What are Accessory Dwelling Units (ADU) and Are They Worth it?
An accessory dwelling unit (ADU) is a great way to increase your property's value, generate passive income, or provide housing for family members or guests.
They're particularly popular in areas where real estate is more expensive because they're an opportunity to invest in real estate where doing so may be cost-prohibitive.
ADUs also have the advantage of having many financing options, making them accessible to many types of investors.
What is an Accessory Dwelling Unit (ADU)?
When you build an additional structure on a property that already has a central unit, then you've got yourself an Accessory Dwelling Unit (ADU). Also known as Granny Flats, Casitas, or In-Law Suites, an ADU can be built on a single-family property, multi-family property, or duplex.
An ADU has everything a resident needs:
- An entrance separate from the main unit
- A kitchen
- A bathroom
- Living space
For this reason, an accessory unit can be rented all year. They also add significant value to your property.
ADUs can be:
- Garage conversions
- Stand-alone units
- Attic conversions
- Basement conversions
- Attached to the main property
What Are the Benefits of an Accessory Dwelling Unit?
Passive Income Stream + Increased Property Value
Your ADU project can generate passive income by being a short-term or long-term rental.
Alternatively, a property owner could choose to live in the ADU and rent out their primary residence instead. Either way, an ADU will also increase the value of your property.
Home for Aging Relatives
Not everyone feels comfortable with their older relatives in a nursing home or retirement community. There are visiting hours to navigate, high quality of life isn't guaranteed, and it may be expensive. With an ADU, you can have your aging family member (or members) nearby or provide a residence for a caretaker. You can also build the ADU to fit its occupants' needs, such as ramps, lower countertops and cabinets, and wider corridors for wheelchair access.
An ADU also doesn't have to be for an elderly family member. It's also ideal for an adult child.
What's the Difference Between a Tiny House and an Accessory Dwelling Units?
ADUs are permanent and sit adjacent to, near, or in conjunction with the main dwelling structure. Tiny homes usually have wheels or exist on small plots of land that have no other buildings.
ADUs can be anywhere where there's already a pre-existing structure, but a tiny house needs a special permit or a small parcel of land just for itself. As a result, it's easier to construct and approve an ADU than most tiny houses.
The laws vary and are evolving on how big a tiny house can be, but they're generally much smaller than ADUs. Meanwhile, the size of ADUs is only constrained by the size of the land they're on, and whatever local zoning rules may apply.
What Are the Different Types of Accessory Dwelling Units?
This is an ADU that's in the back or side yard of a primary residence. They're usually tiny houses with the sole purpose of creating more living space. They can also serve a second function, like a second-floor unit above a detached garage. These structures must sit on foundations, which means RVs and mobile homes don't count.
Since these ADUs are detached, residents can do as they please with little effect on the main property. This is especially appealing for tenants who want a sense of independence. Occupants can come and go as they please and have privacy from the main house.
With a detached ADU, however, you do have extra building and maintenance costs. This includes utility hookups, mechanical appliances (furnace, water heater, etc.). A detached ADU also takes more raw materials to put together.
Attached External Apartments
These units share at least one wall with the primary residence. They still have separate entrances and don't share any internal connections with the main unit. They tend to have their own utility hookups, although connecting them is less expensive since the distance traversed is less. They may share mechanical appliances like a furnace or water heater, but not necessarily.
Attached Internal Apartments
This sort of ADU is entirely a part of the primary residence. You might not even be able to tell it's an ADU at first glance.
These units are usually in a finished basement or attic. They might not have their own entrance, although they will have separate, secured doors that one enters from an internal foyer or hallway.
They tend to share utilities and mechanical appliances with the main unit. Since they require less construction and fewer appliances, they're the most affordable iteration of an ADU.
How Much Does it Cost to Build an Accessory Dwelling Unit?
The cost of building an ADU depends on the cost of labor and materials. Given that an ADU is smaller than a house, you have to make the most of every cubic foot. That means an increased cost per square foot because you don’t get as good of a deal on materials.
Geography will determine the cost. Building a stand-alone ADU in Portland, Oregon, for example, has a median cost of $90,000, according to the Oregon Department of Environmental Quality. An attached ADU is less but still has a median cost of $40 to $50k.
While it’s the case that the Portland real estate market is pricier, given all the expenses, an ADU can be an expensive The cost of building an ADU depends on the cost of labor and materials. Given that an ADU is smaller than a house, you have to make the most of every cubic foot. That means an increased cost per square foot because you don't get as good of a deal on materials.
How to Finance an Accessory Dwelling Unit?
These financing options are ideal for ADUs that are built concurrently with the main house or independently.
Fannie Mae HomeStyle Rehabilitation Mortgage:
These loans are for significant renovations.
- Down payment as low as 5%.
- Private mortgage insurance until 80% loan-to-value (LTV), which is the amount of the loan divided by the appraised value of the property expressed as a percentage.
- Credit score greater than 650.
FHA 203(k) Renovation Loan:
Let's homebuyers combine the cost of major home improvement with purchase loans.
- Ideal for first-time homebuyers who don't have excellent credit.
- Mortgage insurance of 1.75% of the loan's value.
Construction-to-Permanent Loan (All-in-One Loan):
Financing for every part of the home building process from purchasing land to completion then converts into a 30-year loan.
Only one closing necessary.
Short-Term Construction Loan:
Covers ADU construction.
- One-year terms
- Variable interest rates that are higher than long-term loans.
- Once construction is done, the loan converts into a permanent mortgage.
- Second closing is required.
Cash-Out Refinancing Loan:
This is when you refinance for more than your home is worth so that you get a large lump sum of cash.
- Ideal for those with significant equity.
- You may get better rates if they've fallen since your initial mortgage.
- The lump sum of cash is not taxed as income because it isn’t income.
Home Equity Line of Credit:
This is a credit line secured by your equity and has a low interest rate because it's guaranteed.
Unsecured Personal Loan:
Short-term loans ideal for people who plan to sell their homes after building the ADU.
ADUs to Increase Rental Property Cash Flow
An ADU can increase rental income. While an ADU can be used for storage, it’s also great to use as an office, gym, or a home business site. Remote work is changing the future of real estate and many other industries, making an on-property office space very attractive.
The trend of remote work has driven many to leave cities for suburbs and exurbs. Turning an extra room into an office is great, but not every home or family has an extra room. An ADU provides an opportunity for an office space. And, you can use self-showings to decrease the amount of time the ADU spends on the market.
Just remember, if you intend to allow your resident to use the ADU as the site of a home business, that you add stipulations about running a business out of a rental property to your lease agreement.
How to Manage Your ADU
Your ADU is no different from any other dwelling space in so far as it requires maintenance, provides surprising landlord liabilities, could host a tenancy that ends in eviction or early termination, etc. So, just as you would conduct due diligence before renting out a property, you must conduct due diligence before constructing or renting out an ADU.
- Screening to Ensure Successful Residents for Your Rental Property
- How to Handle (and Prevent) Early Lease Termination
- Service Animals & Emotional Support Animals
- Landlord Liabilities That Might Surprise You
- How to Write a (Great) Rental Listing Ad
- Breakdown of an Eviction
- Seasonal Maintenance
- Fire Prevention
- Tax Deductions
Bottom Line on Accessory Dwelling Units
With so many advantages to owning an ADU and routes to constructing one, it's no wonder ADUs are becoming so popular.
They're becoming an increasingly viable real estate investment option for many people, so consider an ADU when contemplating what your real estate investment strategy should be.
And if managing an ADU in addition to your other rental investment properties seems like a lot, consider hiring a property manager.