Chasing Value: an ADU Story

A big new buzzword in the California real estate industry that our legislators believe will scratch the housing itch is ADUs, or Accessory Dwelling Units. Granny Flat, Tiny Home, Guest house, extra house – what is an ADU? If I build one in my backyard, what does that do to the value of my home? I can make a ton of money with these things, right?

Let’s discuss…

In 2020, a mentor gave me simple and elegant advice: Stop buying and develop what you have. Build ADUs on any California assets. From the very beginning, we’ve maintained one asset that nested well in this strategy. How serendipitous that our RE path would bring us full circle back to the beginning.

What made this property special was the parcel size and the Floor Area Ratio or FAR it possessed. After consulting with our architects, we determined we could add a 308 SF attached unit and a 1200 SF detached 3-bedroom/2 bathroom unit. Today, we believe there would have been room to add even more. To replace the lost 308 SF, we would turn it into a new unit; we decided to replace the original master bedroom with an addition on the front of the home where you can see that exquisite “porch.” All told, this business plan would add over 1500 SF of additional livable square footage to the property and two entirely new cash flows off the asset.

This project threw about every contingency situation you could think of at our team. COVID-19, supply chain shortages, City Officials working remotely for the foreseeable future, lumber cost spikes, the sub-meter manufacturer running out of inventory for a year, interest rate hikes, project delays increasing carry costs, and on and on from there.

Smooth seas never made skilled sailors – FDR. Our team exercised crucial RE muscles by adapting and adjusting to each of these as they came up. However, the purpose of this discussion is not to high-five ourselves over how great this went; it is to share a pitfall that awaits those executing this business plan.

Appraisers have no idea how to treat these things… yet. ADUs are such new animals, and our experience highlighted the lack of ability to comp these assets. One appraiser bundled the deck, and the two brand new ADUs in the same line item of value add. Imagine your finished studio apartment, a 3-bedroom home, and a TREX deck shook out to $400K in added value. Yikes! That's a considerable markdown from the construction cost.

Don’t expect to underwrite your ADUs using comparable prices per square foot in your area because the appraisers won’t grant them that much value. Comp’ing your build against multi-family complexes is also difficult because of the zoning discussion. If your property is not zoned multi-family, expect to struggle to justify being compared against existing multi-unit systems. As you plan your execution, consider this during your backside valuations or resale prices. We advise budgeting for some patience in the business plan and keeping any investors you may have brought on board current on what is going on. This strategy does work well on assets intended to be held onto by the original owners for a long time.

There may be some hope on the horizon with AB 1033, California’s new law allowing owners to sell their ADUs like condos. We couldn’t tell you how this system will work from a city planning and subdivision standpoint - it presents a nightmare. You could end up even closer to a nightmare neighbor, and they ain't leaving. From a valuation standpoint, there may be more maturity when allocating the appropriate values to these assets in the future, but only if your municipality accepts this legislation. We’re also encouraged by tax reassessments as these additions aren’t weighted as heavily as expanding the home's footprint or other traditional value-add modifications.

Before embarking on your own ADU play in California, keep those expectations in check and your projections conservative!

Everyone loves a before and after….