What is The ROI of ADU? And is it Still Worth doing ADU in 2022?

The short answer is a resounding YES; ADU is by far the most profitable financial vehicle out there compared to traditional investment.

The Annual Percentage Yield (include year over year growth) for non-leveraged ADU is 19.2%- and the 10-years ROI is 479%. For Leveraged ADU, the Annual Percentage Yield (APY) is 26.6%- and the 10-years ROI is 947%.

Compared to the stocks market, the average APY is about 8%, non-leveraged real estate is about 9%, and leveraged real estate is 15%.

Therefore, the clear winner is an ADU.

If you want to understand how we got to those numbers, keep reading and get ready for a deep dive in the investing world.

What is the best investment in California today?

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.

Option 1 - 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.

Option 2 - Stocks

In comparison to savings, where the returns are gurenteed, in the stock market the APY is not gerentee and can vary greatly. The 10-year average annual return of the S&P500 ranged between a negative APY of -4.98% to 9.7% and will yield a different return depends on 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, when the price of the S&P was 2,303 and pull his fund 10 years later in Jan 2010 at the middle of the great recession, when the price was $1,382 had a negative APY of -4.98%. which means that after 10 years the investor will have $60,008.

So, between 2000 to 2010, the total 10-year return (Loss) for the investor was $39,992.

However, if the investor invested his funds in January 2010 when the price of the S&P was $1,382 and pulled his funds in January 2020 when the price was $3,486, the APY was 9.7% so an investor that invested $100,000 in the S&P500 during those 10 years will have $252,386.

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 $39,992 loss between 2000-2010 will not be subjected to 15% federal capital gain tax and 9.2% in income tax.

For the 2010-2020 period the pre-tax profit was $152,386 however after paying 24.2% in taxes ($36,877), the net profit is $115,509 or 7.98% annually.

With that said you should not expect 10% APY return when investing in stocks. 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.

Option 3 - Non-Leveraged Real Estate

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 5 factors that influence the profit; Rent collected, profits re-invested in stock, rent increase, increase in property value, and leverage.

Net Rental Income

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.

In Los Angeles county the rental yield as of today is 4.7%, in San Francisco is 4%, San Diego %.5.5 (Mangacasa) while in Santa Baraba investors will only yield between 2.4% in the center (Numbeo),

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 pretax profit is $360 a month.

Net Profit reinvested

Rent Increase Rate

Increase in Property Value (Appreciation)

Tax Benefits

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.

Leverage - 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).

Option 4 - Leveraged Real Estate

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)

This 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 a 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.

How does ADU compare to other investments?

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 theoretically the homeowner can save 11% for the property manager.

How do ADU and JADU depreciate?

The last benefit for JADU and ADU compared to standard real estate is depreciation, While in real estate property can only depreciate the value of the structure without the land for 27.5 years. JADU and ADU consider improvement to the house and therefore can be depreciated 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; 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.

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.

what is the ADU and JADU ROI when adding 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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