Are you planning to build an ADU on your property and rent it out for an extra source of income?
An accessory dwelling unit, or ADU, is simply a home that is built on the same plot of land as a larger single-family home. It can be either attached to or detached from the primary residence, but will generally have its own entrance, kitchen, living room, bedrooms, etc.
If properly planned and managed, an ADU can be an excellent source of rental income, as well as a profitable long-term investment.
The average rent for an ADU will depend both on its size and location. For instance, a detached, two-bedroom ADU in the city of Hayward, California could potentially fetch $2,300 to $2,500 per month in rent. On the other hand, a one-bedroom ADU or a studio in the same area would garner around $1,500 per month. Two-bedroom ADUs in Texas can typically be rented out for about $1,600/month.
Taken on their own, however, these numbers can be misleading.
To get an accurate idea of how much you can potentially earn by renting out your ADU, you will need to consider the costs of building and maintaining an ADU, and then deduct those costs from your rental income.
Only by deducting the total expenses involved in maintaining and operating the ADU from the monthly rent will you be able to calculate your actual income from that ADU.
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Potential Expenses Involved In Renting Out Your ADU
Building and operating an ADU on your property involves certain recurring expenses. You must carefully calculate your potential expenses before setting up an ADU as a rental unit on your property.
To help you make a decision, here’s an example to illustrate the potential expenses of building, maintaining, and renting out your ADU. For the sake of convenience, let’s imagine that you’re planning to build a two-bedroom ADU in California.
When the construction of the ADU is complete, and you’re ready to rent it out to your very first tenant, here are some of the most important operating expenses that you will have to bear.
- Property insurance premiums: You will need to extend your current property insurance policy to provide dwelling extension coverage. This will cost you about $1,000 per year, or a little over $83 a month. You might also opt for a separate rental dwelling insurance policy, which will cost you about $600 a year (for $300k worth of coverage).
- Property tax: You would also have to pay an annual property tax amounting to approximately 1.2% of the total cost of the accessory dwelling unit. Depending on how much you paid for the construction of the ADU, this could amount to a yearly expense of about $3,500 to $4,500, on top of the property tax you already pay for the primary residence.
- Utility upgrades: If your primary residence was built a decade ago or more, then the electrical panels probably weren’t designed to support a fully functioning, secondary residential unit. In such a case, you will have to upgrade your standard 100-amp panel to a 200-amp panel so that it can easily operate two refrigerators, washing machines, and the extra air-conditioner.
- Landscaping costs: ADU landscaping is a relatively new area of landscape design, and it might require you to significantly modify the property’s pre-existing landscape. Landscaping is particularly important if you’re building a detached ADU, such as a backyard cottage. (Click here to learn more about detached backyard cottages or ADUs). Regular landscaping services might cost you about $50 a month.
- Mortgage payments: This will depend on the amount of the loan you have taken out in order to finance the construction of your ADU, as well as the type of financing you’ve opted for. It is hard to arrive at an exact figure, but the average homeowner can expect to spend an additional $1,000 per month on mortgage repayments after constructing an ADU.
- Vacancy expense: There will be times when you are unable to find a tenant for your ADU. For every month the ADU is vacant, you will essentially be losing money, as you will have no rental income but most of the maintenance costs will stay the same. It’s a good idea to set aside about 5 percent of your rental income every month to pay for the operating expenses when your ADU is vacant.
- Maintenance services: You will probably have to pay an additional $150 to $180 per month for various maintenance services such as trash collection, water supply, and septic. These services are essential for the health and wellbeing of your tenants, as well as the care and maintenance of your ADU.
After taking these expenses into account, most homeowners in California could earn a rental income of about $500 a month from a two-bedroom ADU. Of course, this number is just a rough estimate, and may not align with your own experience constructing and renting out an ADU.
The Rental Housing Market
The state of the housing market will also determine how much money you can make by renting out your ADU. The rental vacancy rate in your area – which measures the percentage of rental units that are currently vacant – might be a good indicator of your potential income from renting out your ADU.
If the rental vacancy rate is below 7 percent, then you can assume that the market is healthy and you will be able to earn consistent rental income from your ADU. However, if the vacancy rate is above 7 percent, that means many rental properties in your area are sitting vacant. In that case, you might have a harder time finding tenants who are willing to pay the rent you desire.
While these averages might be a good starting point, you must do your own research about the typical rental vacancy rate in your chosen city or suburb. These rates can vary widely, even in different areas of the same city. Similarly, metropolitan areas typically have a much lower rental vacancy rate than rural areas, even within the same state.
There are a handful of ways in which you can determine the “normal” vacancy rate for rental properties in your chosen area. You can contact a local real estate agent who is experienced and reliable. They will be able to help you calculate the average rental vacancy rate over the last few years.
Alternatively, you can check if any local real estate associations publish monthly or quarterly reports on rental activity in your city or county.
Reputable property management companies can also be a good resource, since they would most likely have reliable vacancy rate data for the areas in which they operate. They would also be willing to share this data with someone who might be a potential client. Make sure you ask for the market average vacancy rate, as opposed to just the rental vacancy rate for the properties that they manage.
You can also gain similar insights from the local government, or more precisely, from the local community development department. They will almost certainly have data on the rental vacancy rates in the local market.
You can search the website of the local community development department to see if the information has been published online. If not, you can directly contact an official working at the department.
Making The Most Of A Rental ADU – A Case Study
As a case study, we can learn from the experiences of Chris D., who spent $190,000 to build a 1,250-square-foot single story ADU in the state of Washington. This ADU was located in a rural area, just outside the city, and in one of the top school districts of the state.
As down payment, Chris D. put down more than 30 percent of the total cost of the ADU. This minimized the monthly mortgage payments, as the loan amount was relatively low.
He financed the ADU with a line of credit borrowed from the Washington State Employees Credit Union (WSECU). (Click here to learn more about other potential sources of ADU financing.)
The ADU was constructed in a little over four months, with a down payment of $35,000 and a credit line of $155,000 for the remaining expenses.
Once the construction was complete, the ADU was rented out for $1,895 per month, with an additional $180 for maintenance services like water, trash, and septic.
The total rental income – just a little over $2,000 – was well below market value, allowing Chris D. to choose from a list of several qualified potential tenants.
After paying for all the recurring expenses associated with ADU ownership (like additional property tax, insurance, maintenance costs, and increased mortgage payments), he brings in a little over $560 in net rental income every month. Most of the rental income is currently funneled towards repaying the loan, before it is used for anything else.
Considering that the initial investment made by Chris D. was the down payment of $35,000 for the ADU, the net rental income of $560 per month is equal to a 19 percent return on investment, annually.
Clearly, this is a higher ROI than most other types of investments can offer. However, it can be less consistent, as the income would stop completely without a tenant in the ADU.
Factors To Consider When Renting Out An ADU
You can find tenants for your ADU through a property management company or by placing ads in the newspaper or websites. Word of mouth from friends and relatives might also help you find some potential tenants.
To ensure that your ADU will be well-maintained and cared for, and that you will always receive the rent on time, you will need to come up with a reliable system for screening potential tenants. To start with, you should ask a potential tenant for a copy of his or her credit report.
If you don’t want to learn how to analyze credit reports on your own, you can hire a credit reporting agency. This can be especially useful if you do not have any experience in assessing credit information and are not entirely comfortable doing so. The company will be able to analyze every potential tenant’s rental history and references, as well as their ability to pay non-refundable fees and deposits for the ADU.
You must also ensure that there is a written rental agreement between you and your tenant, to avoid unnecessary stress and arguments for all parties.
Some of the shared concerns – on which you should reach a clear agreement before renting out your ADU – include the splitting of utility bills, the proper use of outside space, and the division of parking space.
Here is a list of the things that must be included in your lease or rental agreement:
- The date by which the rent must be paid every month
- Whether or not pets are allowed in your ADU
- How many and what types of pets are allowed
- Whether the utility costs are included in the rent
- Whether or not smoking is allowed in the ADU
- Whether parking space is included in the rent
- What kind of access the tenant will have to the yard or lawn
You can choose from a wide range of lease agreement templates available on the internet. Make sure to read templates carefully before choosing the one that best suits your needs. Then, you will need to edit the chosen template to ensure that it covers everything that is relevant to your rental agreement, with no extraneous clauses.
You can also hire a property management company to draft the rental agreement and collect the signatures on your behalf, if you would like to save yourself some time and effort.
You can check out websites like Craigslist, Zillow, and Trulia to determine how much rent you should be charging for your ADU. Go through similar listings in your area to find out how much rent other homeowners are charging, for ADUs of a similar size and type.
You can charge a little extra if you’re offering amenities like a washer and dryer, a pet-friendly compound, included utilities, or a month-to-month lease.
If the property is located close to a university, a shopping area, or some other popular location, you will be able to charge a higher rent for your ADU than if you live in a more rural or suburban area.
Be careful to take all these factors into consideration, before deciding on a rent that will cover your costs and allow you to earn a good rental income, while also making your tenant feel like they’re getting a good deal. After all, keeping your tenant happy will save you the hassle of having to look for new tenants every few months.