Many of our clients own rental property in rent and eviction-controlled jurisdictions. Adding value means raising rents, but the rules are getting more difficult to interpret and implement… especially when it comes to banked rent increases and capital improvements. Getting approval from the local rent board to pass through a rent increase can take years, and, once approved, it may take decades to recover capital costs.
So, is there a better way?
At the end of 2019, California passed a series of new laws pertaining to Accessory Dwelling Units (ADUs), and one of the biggest and best changes is that multi-family properties can now add ADUs. You can convert existing non-habitable space to ADUs (one for every four units on the property, 25%), plus two new-construction freestanding units. This is a much more certain and long-lasting way to add value to your property.
First, these new laws allow for the legalization of unpermitted units. If you have a unit not permitted for separate residential use, you can’t legally collect rent, and if you do, you will be subject to code enforcement actions from the local jurisdiction and a host of related legal problems (including a possible refund of rents you charged for the illegal units). In the past, due to zoning restrictions, the property owner couldn’t add more units to the property and, in effect, had no pathway to legalizing those “non-permitted” units. The new law makes it possible; it’s the landlord’s “get out of jail free card.”
There is an expedited approval process if you meet certain requirements, and most properties in urban areas are exempt from adding parking. That empty basement space or underutilized garage or carport could be excellent opportunities to create more housing units.
But what will it cost? We’ve seen expenses vary from $150 to $400 per square foot, depending on the particulars of the space. Obviously, it will also depend on whether you are converting existing space or building from the ground up. It’s an investment, so you should focus not only on costs but on your return on that investment.
Suppose I can turn a potential underutilized ground floor storage space into a new 750 sq. ft. ADU. What is it worth for my time and effort? Glad you asked! This is where I get in touch with my inner Finance Nerd.
If I spend $250 per sq. ft. (including reports, architectural fees, permits, and construction costs) and I 100% financed the improvement at 4% over 30 years, I would need to rent the space for $1,300 to cover my loan costs on my capital outlay. If I could rent the unit for $2,300 per month, the value of my capital outlay would be around $303,325 (assuming a 4% capitalization rate and an income approach to value) and $187,848 in costs to complete. My profit upon completion of the project would be around $115,477. That is an instant over 60% ROI (Return on Investment) … with no money out-of-pocket and approximately $1,000 a month more in positive cash flow after expenses.
The question is, why you would NOT build an ADU! Adding and legalizing ADUs is almost like free money. Sure, there is work involved, but you’re creating value with OPM (other people’s money), in this case, the bank’s money. With debt costs at a 50-year low, why would you spend money out-of-pocket when the banks are willing and ready to finance your improvements?
If you want to learn more about adding value to your property with an ADU, please contact us for a free appointment to discuss your situation.
Steven Edrington has a B.S. Degree in Finance, is a Certified Commercial Investment Member (CCIM), and is actively adding value to real property for himself and his clients.