce the costs involved in constructing the unit.
JADU can only exist in owner occupied residence, that means that once you, the owner leaves the house to live in a different one the JADU will cease to exist until or you will return or sell the property to a new owner that will live in the house. That is obviously a downside since rental property investors will not be able to use those units as a third unit in the house and potentially lose tens or even hundreds of thousands of dollars during the lifetime of the property.
There is a way to rent all the units: JADU, ADU and the main residence, without breaking the law. It's called land trust. You can create a land trust and transfer the property to the land trust. The state did give exemptions for the next 5 years in the process, allowing investors to use this method to rent all units. The main issue in using a land trust is that the lander might recall the loan and you might need to pay off the mortgage in full. Therefore, before doing anything else, we recommend contacting the bank that holds the mortgage.
Can I covert detached Garage to JADU?
No, in case of any detached structre or new construction you can only convert it to ADU and not JADU.
Example #4 house with detached garage
You can still convert part of the main house to JADU, however the garage must be ADU
Can you add the 150 sqft to JADU as well?
No JADU do not qualify to the 150 sqft addition that allowed with ADU
What is better ADU or JADU?
I would say it depends; it depends if you could do ADU or not. If you can do ADU in addition to JADU I would personally recommend doing both JADU and ADU. However, if you don’t have enough space on the lot for both, building ADU and not JADU is the better way to go
5 Creative layout ideas for ADU and JADU to maximize profit
Example #1 Garage conversion to JADU and 2nd story ADU
Example #3 2nd story ADU for homeowners that don't want to lose their garage
Example #2 two stories ADU
Example #4 two stories ADU plus 500 sqft house conversion to JADU.
Example #5 Garage Conversion to JADU plus house conversion to ADU and addition of 150 sqft to the ADU
What are the main reasons that people are building out an ADU and JADU, and why should you do it too?
There are three main reasons why people build an ADU: Capital gains of tens of thousands; thousands of dollars in passive income monthly; and tax benefits. Now let’s dive deeper into each.
1st Reason – Capital Gains.
What are capital gains? Capital gains are an increase in value above the invested amount.
For example, if you bought a stock for $100 and the market went up to $110, you have made $10 in capital gains once you sell it.
So now let us take a classic 1970, four bed, three bath, 2,200 sq ft livable space, and 420 sq ft 2 car garage home as an example. This house is selling for $1,000,000, or $454 per square foot. As you can see, the price per square foot includes only livable square footage, and the garage is not included.
Now let's say that you built an 800 sq ft, 2-bed ADU in the back yard and converted the 2 car 420 sq ft garage into a one-bedroom apartment JADU (we will go over the difference in the next chapter).
Because of the 50% increase in property square footage and the fact that those 3 units (the main house, JADU, ADU) will be able to be rented for twice as much as the main house alone, the property value might theoretically increase by 40%, or $400,000. (We will dive deeper into how to estimate property value increase in the chapter “The Top 3 Ways to Estimate Property Value”.)
This means that if the construction of the 2 new units will cost $300,000, the owner will have an unrealized gain of $100,000 (versus a realized gain, which is generally recognized upon the sale of the property). However, if the construction costs $450,000, the owner will have an unrealized loss of $50,000.
2nd Reason – Rental Income – Generating Passive Income in Your Sleep
Going back to our example of a house with a 1 bed, 1 bath JADU garage conversion and a 2 bed, 2 bath ADU:
In 2022, the average rent for a 1 bed, 1 bath apartment in Los Angeles is $1,995 a month. Likewise, the average rent for a 2 bed, 2 bath apartment is $2,700 a month. Rental prices tend to increase every year, and I personally would not be surprised to see the price of rent double or even triple in 10 years or less. (as of 1/10/2022, the average rent for 1 bed, 1 bath is $2,200, and for 2 beds to bath $2,964)
Based on the current rental market, our two hypothetical units (the JADU and ADU) in Los Angeles could potentially make $4,695 every month while the owners are still living in the main house. If the rental income is higher than the mortgage, the owners could live in the house for free!
Now if the owners do not have any mortgage, they could pocket nearly the entire amount, or $56,340, as passive income, less any expenses related to the rental units. In comparison, the median household income in the United States is $63,179. It would be pretty nice to make nearly the same amount without even having to work, would it not?
3rd Reason – Tax benefits
The tax benefits from owning a rental property are different from owner-occupied tax benefits, as homeowners are generally limited in itemized deductions they are allowed to take. Owners that rent their property or part of it can potentially deduct additional expenses, such as repairs, maintenance, depreciation, other costs associated with the rental portion of the property, and even the construction costs of the ADU and JADU (over their depreciable lifespan, generally 10 years). Often, those deductions are more than enough to offset the entire taxable income generated from renting those units. This means that the $4,695 can contribute to your cash flow without incurring any additional taxes or may even result in a taxable loss that offsets your other taxable income and thereby reduces your tax liability. In other words, you can have more money in your pocket and less taxes to pay, which is really the best of both worlds.
How much does it cost to build an ADU in california?
Prices for ADU can vary greatly from one project to another. New construction ADU will cost much more than a garage conversion to ADU. while New construction on a hillside can almost double the cost in groundwork and preparation
So how much does a new construction ADU cost in CA?
Ground-up ADU can range from $150,000- $350,000, depending on many factors.
Hillside, two stories, hard access, size, expensive finishing materials, and more will all greatly influence the price of an adu
in some cases, a steep slope hillside can almost double the project's cost.
And building one-story ADU is cheaper than two stories.
What about the cost of garage conversion to ADU?
All things being equal, a garage conversion will cost significantly less than new construction.
With a garage convention to ADU, you can expect the cost to range between $75,000-$150,000.
Here the main contributors to the price difference will be the age of the structure, the distance from the water and the power lines, and finishing materials.
While a garage that was built in the '80s is much easier to covert than a garage built in the '50s.
An attached garage will be cheaper to covert than a detached garage in most cases.
Is garage conversion to JADU cheaper than to ADU?
All things being equal, garage conversion to JADU should be a bit cheaper than to ADU since JADU permits do not require running a new electrical line and can use the main electrical line of the house and only need a sub-panel.
The second contributor to the lower cost for JADU compared to ADU is that JADU can use the main water line and the main sewer line of the house.
Therefore save thousands of dollars with the cost of running new lines to the street.
Is it still worth building ADU and JADU in 2021?
To try to answer this question we must understand a concept called opportunity cost.
According to Investopedia:
Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. To read more Click here
In simple terms, opportunity cost is the amount loss or gain from choosing one investment instead of another.
For our example, we will take the most common investment: Savings, Stocks, Real Estate and compare them to ADU.
Let's start with savings.
Today, a savings account will generate about 0.5% APY, Annual Percentage Yield.
So, $100,000 deposited in a saving account that yields 0.5% will return by the end of the year $100,500. After 10 years the same $100,000 will be worth $105,114 due to compound interest.
The total 10 years return for the savings account is $5,114. Not the best investment tool to use, to say the least. However, savings account is with virtually no risk involved.
Now let us look at the stock market and see its returns.
In comparison to savings, the 10-year average annual return of the S&P500 can range between 3.6%-13.2% and will yield a different return depends when the 10 years started and ended.
Historically speaking an investor that invested $100,000 in the S&P500 at the peak of the DOT com bubble in January 2000 and pull his fund 10 years later in 2010 at the low of the great recession will only have an APY of 3.6%. which means that after 10 years the investor will have $142,428.
So between 2000 to 2010, the total 10-year return for the investor was $42,428.
However, between January 2010 to January 2020, the APY was 13.2%
so an investor that invested $100,000 in the S&P500 during those 10 years will have $345,512.
The big difference represents another aspect of investing; Risk.
in a difference of savings account which the APY is guaranteed, when investing in stocks the returns are not guaranteed and carry a certain amount of risk.
For example, from October 2007 to February 2009 the S&P500 dropped by 53%. therefore an investor that place $100,000 at the peak of 2007 lost more than $53,000 if he pulled his funds a year later. And his total balance was only $47,000
Another aspect to think about when investing in the stock market is that the profits are taxable and it is called capital gain taxes. After holding an investment for more than 12 months the profits are subject to federal long-term capital gains tax. at this moment the long-term capital gain tax rate stands at 15% for households making less than $500,000 a year in income and 20% for houses that make more than half a million in income.
in addition, any capital gain in the state of California is considered as regular income and therefore tax as such (Forbes - What Are Capital Gains Taxes For The State Of California?)
To check what is your tax bracket in California Click here (NerdWallet)
Therefore for the average household, the $42,428 gain between 2000-2010 will be subjected to 15% federal capital gain tax and 9.2% in income tax or $6,264 in federal capital gain tax and $3,903 for a total net profit after taxes of only $30,038.
for the 2010-2020 period the pre-tax profit was $245,512 however after taking taxes into consideration, the net profit is only $186,098, or 11% annually.
with that said don't expect those returns, the 13% return that was made from 2010 and 2020 was extremely rare and it required the investor to believe in the market when everyone else thought that the US economy is about to collapse.
And for that reason, most investors and 401k consider the average return since the S&P500 was established in 1957 when they make their prediction. which stand on 8% annual return.
therefore $100,000 invested today are expected to return about $215,892 in 2031. with net profit after taxes of only $87,846.
Not so bad, but also not great when you had to invest $100,000 for 10 full years.
Another option available is instead of buying stock, you can choose to invest in real estate. Meaning that you can choose to buy another property, rent it out, and sell it in 10 years.
In real estate there are 3-5 factors that influence the profit; Rent collected, profits re-invested in stock, rent increase, increase in property value, and leverage.
Net Rent collected
Rent profits are one of the obvious sources of profit to the real estate investor. Rent profit is the rent collected minus all expenses. such as property taxes, insurance, vacancy loss, repairs, replacement reserves (for large repairs such as HVAC replacement, new roof, or any other high ticket repair) management fees, and more.
The rental yield varies greatly from city to city and from house to house. In short rental yield is the annual percentage return from the total cost of the property.
With a state average yield of 6% (homearea)
Therefore a property that costs $100,000 is expected to generate about $500 a month or $6,000 a year in rental revenue.
for simplicity, about 30%-50% of the total rent collected will be used to pay any expenses.
for example, if the monthly rent is $600, and the monthly expenses are about 40% (based on house condition and other factors) your net profit is $360 a month.
Profit reinvested will derive from the net rent profit after paying all expenses.
that means whatever net profit remains will be reinvested back to the S&P500 with an annual average return of 8% as discussed above.
So if a property generates $1,200 a month or $14,400 a year in net profit. this profit will be reinvested annually to S&P500 to grow with an average return of 8%.
Rent increase rate
The Rent Increase Rate takes into consideration the increase in the cost of living. in California, the average rent increase is about 5% annually from 1980 (Department of Numbers). This means a house that was rented for $2,000 today, could probably be rented for $2,100 the following year, and $2,205 the year after, and so on. Those increases will be reinvested as well to the S&P500.
The average rent for a 1-bedroom apartment in Los Angeles, CA is currently $2,200. This is a 13% increase compared to the previous year.
The average rent for a 2-bedroom apartment in Los Angeles, CA is currently $2,995. This is a 11% increase compared to the previous year. (Zumper)
Increase in Property Value (Appreciation)
An increase in property value is probably the most alluring reason why people invest in real estate, especially when considering leverage (will discuss below). However investing in real estate just for the increase in property value can be a very risky strategy, especially if the expected rent is not enough to cover the mortgage and any other expenses.
Let's examine the 2008 crisis, people bought houses with the conviction that the market will keep climbing forever, and most of them bought houses where the monthly gross rent is much lower than the mortgage and monthly expenses. Therefore when the market turned and housing prices drop by 30%-50% a year between 2007-2009 (GlobalPropertGuide) and people lost their jobs and couldn't pay for the house; the bank had to foreclose on the property and force those investors to bankrupt and lose everything.
With that said appreciation is a very strong profit generator in California. Last year for example; the year to year increase (APR20-APR21) in property value in Los Angeles was 18.7%, Orange county rose by 16.6%, San Diego rose by 15.5% (LA Times), Santa barbara prices rose by 24.6% (Zillow) and in San Francisco and the Bay area, prices rose by 17.8% (Norda)
However, the average year to year appreciation in California for the last 20 years stands at 5.35% (neighborhoodscout.com)
For that appreciation should be the cherry on the top when investing in real estate, and not the only reason. If the fundamental of the investment property doesn't work, meaning if the rent can't cover the mortgage payment and the monthly expenses investing in that property carry high risk, especially when the market is at an all-time high.
As you can see in our example of the S&P500, the tax liability can carry a hefty cost.
When it comes to taxes, selling a property in a profit called capital gain fall in the same tax bracket as the long-term capital gain taxes as in stocks.
However, when renting an investment property, you will need to pay taxes on the net rent collected. Any net income your rental property generates is taxable as ordinary income on your tax return. Generally speaking, the federal tax bracket is 22% for business owned property and your tax bracket for individually owned property (How Is Rental Income Taxed? - RoofStock)
In addition to federal taxes, the owner is also liable to California income tax (for California Tax calculator click here - CA.gov)
Because the amount of taxes owed is calculated based on the total income minus all costs, one of the ways for an investor to keep more money in their pockets is to show higher costs.
Thankfully the government supports real estate investors and provides clear guidelines regarding what costs can be deducted and what investments can be depreciated over time.
So besides the obvious expenses, that we discussed above (repairs, management, replacement reserves, and more)
The Californian homeowner can depreciate the property value (minus the cost of the land; based on market value) in a straight line for 27.5 years.
For example, before buying a property for $100,000 we found out that the cost of the land is 15% of the property value. Therefore $85,000 is divided by 27.5 years giving the owner an annual depreciation of $3,090. This depreciation will be added to the annual cost to offset the taxable amount and increase the investor's net income.
So as our previous example shows for $100,000 the expected rental income is about 6% or $6,000 from that amount we will reduce the 40% expenses or $2,400 and the annual depreciation of $3,090. to a total net rent before taxes of only $510. and for that amount, the investor will pay only $112 in taxes to the federal based on a 22% tax rate, and 47$ to the state based on a 9.2% tax rate.
Putting it all together
In order for us to understand what is the actual return for investing in real estate, we will need to add up all the profit generators.
This time our investor buy a single-family mobile home for $100,000 cash outright. This home generates an average rental yield of 6% a year, or $6,0000, after paying 40% of expenses the investor keeps $3,600 before taxes. however, after depreciation, the investor taxable amount is only $510. after paying his taxes federal taxes for 22% and state taxes for 9.2% he keeps (total of $159) $3,441 and he moved the profit to s&P500 to grow.
In year 2 the investor increase the rent by 5% same as the state average so by the end of the year he collected $6,300, paid 40% expenses or $2,520, and had $3,780 pre-tax profit.
From that amount, he deducted another $3,090 for a taxable amount of $690. Lastly, the investor paid his 31.2% in taxes (federal and state) and he kept $3,565 in net income, which he deposited to his s&p500 investment account which by the way increased by the average 8% from $3,441 to $3,716, so by the end of the second year in his investment account he had $7,281.
in year 3 the investor increases the rent again by 5% so after all expenses and taxes are paid he kept $3,695 and his investment account grow to $7,864 to a new total of $11,559.
After 10 years the investor will have $57,729 (check calcxml) in his S&p500 account.
However, from the total cumulative amount in the investor stock portfolio,
he needs to pay again 32.1% taxes for his profit (exclude the invested amount).
Therefore his net profit from the stock portfolio is $52,446.
In addition, the property value increased by 5.35% on average every year to a total of 68.4% increase of $68,400. So today his property sale price is $168,400.
Due to depreciation, the taxable amount from selling the property is $99,310; and with a 31.2% tax bracket the total tax liability from selling the property is $30,984.
Therefore the net profit from selling the property is $37,416.
So by combining the net profit from selling the house plus the net profit from the stock portfolio the investor will have $95,145. which is just above the average net income from the stock market.
So if the average return in the stock market is almost the same as the average return in all-cash real estate why do people even bother?
The two main reasons are Diversification and Leverage.
Diversification in finance is the spread of one's wealth into several investment tools to reduce risk.
But in our case leverage is the main reason why people use Real Estate as a primary engine in their financial growth.
What is leverage? and how investors use leverage to boost their wealth growth?
Leverage is one's ability to invest more money than what he actually possesses, or in another word, to borrow for investing.
in real estate, we call such borrowing mortgage. If you read this post you probably pay a mortgage for your own house, and a mortgage for owner-occupied properties can be as low as 3.5% from the property value as a down payment.
However for the traditional real estate investor, a mortgage needs to be approximately 80% of the total property value, or in investing terms it means being leverage 1 to 4.
Therefore an investor with $100,000 in his bank account can buy a property valued up to $500,000 (Assume zero closing cost, and the investor has sufficient debt to income ratio).
Now let's take this example:
investor had $100,000, and bought $500,000 house ($100,000 own money, and $400,000 banks money)
The house generates 6% annually in rental yield, which is $30,000 in gross rental income. However after paying the expenses of 40%, the owner net operating income, or $18,000.
This time the owner needs to pay back the bank principle and interest for the $400,000.
as of today, the average interest rate for investment property is just below 4%
Therefore for 30 years fix payment mortgage the investor will pay $1,909 a month or a total of $22,908 a year (chart below shows the breakdown between interesting principles)
Which means that the investor will actually need to dig into his own income personal income and pay $409 every month to pay off his mortgage payment.
However, at the end of the year, the investor will do his taxes; for the property value depreciation the investor will be able to deduct up to $15,454 and for interest payment $15,871 (in year one).
Therefore the investor will actually get money back (in form of credit) to offset other passive income sources. if the investor doesn't have any other passive income sources, the loss will be rolled over for the future years indefinitely until it is being able to be used.
For our example, let's assume the investor has other passive investments and he can use the loss to offset the income from those investments.
As our previous example, the rent in the area increase by 5% annually and the mortgage payments are staying the same.
As we can see, after getting the tax credits the investor needs to spend for the first 3 years money out of his pocket to cover his losses, and only starting year 4 the investor can take the remaining cash flow and reinvest it in the stock market for an 8% annual average return. in this case, those 3 years of losses will accumulate as well.
Here the investor has only $22,860 in his stock portfolio thanks to the rental income. then he will only need to pay $938 in tax for his profits, and his net portfolio will be $21,922.
However, the big payout comes when the investor is selling the property in year 10.
With an average annual growth of 5.35%, the property will be valued at $842,006. The mortgage balance will only be $315,169 and the taxable amount is $496,556, or tax liability of $154,925. Therefore the amount that the investor will have at the time of the sale is $374,036 plus $21,922. Or $395,958 in total.
This means that his net profit after taxes is going to be $295,958 or 295.95%. with an average profit of 14.75% annually.
This average real estate market is not a great one.
therefore the clear winner by a strong margin between stocks and real estate is real estate.
So how all of this relevent to building and ADU?
The reason is that ADU and real estate share many of the same advantages. They're both enjoy the rental income, increase in rental, profit reinvestment option, tax benefit, increase in property value. With one significant advantage, the cost of building an ADU or JADU is much cheaper than buying a rental property.
Here, the cost of building ADU or JADU is fixed and will not vary dramatically between cities. What will influence the construction cost are: a slope, mechanical issues, finishing materials, and much more.
However, for the sake of our example, let us take an approximate cost for garage conversion to 1 bedroom apartment JADU for $100,000 and an approximate cost for new construction two bedrooms apartment ADU for $200,000.
The average rent for a 1-bedroom apartment in Los Angeles, CA, is currently $2,200. This is a 13% increase compared to the previous year. (Zumper)
The average rent for a 2-bedroom apartment in Los Angeles, CA, is currently $2,969. This is a 10% increase compared to the previous year. (Zumper)
At first glance, ADU and JADU give the owner much higher returns than standard real estate investing.
A $100,000 worth of real estate is expected to generate only $6,000 a year rental income based on the 6% expected return. However ADU and JADU provide much higher base returns. For a $100,000 JADU, the homeowner is likely to generate about $26,400 a year in Los Angeles; for $200,000 ADU, the homeowner is expected to generate $35,628 a year.
Also, the expenses are much smaller than a rental property, primarily since the JADU and the ADU are brand new construction for the most part. Therefore the homeowner should expect much fewer repairs and malfunctions. Most of our partners provide ten years warranty for the entire project. Thus the expenses for repair and maintenance should be reduced. In addition, property taxes expenses should be reduced as well.
The property taxes from $100,000 property is about $1,250 a year, however percentage-wise, from $6,000, rental yield is 20%.
However, from the $26,400 rental yield, we expect to pay less than 5% (the $1,250 is the same in both cases).
Also, homeowners can choose not to use a property manager because their tenants are just next door to them and not on the other side of town. So theoreticallythe homeowner can save the 11% for the property manager.
How ADU and JADU depreciate?
Last benift for JADU and ADU compare to standard real estate is deprisiaction; While in real estate a property can only depriciate the value of the structure without the land for 27.5 years. JADU and ADU consider improvement to the house and therefore can be depriciate in full in 10 years.
By how much JADU and ADU will increase the property Value? How to calculate by how much ADU and JADU will increase the Property Value?
As you probably know, calculating precisely how much a property value will increase by building an ADU or JADU is the job of appraisals. It is more art than science, and they are still debating it. Therefore the information in this next part should be discussed with a professional and might change once there is clarity in the market.
However, with that said, we can safely assume that a good guideline for ADU or JADU value will be the 6% rule in reverse. Meaning if the rental yield expected from the property is $6,000, the value it should add to the main house is about $100,000.
With that said, two opposing forces influence the property value regarding ADU and JADU.
The positive force; is the increase in property value due to an increase in square footage, increase in rental yield, etc.
And the opposing force; which is the decrease in property value due to loss of parking space, privacy, and others.
The effect of each force will change depending on many factors. For example, if the property has a long driveway and it is possible to park cars in the driveway, the loss of garage space will be minor compared to a property with no driveway and no street parking.
It means that because there is some trade between comfort and profitability, investors will adjust the 6% higher based on the level of discomfort expected from the additional units.
So how does ADU or JADU compare to Real estate?
Let's take our investor once more. This time the investor takes the $100,000 and builds a JADU garage conversion and pays for it in cash.
He finds tenants for $2,200 a month, or $26,400 a year.
Since the JADU is brand new, our investor will only keep 10% for reserve and maintenance (a number that is probably high), 11% for property management, 5% for property taxes, and 4% for utilities (because JADU shares the same water and electric line). That means that he will have a 30% expense rate.
The area has a standard rent growth rate of 5%.
In addition, our investor will follow the same rule, and whatever cash he has left, he will reinvest it into the stock market for 8% annual average growth.
The investor expects to pay about a 32% tax rate.
With JADU, the investor has much larger returns than a rental property.
In year 1, for example, the Net Cash flow is $15,766 compared to $3,564 for buying a rental property, nearly five times as much.
Therefore, on a ten-year scale, the stock pre-tax's total return is $268,376, and after paying taxes is $243,315.
But how about the increase in property value?
Let us assume that in the time of construction, the investor figures out that there will be some discomfort; however, the investor still has a driveway and can park his car there. In addition, he has enough space in the backyard to put a shed for storage.
Considering all those factors, he figures that the reverse 6% rule will be adjusted upward to 9% to account for the changes.
After building the JADU in Year 1, the property value increased by $293,330. And with a 5.35% annual average property value increase, by year 10, if the investor sells the house, the contribution for the JADU alone to the property value will be an increase of $493,971.
on that increase, the investor will need to pay $158,070 in taxes (at the time of sale), and it will leave the investor with $335,901 net profit from the JADU alone (excluding any increase belonging to the house)
Therefore the total amount in the investor's pocket after the ten years is $579,216, or $479,216 net profit.
That is 19.2% growth.
So what is ADU and JADU ROI when you add leverage?
To calculate the ROI of ADU and JADU with leverage, let's take our investor; he has $100,000 to invest. The cost of both the ADU and JADU combined is $300,000. And the investor decides to use the maximum leverage of 1 to 4. meaning that for doing this project, he will need to use only $60,000 from his own money. He will invest the remaining $40,000 in stocks with an 8% return.
The investor will secure 30 years of mortgage/refinance for building the ADU and JADU. The balance contributed to those units will be $240,000 with 3.5% interest (interest for owner-occupied properties is lower by 0.5% than investment properties). That makes a $1,077 monthly mortgage payment.
The investor will have a one-bedroom JADU that generates $2,200 a month in year one and a 2-bedroom ADU that generates $2,969 a month, to a total rental income of $62,028 in year 1. The rate of rent increase will be 5% annually every year after.
The expense rate will stay 30%, as in the previous example.
Lastly, the investor still needs to pay the 32% taxes rate.
Here we can see that the investor put into his pocket in year 1 $28,857. He will now reinvest that amount alongside any future cash from his rental units, in addition to the $40,000 cash that he had spare.
When the investor decided to do both units and use leverage, his ten-years portfolio was even more incredible with a pre-tax return of $595,116 and a post-tax portfolio value of $533,349.
At the time of the construction, our investor found that he would have to adjust the 6% rule even higher, to 10% due to the discomfort. That means that both of the units had a net positive effect on the property value at the time of construction and appreciated it by $620,028.
Ten years later, with 5.35% average growth. The investor is selling his house and contributing the profit from those units alone to $1,044,135.
After paying off his taxes ($334,123) and the loan balance ($185,843), the investor has kept $524,169 in addition to his $533,349 in his stock portfolio minus his initial $100,000 investment. To a total net profit after taxes of $957,518.
Our investor made nearly a million-dollar or 26.6% annual average return in only a decade.
This investor could be you!
Today nearly all homeowners in California can build ADU and JADU on their property, and if you're thinking all good and well but I don't have the $100,000 to start.
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