Photo of a tiny house made of wooden blocks on a grass background with a "For Rent" sign in front of it and the caption "Do ADUs Make Good Rental Properties?"

Are you a seasoned real-estate investor looking for a new, cost-effective investment opportunity? Or do you just want to earn some extra income through rent, without having to purchase a separate rental property?

If the rental market in your area is currently booming, then it is only natural for you to want to take advantage of it. An accessory dwelling unit or ADU can be a simple and affordable way to achieve this goal.

Essentially, an accessory dwelling unit is a smaller, secondary house that is built on the same plot of land as a larger, primary house. So, if you already own a home that has a significant amount of land around it, then building an ADU in your backyard might turn out to be a good investment.

An ADU can either be attached to the main house or be a smaller, stand-alone unit built separately from the primary residence. Typically, building an attached ADU is cheaper and faster than building a stand-alone one.

This is because most attached ADUs are created by converting a pre-existing garage into a small living space. If you have a decent-sized garage, you can easily convert it into an attached ADU. A typical two-car garage would be around 400-450 square feet, which is the perfect size for a small one-bedroom home, or even a studio.

Since the garage already has a roof, walls, and a foundation, converting it to an ADU will be a relatively simple task, and not too expensive. Since you will be doing very little to alter the exterior of the garage – apart from adding windows and a front door – the building process probably won’t take long at all.

ADUs As Investments

Most ADUs, whether they be attached or stand-alone units, will make use of the energy and water connections of the main house. An ADU must also have a separate entrance, as well as its own kitchen and living area.

Depending on the type and location of the ADU, your property taxes might increase and cut into your profits. You should definitely consult an experienced tax professional to fully understand the impact of the ADU on your yearly property taxes before you start building one.

a picture of a small accessory dwelling unit house with brown exterior walls and a pathway going to it
Picture courtesy of Studio Shed. Little ADU’s like these can add extra income on your property for long-term rentals, or even very unique and profitable short term rentals like with AirBnB or VRBO.

An ADU cannot be purchased or sold separately from the main house, but can be rented out for some additional income. It also adds value to the property as a whole. However, exactly how much value is added can be hard to determine until you sell the property, which will probably be several years down the line.

Whether or not an ADU is a good investment for you will depend on a wide variety of factors, including your personal financial situation, the local zoning ordinances, as well as the current and future rental rates in your area.

There’s a lot you will need to know before you can build a high-quality ADU in your yard. Choosing a floor plan, evaluating the associated cost and revenue, and hiring a contractor are just some of the steps you will need to take before you can start the construction process. However, if done properly, an ADU can yield excellent returns on investment over the long term.

Will An ADU Work As A Rental?

Most people usually build accessory dwelling units on their property for one of two reasons:

  • To rent it out to tenants for an additional source of income
  • To house a family member, such as an elderly relative or adult children still living at home

In this article, we will focus largely on the first point–how an ADU can be used to earn additional income through rent.

Whether or not an ADU will work well as a rental depends on a number of factors. Before you build an ADU on your property with the intention of renting it out for some extra income, here are some of the factors that you should keep in mind.

Legal Considerations

This is one of the most important factors you will need to consider before you embark on your ADU construction plan. Building an ADU for rental income will only be profitable if the construction is legal under local, state, and federal laws.

If the project is unlawful, an appraiser will not assign it any value. This, in turn, will pose a major problem if you ever need to sell or refinance your property. No lender will lend money if the underlying collateral was constructed illegally. Nor will an illegally-constructed ADU improve the market value of your property.

Moreover, if you build an ADU on your property without checking the legality of such a construction, then you might be subject to code enforcement action and have to pay a hefty fine. You may even be forced to remove the ADU altogether. So, make sure to do your homework before you begin construction, so as not to lose money on your ADU project.

Photo of two individuals on either side of a desk with a clipboard, pen and a judge's gavel to represent legal advice. ADUs are only good for rental if it's legal in your area.
Make sure you get the information and advice you need before investing in an ADU.

You can check the local zoning ordinances to find out whether or not an ADU would be lawful on your property. A zoning ordinance is simply a set of rules that determines the land-use policies applicable to a particular region or geographic zone.

If the zoning ordinance seems unclear or difficult to understand, you should hire the services of an experienced land-use attorney, to help you better comprehend the legal aspects of your ADU construction project. This will help you understand the restrictions (if any) on the location of a detached ADU, the requirements for additional on-site parking on your property, what types of attached ADUs can be constructed on your plot, and much more.

To avoid legal issues and make the most of your investment, you must be sure to take all these factors into consideration before building an ADU.

Costs & Logistics

Before you start building an ADU in your backyard, you must first consider the potential costs, as well as logistical issues, that you might have to deal with. An ADU will only work well as a rental property if the monthly income you receive (in the form of rent) is enough to cover the expenses you incurred during the construction process.

To avoid overspending, you should first decide on what type of ADU you want to build, and plan accordingly. Building a detached ADU can be quite expensive, as it would typically cost as much as a small house. Attached ADUs are more affordable, especially if they’re constructed by converting a garage or other existing area into a living space. A prefabricated or modular ADU would be another relatively inexpensive option.

The cost of your ADU, as well as the time required to build it, will also depend largely on the size, type, and design of the unit. (Don’t forget to consider making it energy efficient or even net-zero.) Once you’ve decided on the design and the floorplan, you should get bids from many different contractors who have experience building ADUs in your area. This will help you find a contractor or builder that can build you a high-quality ADU without exceeding your budget.

Apart from the construction costs – including labor, building materials, interior design, etc. – you will also need to pay for things like land use permits, attorney fees, and any other financing expenses you might incur. Be sure to take these expenses into account when budgeting for your ADU project.

Additionally, you must check if there are any government-mandated requirements for building an ADU in your area. For instance, are you required to offer your potential tenants additional on-site parking space when you build an ADU? Are there any restrictions involving the location of a detached ADU, or its distance from the main house? These requirements could put an extra burden on your finances, so make sure that you’ve taken all of them into account before you start construction.

Photo of a checklist with a pen laying on it and four boxes checked off in blue ink. There are a lot of steps to check off before you're ready to build ADUs for rental.
Building your ADU will be the fun part after you’ve done all the homework to get ready.

Financing

Financing an ADU might be harder than financing a regular rental property. This is because most major banks (such as Bank of America and Wells Fargo) don’t currently offer mortgage products for the construction of ADUs.

Therefore, if you want to construct a rental ADU on your property and you don’t have the cash, you will have to choose one of the financing solutions listed below:

  • If you have equity in your home, then you can apply for a Home Equity Line of Credit (also known as HELOC) to cover some of the construction expenses.
  • You can also take out a home equity loan against your property, if you want a fixed-rate alternative to the HELOC.
  • If you do not yet have equity in your property, but do have a steady source of income (such as a salary), you can apply for the Fannie Mae HomeStyle Renovation Mortgage or any other type of home renovation loan.
  • Lastly, you can also choose cash-out refinancing to get some cash by replacing your old mortgage for a new one, with a larger amount than was owed on the previous mortgage.

You should do some careful research and analysis to find out which of these financing options is best suited to your needs. Also, be sure to keep in mind that the interest you will be paying on your loan, as well as the lending fees, will add to the overall cost of the project.

You should talk to different lenders before making a decision, so you can choose the one that offers the best terms or the lowest interest rates. Of course, if you would rather not take out a loan of any kind, you can liquify some of your existing assets to raise the cash needed for the construction of your rental ADU.

Rental Rates In Your Area

Before constructing an ADU on your property, you must find out the average rental rates for similarly-sized ADUs in your neighborhood. This will help you predict what your monthly cashflow will be, and whether or not it would be enough to meet your financial goals.

a small white home in the backyard with a wet wood deck around it
Photo credit to Champion Home Builders. Even the smallest of ADU’s in the backyard of a big city, for instance, can bring in big rent. This is due to the general housing supply shortage that is widespread now across the United States. There just isn’t enough land and labor to keep up with demand.

One way to find reliable data regarding rental rates in your part of the city is to contact a real-estate agent who specializes in investment properties. Such agents are typically familiar with the residential rental rates in the areas where they operate. Alternatively, you can also check websites like Trulia, Craigslist, and Zillow to see how much similar ADUs in your area typically rent for.

The rental vacancy rate in your area is also a good indicator of how much you can potentially earn by renting out your ADU. The rental vacancy rate is simply the percentage of unoccupied rental properties or units in your area. The lower the rental vacancy rate is, the higher the rent you can potentially earn per month, and vice versa. A rental vacancy rate higher than 10 percent should be seen as an indicator of an unfavorable rental market.  

You can typically charge slightly more rent for a detached ADU than you would for a similarly-sized apartment unit. This is because detached ADUs offer more privacy and outdoor space than the typical apartment, which are desirable qualities for renters. This is especially true if you have a garden or an open yard surrounding the detached ADU.

Therefore, you can also check out the average rent for small apartments in your area, to get a rough estimate of how much you will potentially earn by renting out your ADU. But when planning your monthly income, you must take into account the fact that your ADU might not always be occupied. There might be months when you aren’t able to find tenants for your ADU. You need to still be able to meet your monthly expenses even if your ADU is sitting empty.

Taxation & ROI

So, is it a good idea to build an ADU in your yard, and then rent it out for some extra income? Well, the honest answer is–

It’s complicated.

An ADU might significantly increase your property tax bill. Moreover, you will probably also have to pay tax on any rental income. These are some of the tax consequences of ADUs that might reduce their profitability and minimize their appeal for real-estate investors. 

That’s why we suggest consulting a land-use attorney and a tax professional, as well as a financial advisor, before you begin constructing an ADU. They will help you determine how profitable an ADU will actually be for you, after you’ve paid all your taxes and dealt with all the upfront construction costs.

If you are committed for the long term, however, an ADU can yield impressive returns on investment. To get a good sense of your potential ROI, you need to take into account all the costs of financing, permitting, designing, and constructing your ADU.

Then, you need to estimate the amount of rent you will be charging your tenants, by researching average rental rates in your area. Subtracting the total cost of construction from your expected rental income will help you decide whether or not the project is worth undertaking.  

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