The ADU Guru
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
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 APY 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.
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.
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.