Many empty nesters would like to downsize, but because their home loan is locked in at such a low interest rate, it doesn’t make financial sense to move. A friend of mine recently asked if she should build an accessory dwelling unit (ADU) on her property and move into that while renting her big house. The answer is: it depends.
ADUs are sometimes referred to as granny units or mother-in-law units. They are small residences intended to provide visitors with a comfortable place to stay or a place for someone to live separate from the main house.
If you have a lot of visitors and you’d like them close but maybe not in your home, building an ADU is a great option if there’s room on your property. However, if you thought building an ADU would be a cheap way to gain some rental income, you may need to think again, especially if you plan to move into the ADU and rent the main house.
According to a local contractor I work with, building an ADU with utilitarian, apartment-grade fixtures and appliances will run about $300-350 per square foot. Building an ADU with the fixtures and appliances you’d want if you plan to live there will run closer to $450-500 per square foot. So, a 1000-square-foot ADU will cost anywhere from about $300,000 to $500,000.
Based on today’s rental rates, a two-bedroom, one-bath 1,000 square foot ADU in a preferred part of town will earn you about $1,500 per month. The interest rate on a home equity loan to build an ADU would be somewhere in the neighborhood of 7.5 percent on a 30-year, fully amortized loan. Loan payments for a $350,000 ADU would cost about $2,450 per month. Maintenance and upkeep would cost another 3.5 percent, so with loan payments, taxes, insurance, maintenance, and upkeep, you’d be looking at about $3,000 per month. (So far, you’re $1,500 in the hole.)
On the positive side, there are tax benefits to owning income property. You can depreciate your new ADU over 39 years, which amounts to a tax savings of about $750 per month. So, when you add your cash loss of $1,500 to your depreciation expense of $750, you’ll have a monthly write-off of $2,250 per month. You’ll save half of that in taxes, presuming you’re in the 50 percent tax bracket (combined state and federal). As you can see, you’re still not breaking even.
If you have the financial resources to build an ADU, it can certainly increase your property value and provide either rental income to offset your costs or a convenient place for people to stay, but the up-front investment is significant. You need to explore why you want the ADU. If your sole motivation is to earn rental income, consider buying an investment property.
ADUs come with more than just financial costs. With an ADU, you lose privacy and space because you now have someone living in your backyard. You’ll have to contend with an extra car or two in the driveway or in front of your house. Plus, the tenants will have easy access to you; they can simply knock on your door with questions or concerns.
If you have five acres in Redwood Valley and the ADU is on the far corner from yours, that’s one thing, but if you have a 12,000 square-foot lot, there’s no escaping interactions with your tenant. Even if you hire a property manager, which I recommend, you’ll need to look the tenant in the eye and redirect them to the property manager. This can be hard when they know you have the authority to solve their problem.
If you manage the property yourself, you’ll have to deal with filling vacancies, screening prospective tenants, and holding the line with regard to the lease agreement (no loud parties, no pets, no more than four residents, etc.). This is true whether you build an ADU or purchase investment property.
The long and short of it is that ADUs can be handy, but I recommend carefully considering your needs and goals before building in your backyard.
If you have questions about property management or real estate, please contact me at [email protected] or call (707) 462-4000. If you have an idea for a future column, share it with me, and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.
Dick Selzer is a real estate broker who has been in the business for more than 50 years. The opinions expressed here are his and do not necessarily represent his affiliated organizations.
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