A small ADU can be worth over $1,000,000!
No, that is not a misprint. Or an exaggerated number.
In fact, I am going to show you exactly how building one new 650 square foot ADU is projected to add over $1,000,000 to my net worth over the next 30 years (hint: you can copy this exact formula and do the same thing).
ADU Investment Assumptions:
We are going to assume that you, like I do, own (or are in the process of buying) a residential home in Los Angeles. You have heard about ADUs and decided you want to build a detached ADU in your backyard. When complete you will use your new ADU as a long-term rental property.
Your budget for the ADU is $180,000 (including all design, construction plans, permits, labor and material). A $180,000 budget will cover the cost of a nicely appointed, well designed small house which will be easy to rent and is built to last. A full break-down of costs for building an ADU in California can be found here.
You are going to finance the ADU cost with a 30-year fixed rate loan at a 3.5% interest rate via a refinance, construction loan, or Home Equity Line of Credit (HELOC). There are many other ways to pay for the design and construction of an ADU, but for this article our assumption is that you are going to finance the cost with a 30-year amortized loan.
Once the ADU is complete your home will be worth at least $300,000 more than it was without an ADU (based on an assumption of $461 for average resale homes in the neighborhood). The average price per square foot for residential single-family homes throughout Los Angeles County at the end of 2020 was $552, so our assumption of $461 is a little low and conservative. Like I said, we want these numbers to be realistic and show the true value an ADU can provide.
We are going to assume an annual home appreciation of 3% (based on historical averages). Over the last 10 years the annual home appreciation in Los Angeles County has been about 6.5%, but over the course of 30 years the annual appreciation should be closer to the historical average of around 3%.
As we stated before, your new ADU will be used as a long-term rental. We will assume the monthly rent will start out at $1,650. $1,650 is the current median rental rate for one-bedrooms in Los Angeles County so we will use this number. Although a detached ADU should bring in more than the median rent as it is a small stand-alone home with no shared walls, and in most cases will be designed to have dedicated outdoor space. So, your new ADU should have no problem renting for $1,650 or more.
Finally, we will assume an annual rent increase of 2%. This is a very modest increase based on historical rental rates and I believe gives you a realistic expectation of rental rate appreciation.
ADU Investment Returns
Given these assumptions your initial investment of $180,000 will grow to $1,229,479 over the next 30 years. $1,229,479! Amazing.
Of that $1,229,479 approximately $321,000 will come from rental income for renting the ADU long-term, and the rest will come from price appreciation and paying down your ADU loan.
Now that we've agreed on our ADU investment assumptions, let's take a closer look at how we calculated these investment numbers.
Development Return on Investment (ROI) and Property Price Appreciation
Our initial investment is $180,000. That is the cost we are going to pay for designing and building the new ADU, but the value it adds to our property will be $300,000.
That means that our initial investment of $180,000 has an immediate return of $120,000, which is almost 67%. This is our Development ROI and it is the return we receive for taking on the risk of building the new ADU. It is a really nice return and is the exact reason real estate development is such a lucrative field of investment.
So, now our property is worth $300,000 more than it was before we added the ADU, but we are not done yet. Historically, homes appreciate at about 3% per year. If this historical rate of appreciations stays consistent at 3%, we would expect the ADU to be worth $728,179 at the end of 30 years.
And if we subtract the $180,000 we originally paid for the ADU, we're left with $548,179 of appreciation gains over the 30 years of ADU ownership.
ADU Rental Income
As we discussed earlier in this article, we are assuming that our new one-bedroom ADU will rent for the Los Angeles County median rent of $1,650, or $19,800 per year. Not all of that is profit as we will have property taxes, utilities, advertising expenses, and routine maintenance to take care of which we will have to pay out of the gross rents. As good rule of thumb is 30% of our gross rental income will be used to cover expenses related to operating the ADU as a rental unit, which leaves 70% as the Net Operating Income (NOI). 70% of $19,800 is $13,860.
And since we assumed that we are going to pay for the $180,000 cost of our ADU with a 3.5% loan amortized over 30 years, we will have a monthly loan payment of $808.28. Or $9,699.36 per year.
If we take our NOI ($13,860) and subtract our loan payments ($9,699.36), we are left with a $4,160.64 in cash flow in the first year of operation.
As the years go by, we can increase the rental income, which will improve our cash flow. Remember each year we assume we can increase the rental rate by 2%. For example, in Year #10, the monthly rent we will receive from the ADU is $1,972 (or $23,664 per year), while our expenses will remain relatively the same as they were in year #1. This means in Year #10 our cash-flow will be closer to $6,800 per year.
When all is said and done at the end of 30 years we will have collected approximately $583,000 in gross rental income, and $321,300 of that will be NET income, meaning it goes directly to our bottom line as cash flow.
ADU Loan Payoff
The ADU has been appreciating and you have been making money every month on rental income, but you've also be diligently paying your loan payment every month too. And a portion of that payment has gone to the loan's principle balance every month. And at the end of 30 years you will have paid back every cent of the $180,000 you borrowed to build the ADU.
That $180,000 is now equity in your home or will be cash in your pocket when you sell the property. And it was paid-off 100% by the renters that occupied your ADU over the last 30 years.
ADU Investment Summary
Price appreciation, rental cash-flow, and paying off the loan all add to the income we receive over the 30 years of ADU ownership. Added together these factors generate a total of $1,189,815 of income and equity to your net worth.
|NET Cash flow
$1,229,479! It is a phenomenal number and is equal or greater than most people need to enjoy a nice relaxing retirement.
These new ADU laws have opened a huge opportunity for California homeowners to participate in wealth creation through real estate development and long-term rentals.
So what are you waiting for? Get started today and enjoy the financial benefits of an ADU for years to come!