Refinancing my Property with an ADU

Payback Rate--better than previously stated?

With my main house rented out, I have no living costs. In fact, the main house is generating a substantial monthly profit. Financially, the main house/ADU combination is working out far better than I initially expected.

Based on the assumption that renting the ADU would cost me $1,000/month, I had previously stated that the payback period for the ADU was 8 years (8 years x $12K/year=$96K). However, these initial calculations did not include the income that I am now generating from the main house each month. The main house is generating ~$1,000/month on top of the monthly PITI payments. In other words, the profit from the rental income from the main house will pay entirely for the cost of the ADU in eight years (8 years x $12K/year=$96K).

In four years, the main house will have generated $48K in profit (48 months x $1,000), and I will have saved $48K in ADU rent (48 months x $1,000). Therefor, it’s valid to say that the payback for the ADU is actually four years, not eight years.

You can figure out which payback rate calculation makes sense to you, but given that "living expenses" are typically "expenses" instead of "income", both payback rates are phenomenal. Rather than a “living expense”, my living situation provides a "living income". Consider that a renter paying $1K/month would spend $96K over the same eight years living in an equivalent space.

Each financial scenario will vary greatly for homeowners who build ADUs. Most will somehow finance the cost of construction. And, for most, the cost of financing an ADU will likely be less than a realistically achievable rent. Any difference between monthly finance payments and the rental income is good for the owner. The full financial benefit will come when the ADU is fully paid off.

Clarification about Total ADU Cost

In one of my ADU classes (the next class will be April 14th), a class participant astutely pointed out that I hadn’t included my personal labor in the ADU cost calculations. I spent $96K building the ADU (or $110/sq ft), but this cost does not include the value of the personal labor that I put into the ADU, which I’d estimate at ~$15K. So, it’s fair to say that the ADU really cost $110K, or $137/sq ft.

That said, it’s also fair to say that the ADU is actually 1,000 sq ft of conditioned, livable space, instead of the 800 sq ft counted by the City.

If we count the total cost of the ADU as $110K (instead of $96K), and the total space as 1,000 sq ft (instead of 800 sq ft), the cost is still in line with my initial calculation of $110/sq ft.

Distilling narratives from financial data like this reminds me of a funny phrase I read in a NY Times article recently: “All the data in the world can’t teach us how to sift through data”.

Mortgage Payments

Now that the ADU was built and permitted with the City, I also wanted to take advantage of the equity that I added to the property in building the ADU in terms of my mortgage payments. When I purchased the property in December of 2010 for $325K, I got a fantastic FHA loan in which I only had put down 3.5% of the principal costs--the loan was at a 4% interest rate--- historically, this is very good rate. My mortgage payments (including Principal, Interest, Taxes, Insurance --a.k.a. ‘PITI’) were ~$1,900/month for the main house and property.

With only 3.5% down (~$10K) for the initial property purchase in 2010 ($325K), I was required to pay mortgage insurance, which amounted to $233/month. If I refinanced with a conventional "80/20 loan", I’d be able to drop the mortgage insurance, saving $233 each month. To refinance the property though, I had to prove that I now had accrued '20%' equity in the property.

I needed to prove that the equity I’d added to the property by adding the ADU, was equal to 20% of the total loan amount. The property (the main house and ADU and their shared lot) needed to appraise at $398.75K (80% of $398K = $319K) in order to qualify to refinance with a conventional loan (without mortgage insurance).

Amazingly, interest rates in 2012 are even lower than they were in 2010, and I was able to get an interest rate lock to refinance the property at 3.875%. Since the housing crisis in 2008, loans are more difficut to secure than they used to be. A rate lock is only useful if one can prove that the property is a safe investment for the cautious lenders. This is probably a good thing---this means that one’s personal finances have to be in order, and that the property must be worth an amount to justify the amount that is being loaned by the bank to the homeowner.

The Appraisal - A Non-Trivial Matter

I was lucky to have Taylor Watkins as the home appraiser. Taylor was the co-author of a recent study entitled Understanding and Appraising Properties with ADUs. Based on the findings in this paper, Taylor used the ‘Income-Based Valuation’ appraisal method in addition to the ‘Cost to Build’ and ‘Sales Comparison’ methods to inform his ‘opinion of value’ for the property.

Using the ‘Income-Based Valuation’ method, Taylor determined that the house would rent for $2,100/month, and the ADU would rent for $700/month, totaling $2,800/month. When appraised as an income-generating property, using a ‘gross rent multiplier’ of 145, the total value of the property came out to $406K ($2,800 x 145=$406K).

Even though the appraiser determined that the ADU could rent for $1,000/month, he deducted 30% of that theoretical ADU rental value based on fact that the land is shared with the main house. This 30% discount calculation was one of the ADU appraisal methodologies discussed in Taylor and Martin’s recent study on the Appraisal of ADUs.

---In reality, both of these rental income estimates are less than the actual rental income. I have been able to rent the house as a vacation rental for $3K ($900/month more than the estimate) for the last several months and I suspect that I could rent out the ADU for closer to $1500 ($800/month more than the estimate). ---

Using the comparable sales method, Taylor determined that 'comparable properties' had sold for $400K. Using ‘Income-Based Valuation’, the comparable sales method, and the ‘Cost to Build’ method, Taylor then determined his ‘opinion of value’ for the property to be $400K.

Without the aid of the income based valuation, which is rarely used in single family home appraisals, the opinion of value would likely have been lower. This method is also discussed in their recent study.

With the appraisal coming in at $400K, my loan was approved, and I was able to secure it. Without the $233 mortgage insurance burden, my new 30 year, conventional mortgage payments (with interest and taxes) will be reduced by over $200/month, to $1,700/month.

And yes, for those still following me, this refinance actually reduces the payback period for the ADU down by 5 months (to 3 years 7 months)...but who’s counting?

Working with my great and talented mortgage lender, Heather McGarry, who has personal and professional experience with ADUs, we followed the guidance document below. I’d encourage anyone dealing with an appraisal of a property with an ADU to reference this guidance document.

Guide to Appraising ADUs


I’m attaching the actual appraisal here as well. I hope that referencing it, as a companion piece to the aforementioned study and Guide to Appraising ADUs shown above, will aid future homeowners, lenders, and appraisers, who are seeking to fairly appraise a property with an ADU.

Appraisal of Property with ADU

(update- 3/13/12: My mortgage adviser, Heather McGarry, has authored a piece about this same refinance transaction from her perspective on accessorydwellings.org)

Financing Your ADU

There are two main barriers for homeowners who wish to build an accessory dwelling unit. One barrier is zoning and building codes. In many municipalities, due to existing building, planning, or zoning ordinances, ADUs simply aren’t allowed. 

The other barrier, which is equally formidable to those who live in places that DO allow ADUs, is the capital cost required to build an ADU. Many homeowners are intrigued by the idea of building an ADU, but financing an ADU in real life is daunting. This post is a detailed exploration of costs, funding approaches, and other options that you can consider in order to fund ADU construction. 

As I’ve written about in a previous post, my personal top priority for this project was to create a financially sustainable living situation. I see ADU’s as a very sustainable way to reduce living expenses, and even a way to generate significant income. However, the initial expense was a formidable barrier for me, as it is for everyone. Case in point: I estimate that my project will end up costing about $92K; you can read more about that cost breakdown.

How much does it cost to build a custom ADU?

Design/build cost for new construction ranges between $100-175/sq ft for a small, fully livable dwelling unit. For an 800 sq ft ADU, one should count on spending $80-140K, depending on the style of construction.  

For the purpose of this blog post, let’s say that we plan to build a 400 sq ft ADU. At $100/sq ft, we'd only spend have to spend $40K. However, smaller structures tend to cost more per square foot. For a 400 sq ft ADU, you should count on paying closer to $125-$200 per sq ft (aka. $50K-80K).

This increased cost is due in part to fixed costs. For example, no matter how small the structure that you’re building, you’re probably going to have to pay at least ~$5K just for plumbing, $5K for electrical and $3-5K for a permit. For a 400 sq ft ADU, you man end up spending almost as much on plumbing, electrical, and permit as one would spend designing/building a 2000 sq ft house.  My point is that you'll save money on most of your costs by building smaller, but there is a diminishing return on building smaller in terms of savings. 

Major Design Considerations that Significantly Reduce Design/Build Cost: 

• The cost for pre-fabricated houses is considerably less than custom new construction. Here’s an example of very pretty prefabricated cottages that start at $14K. I don’t know how to permit a prefabricated cottage as an ADU, but this seems to be a viable ADU design option to pursue if you’re on a very tight budget. Also, consider “tiny houses” or trailers if your budget is limited to about $10K.
• You can save big dollars if you build a “detached bedroom” or structure under 200 sq ft that does not require its own plumbing or kitchen. If you are just looking to expand the livable space of your property to build a guestroom or office, you can dramatically reduce your projects costs by simply not constructing an "Accessory Dwelling Unit". In Portland, structures under 200 sq ft don't even need to be permitted. However, such structures also not supposed to have basic building services that do require permits, such electrical, plumbing, or heat. Plenty of people reside in such structures though.
• Obviously, the more labor that you do not pay others to do for you, the lower your total design/build costs will be. I’ll cover this in much more depth below.
• According to one builder and an article that I have read on the matter, the costs for converting an existing garage are approximately the same cost per square foot as new construction (depending on the condition of the foundation and structure). Building an ADU from an interior carve out or bump out from an existing house, basement, or attic, are considerably less expensive than a standalone detached ADU. 
  

Building a Non-Permitted ADU:

In Portland, you can count on paying between $3-6K for an ADU permit. Nationally, where ADUs are allowed, permit fees will vary greatly by municipal and county jurisdiction. Portland has conventionally required System Development Charges for ADUs, which typically cost about $10K. However, through June 30th, 2013, Portland has waived System Development Charges for ADUs as a regulatory incentive to promote ADUs. You can read the City of Portland’s full stately and elegant policy statement about this issue here (I think it’s a great read, actually).

Read the full ADU system development charge waiver policy here

Non-permitted ADUs are cheaper to build. There are major drawbacks to building without permits,  but I understand why people would choose this option. A single conversation with a city planning officer, who tells you that you can not build where you would like to build, or that you would need to replace what you thought was a perfectly solid foundation in order to build a permit-able ADU, may be enough to spur you to bypass the permitting process altogether. 

In fact, one local study of MLS listing descriptions indicated that only 38% of ADUs in Portland were actually permitted -- most of the ADUs in Portland have not been built to code nor permitted. So, if you choose to go this route, you're not alone. And, where ADU's aren't allowed by code, you may feel that building without permits is the only option available to you. Interestingly, Tiny Houses were born as a smaller dwelling option that exploited a regulatory loophole that allows smaller, accessory houses---as long as they're on wheels.

Financing Options

1) Savings and Liquid Assets

The easiest and best way to finance an ADU is with pre-existing savings, but most of us don’t have $50-200K cash to spare. But, think it over. Maybe you have a retirement savings 401K plan against which you can borrow cash. Others may consider selling stocks other property to generate sufficient capital. And, some people may have family or relatives who are willing to loan you money at a low interest rate. 

Remember that even a 3% interest “family-loan” rate is a better rate that most retirees can reliably get for their retirement savings in this sluggish market, so this investment loan may be more appealing to your endowed elders than you would think.

2) 203(K) Loan

For those who are purchasing a new home, consider wrapping an ADU construction loan into your mortgage. FHA 203(k) loans are intended for people who are buying a home and want to make repairs and renovations to the property.  The program is supposed to help revitalize/rejuvenate the country's existing housing stock.

The rules for 203(k) loan projects that can qualify are a bit vague.  The rules do say that you must rehab an "existing dwelling" but they also say that you can buy a house, raze it and use the program to build a new house as long as you use some of the existing foundation.  So it's not really written with ADU's in mind, but it seems you can get an ADU project to qualify if you have an existing structure like a garage that you're going to "convert".  

Some banks who want to sell these loans have decided to read the FHA rules in a way that makes ADU projects possible, and then they ask an FHA underwriter to review site plans on a case by case basis.  Some loan officers at some banks that will tell you that you can't build an ADU using the 203(k) program.  Some loan officers are  on the opposite side, actively trying to sell the loans to people who want to build ADU's.

203(k) loans take a lot of planning and work up front. The bank tells you that from the day you have an accepted offer on the house, you have 30 days to submit to them all of the paperwork necessary for them to order an appraisal for the whole (house plus ADU) property. That means, in those 30 days, you need to be able to submit a full bid for the construction, down to some fairly detailed items like what  type of flooring, countertops, appliances, paint, windows, doors, etc.  Basically, they want to know everything about the ADU so they can value it accurately.  Once you submit all of the required forms you're required to work with an FHA Consultant, who has FHA forms to fill out with all of the specifications and expected costs on a line item basis), the bank orders the appraisal, and then your loan processing starts and will be complete in another 30 days.  So it's a total 60 day closing period (minimum).  So you need to have a seller that's okay with that time frame.   

This loan could potentially work if you could use part of an existing structure to make an ADU.  So, this low interest federal loan option is great to consider if you are buying a new house, are already eligible for a 203(k) loan (check with your loan officer), and are interesting in converting part of your house or converting your garage to an ADU.

3) Refinancing An Existing House

Refinancing a home to help you finance an ADU may be a good option to consider if you already have substantial equity in an existing house and the payback calculations for an ADU work out in your favor. And, refinancing has fewer strings attached to it than construction loans.

4) Remodel Construction Loan

Very few banks have taken this step, but according to this article in the Daily Journal of Commerce, at least Washington Federal has made the logical leap to giving out remodel loans for ADU construction. Here’s Washington Federal guidance about their “All in One” loans. 

In general, the difficulty with construction loans is that their rules are more strict, the interest rates are higher, and banks don’t know how to accurately evaluate the value of ADUs yet, so banks are reluctant to give a loan out that assumes a particular dollar value for them.  

5) Live-Work Trade

This next idea is a great option for younger homeowners with relatively little financial capital, and who have talented builder friends. There’s plenty of ways that a live work trade could be structured. If you’re planning on using the ADU as a income generating guest house, you may be able to figure out a fair way to split the costs with relative or friend, making them an business partner in your micro-venture. Here’s one example of a work-trade arrangement: 

Someone I know built a beautiful detached living space in Portland. Simultaneously, he also built a new bathroom and kitchen attached to an existing garage. The detatched bedroom has close, convenient, and private access to both amenities, although it is not physically connected. This detached bedroom structure is approximately 200sq ft, and the materials for the kitchen, bathroom, and detatched structure cost about $15K. He worked with a builder on this project for a year, and rather than paying the builder with cash, the builder had free rent in the bedroom for a three year period, which they valued at $30K. $30K is the amount that he would have paid the builder if he paid the builder with cash instead of free rent for three years. 

This project is about 320sq ft, and cost about $45K (~$140 sq ft). However, because of the live work trade arrangement, and the lack of permit fees beause it isn’t considered an ADU, the whole project only cost him $15K in cash.

This kind of bartering arrangement is wonderful, and indeed, can work out to be very favorably for all parties financially, personally, and professionally. One drawback is that the ADU is not going to generate any income for the homeowner for three years. And, the builder is going to living on their property, which may not be an option for many homeowners. But, if you don’t have access to a lot of capital, a live/work trade option may be the be right option for you.  

As another benefit, since both the homeowner and the builder were very personally invested in how the project came out, the structure came out looking gorgeous.

How to Lower the Design/Build Cost of Your ADU through Time, Labor, and Materials

The amount of work that the homeowner does in designing/building an ADU will vary from none of the work, to all of the work. I suspect that most homeowners who are designing/building a custom ADU are going to want to be at least a little bit involved in the design process, if not the building process. 

Personally, after much debate, I contracted out the majority of the work up to the final stage of construction. Initially, I wanted to do the work myself, but I realized that most of the work beyond my capacity. I could have helped as a laborer if I had more free time, but I could not have constructed the project on my own. However, I will be doing the ‘finish work’, including the hardwood flooring, the kitchen and bathroom, and the painting.

I spent roughly 33% on purely material costs (such as wood, siding, concrete, paint, and appliances) and about 66% purely on labor costs. Labor for new construction in the United States is not simple nor cheap. But, if one had the know-how to do all of this work themself (including electrical and plumbing), and a year of time to put into it, one could have do this job on their own for just the material costs (ie. $30K, as opposed to my projected cost of $92K). 

Furthermore, with enough time and building knowledge, it would be conceivable to source many of the materials that were needed through Craigslist and other building material resellers and design the project partially around those materials. 

For example, I paid $3K for 15 new windows. I think it is possible to acquire 15 wonderful, unused windows for as little as $1000. However, it would be impossible to get a particular kind of window, with say, specific height and widths, or Energy Star specifications. But, if the homeowner is VERY flexible about what materials they use, has ample time to source and collect those building materials, they could cut material costs by possibly 30-50%. It is conceivable that with sufficient time and flexibility, I could have acquired usable building materials for as little as $15-20K (as opposed to $30K, a $10-15K savings). 

The most practical way to source used materials for an ADU would be to collect building materials over time, and design a house using those materials. Some of the building materials would necessarily have to purchased new. For example, if you need to pour a concrete foundation, you would have purchase new concrete. If your project will be inspected, you would need to use many new materials. For example, due to inspections, I need to have new light fixtures with the UL stickers still on them, instead of reusing light fixtures as I had originally planning. And just inexpensive light fixtures, I had to pay nearly $700. 

In summary, if I did all of the work myself, including all of the highly skilled trades of architecture, plumbing, and electrical; and had the patience and determination to build a structure over a very laborious year-long period, I believe it would be conceivable to design and build a comparable structure from mostly salvaged materials for $20K + a working year of my time.  

For me, and the vast majority of the population, this type of DIY scenario is highly unrealistic. But, for an highly skilled homeowner with a year of time at their disposal, this approach may be an option to consider. Given our nation's cultural self-reliant mentality, I am sure that this DIY approach has been used a countless number of times.  

Here's an article about "Re-Creation" house renovation project that a friend of mine built using 90% salvaged materials. As a point of reference, the mostly-used material expenses for this 640 sq ft project amounted to ~$20,500.

Calculating Payback on the ADU Capital Investment 

In my case, to fund the project, I borrowed money from my future self by borrowing against my retirement savings via my 401K. I calculated that the benefit of living mortgage-free after this project made it worth the trade-off of using my retirement funds.  

Generally speaking, financial advisers would not recommend taking money out of a retirement account. While I am paying my future back over the next 15 years, this retirement money is not going to invested in the market. It's an open question as to whether the value of real estate in Portland will increase at quicker rate than the a 401K (which mirrors the S+P 500), but the ADU investment has other financial paybacks that seem more reliable to me the S+P 500.

Upon completion of construction, I will be relatively cash poor and relatively equity rich. The primary house on the property is going to 'cash flow' as soon as I move into the ADU. This means that I anticipate that the rental income from the main house will fully cover the cost of the mortgage, interest, and taxes on the total property. If this assumption is accurate, though I won't have much money left in my bank account, I'll be in a position of relative financial freedom in the sense that I will not have to pay monthly living expenses. 

In terms of resale value, my Realtor described it to me this way. If I spent $100k on my project and assume a conservative number of $50k increased property value, the property would need to earn $50,000 before I'd break even. Conservatively assuming I rented out the ADU at $1000/month, it would take 4.2 yrs to "break-even" on the project. 

I'm guessing that, in reality, the ADU will add $100K to the assessed value of the property. If I resold the property (house and ADU) immediately upon completion this fall, I would not make much profit from this venture. However, if I were to hold onto the ADU for 10 years as a $1000/month rental property, it would generate $120,000 in rental income. The longer that I hold onto the property, the better it will work for me financially.

Personally, I don't intend to sell the property anytime soon, so at $1000/month, the payback period for $92K is 7.6 years. After 7.6 years, the investment will have paid itself back. Since I will be living in the ADU, this equation isn't actually this simple. But, for the purpose of this blog post, we can safely say that the investment pays for itself in 7.6 years or less and then generates income thereafter.

Conclusion 

To me, ADUs represent a very compelling financing investment for homeowners. But, they aren’t possible for many homeowners due to the cost barrier. There’s many factors to consider if you’re starting to get intrigued about the idea of building an ADU, but I’ll suggest that the most important factor to consider is whether/how the ADU will work out for you as a financial sustainable investment, and whether you can figure out some creative financial mechanism to overcome their formidable up front costs. Hopefully, if you're toying with the idea of building an ADU, one of the ideas listed in this blog post will help you overcome that first capital hurdle.