Everything You Need to Know About ADU - Accessory Dwelling Units
Real Estate Investing, Construction, and Diet are probably the top three subjects with the most misinformation. And although Accessory Dwelling units have nothing in common with Diet, building and managing a profitable ADU have everything to do with Real Estate Investing and with construction.
Therefore we created this article to remove some of the misconceptions related to those two topics so you could use it as a guide throughout your entire process of building an ADU.
From planning and understanding if ADU is a good investment for you or not to the construction and even finding the right tenants for long-term peace of mind.
If those subjects might overwhelm you or bored you, don't worry you can use the links below and get directed to the place you need to help you with your ADU journey, on your path to build financial freedom.
What is an Accessory Dwelling unit or ADU?
Accessory Dwelling Unit, ADU, also known as Granny Flats, in-law unit, is a legal and regulatory term for a secondary house or apartment that shares the building lot of a larger, primary home.
ADU can be new construction, garage conversion, or conversation parts of the living space in the house.
Due to the lack of affordable housing in California, new legislation was made, And today virtually all single-family homeowner has the right to create an ADU and generate themself.
In California, ADU cannot sell separately unless it goes through the process of SB9.
However, they can be rented separately from the main house.
So what is JADU or Junior Accessory Dwelling Unit?
Junior Accessory Dwelling Units (JADUs) are small living units (up to 500 square feet) created out of space within an existing single-family home or an attached garage.
JADU is a legal and regulatory term unique to California and can be built as an accessory unit in addition to an ADU. The Difference between JADU to ADU
ADU & JADU Laws and Guidelines
Urban development is perhaps the most bureaucratic aspect we will all encounter sooner or later as homeowners. Wheter it is a stop light that doesn't make sense, a need for a nearby bus station, or even a request to fix a pothole that seems like it drags forever.
And unfortunately the construction of an ADU was no different.
Previously only a handful of cities allowed the construction of ADU, and the process was long and could drag on a span of years, and this is why you must have seen or heard about people that are building those granny flats or in-law suites without permits or inspections.
Fortunately, due to the increase in the cost of living and the limited housing supply in the rental market, the state of California decided to improve housing availability and increase the supply by legislating laws, codes, and regulations that will allow the construction of ADUs on the state level.
A small change that allows virtually all homeowners to build an ADU if they choose to, and the city cannot do anything to stop them.
ADU can be new construction, garage conversion, or conversation parts of the living space in the house and must function as a self-sufficient unit. This means it must have its kitchen and a full bathroom.
Save time, and let us help! Book a quick 15 minutes call with our ADU Specialist and save hours searching for answers
ADU laws on single-family property
As of January 2020, California allows virtually all single-family owners to build an ADU on their properties regardless of city or HOA (homeowner association) regulations. The state of California passed a series of laws that provide the absolute minimum benchmark that every city must meet. Again, those benchmarks are the absolute minimum. However, each city can choose to write more lenient guidelines. For this discussion, we will call that ADU state exempts ADU.
To be more specific, we will need to separate the new construction ADU and Converting the existing structure ADU.
What is the size limit for ADU?
As far as size goes, the state benchmark says; that a new construction state exempts ADU maximum size must be not less than 850 sqft or 1000 sqft for more than one bedroom ADU (2 and above). And for cities that didn’t establish their ADU guidelines, the maximum size will not be larger than 1200 sqft, which means that homeowners can choose to build smaller than 850 sqft (or 1000 sqft for 2bds), the planning department of the city must approve any project below 850 sqft as long as it meets all other requirements.
Example #1: 1600 Sqft house with 400 sqft garage
Same house as example #1 plus new construction ADU of up to 850 sqft for one bedroom or studio, and 1000 sqft for 2 bedrooms or more
What is the size limit for converting an existing structure to ADU?
It is a different story when it comes to an existing structure ADU. You can convert any permanent, permitted structure such as a barn, shed, garage, or part of the existing structure or main house without the size limit laws imposed on new construction. Furthermore, if you would like to expand the existing structure, even more, you can add up to 150 sqft without being subject to the size limit of the new construction. That means that if you currently have a 3,000 sqft barn, you can convert the bard to a 3,150 sqft ADU and the city can tell you nothing about it.
Example #2: 1600 Sqft house with 3000 sqft barn
Same house as example #2, only that the 3000 sqft barn converted fully to ADU
Same house as example #2, only that the 3000 sqft barn converted fully to ADU plus 150 sqft were added to the bard as new construction
ADU and percentage of the primary residence? True or false?
One misconception that people have is that there is a minimum percentage requirement for the total size of the house. Although it might be true that each city can enforce a percentage of the entire property, that only applies for units larger than the minimum benchmark of 850 sqft (or 1000 sqft for more than 1bds). That means technically if you own a 700 sqft house and you have an adequate size back yard to meet the required setbacks. (Scroll down for more information) you can build up to 1000 sqft (for more than 1 bds ADU) even if the city allowed only 50% ADU from the original structure. Amazing, isn’t it?
Example #3: 800 Sqft house with 200 sqft garage
Same as example #3 plus new construction ADU of up to 850 sqft for 1-bd or studio, and 1000 sqft for two bedrooms or more. as you can see, the ADU is larger than the main house
With that said, if you want to build more than 1000 sqft ADU, you will be subject to the city limitation even on existing structure conversion.
Go back to the 3,000 sqft barn example. In this case, the city had a 50% limit of the original structure. The main house must be larger than 6,000 sqft to convert the entire barn. If the city imposes a 25% limit to convert barn as a whole, the main house must be 12,000 sqft.
For a city with a percentage requirement, the owner could convert only from the primary house size or up to 1000 sqft, whichever is higher.
For a city with a percentage requirement, the owner must have at least 6000 sqft house to convert the entire barn to ADU
Heights and setbacks for an ADU
What is the maximum height allowed when building new construction ADU?
As far as height goes, state-exempt ADUs can be up to 16 ft tall from the curb.
However, some cities and counties (Santa Barbara, for example) allow you to build up to 30 ft high or the height of the primary house. Whichever is less.
Can you build two stories ADU 2023?
The short answer is Yes!
Thanks to recent regulatory changes, the most restricted ADU height is 18 ft, As long as you live within half a mile of a major public transportation station.
This is a big change that was put in place only a few days ago. Up until now, the ADU maximum higher was only 16 ft, although it doesn't sound like much. Those 2 feet are the difference between being able to build 2 stories with no problems and getting into very expensive prep work to make it happen.
What is setback?
A setback is a minimum distance in which a building or other structure must be set back from a street or road, a river or other stream, a shore or flood plain, or any other place deemed to need protection. In ADU terminology, setback means the distance between the ADU and the property line.
What is the minimum setback requirement for ADU?
Any new construction ADU must be built with no less than 4 ft rear and a side yard setback.
However, if you convert an existing permitted structure (such as a detached garage or part of the house), you don’t need to follow the setbacks requirement.
For example, the garage was converted to ADU and didn't need to comply with the setback requirement. However, the new construction on the second floor must yield to the 4ft setback requirement.
Zoning Code Requirements for building an ADU
You can build an ADU regardless of the building zone. The only zone that is important is the fire zone.
My Zone has changed to industrial or commercial, can I still build ADU?
Yes, it is possible to build ADU in any zone, as long as the house itself is a single or multi-family residence. Regardless of the change in zone
Can I build ADU in a fire zone?
You can convert the garage or any part of the house to ADU regardless of the fire zone.
You can also build a new construction ADU in a moderate fire zone, high fire zone, and very high fire zone.
You will not be able to build a new construction ADU if the property is located in a very high fire zone AND on a steep slope.
Please check the Fire Hazard Severity Zone map from the state fire marshal website to check if your house is in a very high fire zone. Click Here.
Do I need to make parking spots to the ADU?
There is a parking requirement for the new ADU and JADU of one space per bedroom. This parking space can be but not limited to cover space, uncover space, tandem space (parking one behind another), or a mechanical lift.
Although there is no parking requirement if the property is located within half a mile from a public transportation station.
Do I need to create new parking if I convert the garage to ADU?
In the case of garage conversion, the number of spaces that were removed due to the conversion needs to be replaced in addition to the new spaces that the ADU and the JADU require. However, there is NO parking replacement requirement if the property is located within half a mile from a public transportation station (bus station, train station, or metro station).
Unsure if you need to include additional parking? Want to know if you can build an ADU above the garage but don't know whom to ask? Book a 15 minutes quick consultation with our ADU specialists, and they will answer all of those questions and many more. All without wasting time or money. No commitment needed
What is Junior ADU or JADU?
Junior Accessory Dwelling Units (JADUs) are small living units (up to 500 square feet) created out of space within an existing single-family home or an attached garage.
JADU is a legal and regulatory term unique to the state of California and can be built as an accessory unit in addition to an ADU.
Although JADU and ADU sound similar, the two couldn't be more different.
JADU vs. ADU, Whats the difference? which one is better?
JADU must be contained in the existing structure of the main house, which means it can be a converted living space such as a playroom, bedroom, etc. Or a converted, unlivable space that confides within the main house, such as an attached garage (conversion of a detached garage must be an ADU), conversion of the basement, or attic space.
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Example #1: 1600 Sqft house with 400 sqft garage
You can choose to convert more than the garage alone to JADU. You can convert up to 500 sqft from the structure to JADU
Lastly, JADU does only need a kitchen, and can share the bathroom with the main house, needs only an electrical sub panel box and not a new meter, and can connect to the main sewer line of the house. All of those will reduce the costs involved in constructing the unit.
JADU can only exist in owner occupied residence, that means that once you, the owner leaves the house to live in a different one the JADU will cease to exist until or you will return or sell the property to a new owner that will live in the house. That is obviously a downside since rental property investors will not be able to use those units as a third unit in the house and potentially lose tens or even hundreds of thousands of dollars during the lifetime of the property.
Pro tip:
There is a way to rent all the units: JADU, ADU and the main residence, without breaking the law. It's called land trust. You can create a land trust and transfer the property to the land trust. The state did give exemptions for the next 5 years in the process, allowing investors to use this method to rent all units. The main issue in using a land trust is that the lander might recall the loan and you might need to pay off the mortgage in full. Therefore, before doing anything else, we recommend contacting the bank that holds the mortgage.
Can I covert detached Garage to JADU?
No, in the case of any detached structre or new construction you can only convert it to ADU and not JADU.
Example #4 house with detached garage
You can still convert part of the main house to JADU, however the garage must be ADU
Can you add the 150 sqft to JADU as well?
No JADU do not qualify to the 150 sqft addition that allowed with ADU
Bottom line: ADU vs. JADU, which one is better?
I would say it depends; it depends if you could do ADU or not. If you can do ADU in addition to JADU I would personally recommend doing both JADU and ADU. However, if you don’t have enough space on the lot for both, building ADU and not JADU is the better way to go.
Don't know which one to start with, ADU or JADU?
Don't stress. Book a quick 15 minutes free call. Our ADU specialist will help you determine which one has the greater value added to your property, allowing you to maximize your home's income and get you closer to financial freedom.
5 Creative layout ideas for ADU and JADU to maximize profit
Example #1 Garage conversion to JADU and 2nd story ADU
Example #3 2nd story ADU for homeowners that don't want to lose their garage
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Example #2 two stories ADU
Example #4 two stories ADU plus 500 sqft house conversion to JADU.
Example #5 Garage Conversion to JADU plus house conversion to ADU and addition of 150 sqft to the ADU
If the thought of missing out on hundreds of thousands of dollars due to building a suboptimal ADU arrangement worries you, don't! Book a quick 15 minutes call with our ADU specialist and learn what is the absolute best use of your property
What are the main reasons that people are building out an ADU and JADU, and why should you do it too?
There are three main reasons why people build an ADU: Capital gains of tens of thousands; thousands of dollars in passive income monthly; and tax benefits. Now let’s dive deeper into each.
1st Reason – Capital Gains.
What are capital gains? Capital gains are an increase in value above the invested amount.
For example, if you bought a stock for $100 and the market went up to $110, you have made $10 in capital gains once you sell it.
So now let us take a classic 1970, four bed, three bath, 2,200 sq ft livable space, and 420 sq ft 2 car garage home as an example. This house is selling for $1,000,000, or $454 per square foot. As you can see, the price per square foot includes only livable square footage, and the garage is not included.
Now let's say that you built an 800 sq ft, 2-bed ADU in the back yard and converted the 2 car 420 sq ft garage into a one-bedroom apartment JADU (we will go over the difference in the next chapter).
Because of the 50% increase in property square footage and the fact that those 3 units (the main house, JADU, ADU) will be able to be rented for twice as much as the main house alone, the property value might theoretically increase by 40%, or $400,000. (We will dive deeper into how to estimate property value increase in the chapter “The Top 3 Ways to Estimate Property Value”.)
This means that if the construction of the 2 new units will cost $300,000, the owner will have an unrealized gain of $100,000 (versus a realized gain, which is generally recognized upon the sale of the property). However, if the construction costs $450,000, the owner will have an unrealized loss of $50,000.
2nd Reason – Rental Income – Generating Passive Income in Your Sleep
Going back to our example of a house with a 1 bed, 1 bath JADU garage conversion and a 2 bed, 2 bath ADU:
In 2022, the average rent for a 1 bed, 1 bath apartment in Los Angeles is $1,995 a month. Likewise, the average rent for a 2 bed, 2 bath apartment is $2,700 a month. Rental prices tend to increase every year, and I personally would not be surprised to see the price of rent double or even triple in 10 years or less. (as of 1/10/2022, the average rent for 1 bed, 1 bath is $2,200, and for 2 beds to bath $2,964)
Based on the current rental market, our two hypothetical units (the JADU and ADU) in Los Angeles could potentially make $4,695 every month while the owners are still living in the main house. If the rental income is higher than the mortgage, the owners could live in the house for free!
Now if the owners do not have any mortgage, they could pocket nearly the entire amount, or $56,340, as passive income, less any expenses related to the rental units. In comparison, the median household income in the United States is $63,179. It would be pretty nice to make nearly the same amount without even having to work, would it not?
3rd Reason – ADU Tax benefits
For the most of us, paying our taxes is an activity we would love to avoid. However we all know that beside the fact that we can get fined or even arrested it is also imoral. Taxes are the building block of our great country.
Yet the government did create incentives for people, in form of tax breaks, for promoting its vision. And building more affordable housing and renting them out are a big part of the government goals, therefore the tax benefits for taking that action, like building ADU, are great!
The tax benefits from owning a rental property are different from owner-occupied tax benefits, as homeowners are generally limited in itemized deductions they are allowed to take. Owners that rent their property or part of it can potentially deduct additional expenses, such as repairs, maintenance, depreciation, other costs associated with the rental portion of the property, and even the construction costs of the ADU and JADU (over their depreciable lifespan, generally 10 years). Often, those deductions are more than enough to offset the entire taxable income generated from renting those units. This means that the $4,695 can contribute to your cash flow without incurring any additional taxes or may even result in a taxable loss that offsets your other taxable income and thereby reduces your tax liability. In other words, you can have more money in your pocket and less taxes to pay, which is really the best of both worlds.
Those are only few of the reason why people are choosing to build an ADU.
So if you want to make more money on the short term and on the long run, book a free 15 minutes phone call with one of our ADU specialist and together you'll determine if an ADU can be a good for you.
How much does it cost to build an ADU in california?
Prices for ADU can vary greatly from one project to another. New construction ADU will cost much more than a garage conversion to ADU. while New construction on a hillside can almost double the cost in groundwork and preparation
So how much does a new construction ADU cost in CA?
Ground-up ADU can range from $150,000- $350,000, depending on many factors.
Hillside, two stories, hard access, size, expensive finishing materials, and more will all greatly influence the price of an adu
in some cases, a steep slope hillside can almost double the project's cost.
And building one-story ADU is cheaper than two stories.
What about the cost of garage conversion to ADU?
All things being equal, a garage conversion will cost significantly less than new construction.
With a garage convention to ADU, you can expect the cost to range between $75,000-$150,000.
Here the main contributors to the price difference will be the age of the structure, the distance from the water and the power lines, and finishing materials.
While a garage that was built in the '80s is much easier to covert than a garage built in the '50s.
An attached garage will be cheaper to covert than a detached garage in most cases.
Is garage conversion to JADU cheaper than to ADU?
All things being equal, garage conversion to JADU should be a bit cheaper than to ADU since JADU permits do not require running a new electrical line and can use the main electrical cable of the house and only need a sub-panel.
The second contributor to the lower cost for JADU compared to ADU is that JADU can use the house's primary water and the main sewer line.
Therefore save thousands of dollars by running new lines to the street.
Don't know which one to start with, ADU or JADU?
Don't stress. Book a quick 15 minutes free call. Our ADU specialist will help you determine which one has the greater value added to your property, allowing you to maximize your home's income and get you closer to financial freedom.
Is it still worth building ADU and JADU in 2022?
What is the real ROI of the ADU? ADU ROI
To best answer this question, we must first understand a few basic (and some advanced) financial concepts. To start, a concept called opportunity cost.
According to Investopedia:
Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. To read more, Click here
In simple terms, opportunity cost is the amount lost or gained from choosing one investment instead of another.
For our example, we will take the most common investment: Savings, Stocks, and Real Estate and compare them to ADU.
Let's start with savings.
Savings
Today, a savings account will generate about 0.5% APY, Annual Percentage Yield.
So, $100,000 deposited in a saving account that yields 0.5% will return by the end of the year $100,500. After 10 years the same $100,000 will be worth $105,114 due to compound interest.
The total 10 years return for the savings account is $5,114. Not the best investment tool to use, to say the least.
However, savings account is with virtually no risk involved. Now let us look at the stock market and see its returns.
Stocks
In comparison to savings returns on stocks are not guaranteed. There will be some years that are better then others, and some years that you would ask yourself why did I even invested in stocks from the first place. Therefore the 10-year average annual return of the S&P500 fluctuate as well and range between 3.6%-13.2% and will yield a different return depends when the 10 years started and ended.
Historically speaking an investor that invested $100,000 in the S&P500 at the peak of the DOT com bubble in January 2000 and pull his fund 10 years later in 2010 at the low of the great recession will only have an APY of 3.6%. which means that after 10 years the investor will have $142,428.
So between 2000 to 2010, the total 10-year return for the investor was $42,428.
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However, between January 2010 to January 2020, the APY was 13.2%
so an investor that invested $100,000 in the S&P500 during those 10 years will have $345,512.
The big difference represents another aspect of investing; Risk.
in a difference of savings account which the APY is guaranteed, when investing in stocks the returns are not guaranteed and carry a certain amount of risk.
For example, from October 2007 to February 2009 the S&P500 dropped by 53%. therefore an investor that place $100,000 at the peak of 2007 lost more than $53,000 if he pulled his funds a year later. And his total balance was only $47,000.
Another aspect to think about when investing in the stock market is that the profits are taxable and it is called capital gain taxes.
After holding an investment for more than 12 months the profits are subject to federal long-term capital gains tax. at this moment the long-term capital gain tax rate stands at 15% for households making less than $500,000 a year in income and 20% for houses that make more than half a million in income.
In addition, any capital gain in the state of California is considered as regular income and therefore tax as such (Forbes - What Are Capital Gains Taxes For The State Of California?)
To check what is your tax bracket in California Click here (NerdWallet)
Therefore for the average household, the $42,428 gain between 2000-2010 will be subjected to 15% federal capital gain tax and 9.2% in income tax or $6,264 in federal capital gain tax and $3,903 for a total net profit after taxes of only $30,038.
for the 2010-2020 period the pre-tax profit was $245,512 however after taking taxes into consideration, the net profit is only $186,098, or 11% annually.
with that said, don't expect those returns. The 13% return made between 2010 and 2020 was extremely rare, and it required the investor to believe in the market when everyone else thought the US economy was about to collapse.
And for that reason, most investors and 401k consider the average return since the S&P500 was established in 1957 when they made their prediction, which stands on 8% annual return.
therefore $100,000 invested today are expected to return about $215,892 in 2031. with net profit after taxes of only $87,846.
Not so bad, but also not great when you had to invest $100,000 for 10 full years.
Real Estate
When it comes to investing we all know that real estate is probably the best investment out there. It is a real house that you own, you can rent it, and over time its value usually goes up.
In the section below, we will examine investing in real estate as an alternative to investing in the market, and together we will find if it is actually a good idea as we think it is.
To do it we will go over the 3-5 factors that influence the potential profit in each real estate investment.
They are:
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Rent collected
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Profits re-invested in stock
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Rent increase
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Increase in property value
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Leverage.
Net Rent Collected
Rent profits are one of the apparent sources of profit for the real estate investor. Rent profit is the rent collected minus all expenses. Such as property taxes, insurance, vacancy loss, repairs, replacement reserves (for extensive repairs such as HVAC replacement, new roof, or any other high ticket repair), management fees, and more.
The rental yield varies significantly from city to city and from house to house. In short rental yield is the annual percentage return from the total cost of the property.
In Los Angeles county, the rental yield as of today is 4.7%, in San Francisco is 4%, San Diego, %.5.5 (Mangacasa), while in Santa Baraba, investors will only yield between 2.4% in the center (Numbeo), with a state average yield of 6% (homearea)
Therefore a property that costs $100,000 is expected to generate about $500 a month or $6,000 a year in rental revenue.
For simplicity, about 30%-50% of the total rent collected will be used to pay expenses, such as repairs, reserves, management, property taxes, and insurances
For example, if the monthly rent is $500, and the monthly expenses are about 40% (based on house condition and other factors), your net profit is $300 a month.
Profit reinvested
Although spending the money you made feels much better in the short term than taking the profit and saving it, it is much wise to take this profit and reinvest it.
Ideally, when you reinvest profits, you would reinvest them back into the same assets. However, when it comes to real estate, it is impossible to take a few months' worths of rental income and buy with them another rental unit (especially in California).
That leaves us with the second best option; taking whatever net profit remains and reinvesting back to the S&P500 with an annual average return of 8%, as discussed above.
So if a property generates $300 a month or $3,600 a year in net profit, this profit will be reinvested annually to S&P500 to grow with an average return of 8%.
Rent increase rate
Yes, we understand that the rent increase is a sensitive subject. The tenants might say it is not fair, but you have to think differently as a landlord. The costs to manage your property are constantly raising, and your cost of living is also increasing.
Therefore a professional real estate investor considers the potential rent increase or the Rent Increase Rate. The Rent Increase Rate considers the increase in the cost of living as a percentage of the total rent amount.
In California, the average rent increase has been about 5% annually since 1980 (Department of Numbers). This means a house that was rented for $2,000 today could probably be rented for $2,100 the following year, $2,205 the year after, and so on. Those increases will be reinvested as well to the S&P500.
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The average rent for a 1-bedroom apartment in Los Angeles, CA, is $2,200. This is a 13% increase compared to the previous year.
The average rent for a 2-bedroom apartment in Los Angeles, CA, is $2,995. This is an 11% increase compared to the previous year. (Zumper)
Increase in Property Value (Appreciation)
An increase in property value is probably the most alluring reason why people invest in real estate, especially when considering leverage (will discuss below). However investing in real estate just for the increase in property value can be a very risky strategy, especially if the expected rent is not enough to cover the mortgage and any other expenses.
Let's examine the 2008 crisis, people bought houses with the conviction that the market will keep climbing forever, and most of them bought houses where the monthly gross rent is much lower than the mortgage and monthly expenses. Therefore when the market turned and housing prices drop by 30%-50% a year between 2007-2009 (GlobalPropertGuide) and people lost their jobs and couldn't pay for the house; the bank had to foreclose on the property and force those investors to bankrupt and lose everything.
With that said appreciation is a very strong profit generator in California. Last year for example; the year to year increase (APR20-APR21) in property value in Los Angeles was 18.7%, Orange county rose by 16.6%, San Diego rose by 15.5% (LA Times), Santa barbara prices rose by 24.6% (Zillow) and in San Francisco and the Bay area, prices rose by 17.8% (Norda)
However, the average year to year appreciation in California for the last 20 years stands at 5.35% (neighborhoodscout.com)
For that appreciation should be the cherry on the top when investing in real estate, and not the only reason. If the fundamental of the investment property doesn't work, meaning if the rent can't cover the mortgage payment and the monthly expenses investing in that property carry high risk, especially when the market is at an all-time high
Tax Benefits
Let us start by saying that we are not tax advisors, and this post is not a tax recommendation by no means possible. Also, I want to add that we are not trying to encourage tax avoidance. What we do say is that tax benefits are there for a reason. The government gives us those tax benefits to encourage us to take action to improve the country in a way that they see fit.
Regarding real estate investing, the government gives tax benefits to increase housing availability and development.
Because as you saw in our example of the S&P500, the tax liability can carry a hefty cost that might sway an investor to invest in one investment than the other.
When it comes to taxes, selling a property for a profit, called a capital gain, falls in the same tax bracket as the long-term capital gain taxes as in stocks.
However, when renting an investment property, you must pay taxes on the net rent collected. Any net income your rental property generates is taxable as ordinary income on your tax return. Generally speaking, the federal tax bracket is 22% for business-owned property and your tax bracket for individually owned property (How Is Rental Income Taxed? - RoofStock)
In addition to federal taxes, the owner is also liable to California income tax (for California Tax calculator, click here - CA.gov)
Because the amount of taxes owed is calculated based on the total income minus all costs, one of the ways for an investor to keep more money in their pockets is to show higher costs.
Thankfully the government supports real estate investors and provides clear guidelines regarding what costs can be deducted and what investments can be depreciated over time.
So besides the obvious expenses that we discussed above (repairs, management, replacement reserves, and more)
The Californian homeowner can depreciate the property value, minus the cost of the land, (you can use the property tax assessor's values to compute a ratio of the value of the land to the building) in a straight line for 27.5 years.
For example, before buying a property for $100,000, we found out that the land cost is 15% of the property value. Therefore $85,000 is divided by 27.5 years, giving the owner an annual depreciation of $3,090. This depreciation will be added to the annual cost to offset the taxable amount and increase the investor's net income.
So as our previous example shows, for $100,000, the expected rental income is about 6% or
$6,000 from that amount, we will reduce the 40% expenses or $2,400 and the annual depreciation of $3,090. To a total net rent before taxes of only $510. And for that amount, the investor will pay only $112 in taxes to the federal based on a 22% tax rate and 47$ to the state based on a 9.2% tax rate.
Putting it all together
In order for us to understand what is the actual return for investing in real estate, we will need to add up all the profit generators.
This time our investor buy a single-family mobile home for $100,000 cash outright. This home generates an average rental yield of 6% a year, or $6,0000, after paying 40% of expenses the investor keeps $3,600 before taxes. however, after depreciation, the investor taxable amount is only $510. after paying his taxes federal taxes for 22% and state taxes for 9.2% he keeps (total of $159) $3,441 and he moved the profit to s&P500 to grow.
In year 2 the investor increase the rent by 5% same as the state average so by the end of the year he collected $6,300, paid 40% expenses or $2,520, and had $3,780 pre-tax profit.
From that amount, he deducted another $3,090 for a taxable amount of $690. Lastly, the investor paid his 31.2% in taxes (federal and state) and he kept $3,565 in net income, which he deposited to his s&p500 investment account which by the way increased by the average 8% from $3,441 to $3,716, so by the end of the second year in his investment account he had $7,281.
in year 3 the investor increases the rent again by 5% so after all expenses and taxes are paid he kept $3,695 and his investment account grow to $7,864 to a new total of $11,559.
After 10 years the investor will have $57,729 (check calcxml) in his S&p500 account.
However, from the total cumulative amount in the investor stock portfolio, he needs to pay 24.2% for the long term capital gain taxes for his profit (exclude the invested amount).
Therefore his net profit from the stock portfolio is $12,835.
In addition, the property value increased by 5.35% on average every year to a total of 68.4% increase of $68,400. So 10 years later his property sale price is $168,400.
Due to depreciation, the taxable amount from selling the property is $99,310; and with a 15% + 9.2% tax bracket the total tax liability from selling the property is $24,033.
Therefore the net profit after taxes from selling the property is $44,368.
So by combining the net profit from selling the house plus the net profit from the stock portfolio the investor will have $197,999 or 97,999 Net Profit; $10,000 more than investing in stocks!
IYou can download the exel that we used and much more by clicking here
If those calculation gave you an headech or you just want an professional to give you an accurate estimate for your profit Book a 15 Free Call with our ADU sepcilist.
So if the average return in the stock market is almost the same as the average return in all-cash real estate why do people even bother?
The two main reasons are Diversification and Leverage.
Diversification in finance is the spread of one's wealth into several investment tools to reduce risk.
But in our case leverage is the main reason why people use Real Estate as a primary engine in their financial growth.
What is leverage? and how investors use leverage to boost their wealth growth?
Leverage is one's ability to invest more money than what he actually possesses, or in another word, to borrow for investing.
In real estate, we call such borrowing "Mortgage". If you read this post you probably pay a mortgage for your own house.
In most cases to take a mortgage for owner-occupied properties, the borrower must come with a certain amount of equity, also know as down payment. In a tradition mortgage the borrower need to come with at least 20% equity. That means that in a traditional mortgage the borrower can borrow for each dollar that they bring as equity, 4 additional dollars as mortgage.
While in FHA and other, the borrower can bring only 3.5% as equity so for each dollar that they bring they can borrow $28.5 additional as their mortgage..
However when it comes to investing in second property the only option available is a traditional mortgage. Therefore the mortgage needs to be approximately 80% of the total property value, or in investing terms it means being leverage 1 to 4.
Therefore an investor with $100,000 in his bank account can buy a property valued up to $500,000 (Assume zero closing cost, and the investor has sufficient debt to income ratio).
Now let's take this example:
investor had $100,000, and bought $500,000 house. $100,000 from their own money, and $400,000 in mortgage. The house have 20% land value.
As we said before the average rental yeild in real estate is about 6%, or $30,000 in this case.
After paying all expenses, with the average ratio of 40%, the owner's net operating income is $18,000. This time the owners must pay back the principle and interest for the $400,000 they borrowed.
As of the today, the average interest rate for investment property is just above 7%. Therefore for 30 years fix payment mortgage the investor will pay $2,661 a month or a total of $31,932 a year.
Which means that the investor will actually need to dig into his own income personal income and pay $1,161 every month to pay off their mortgage payments.
At the end of the year, when the investors will do their taxes they will be able to deducted Interest Expence of $27,871, and Depreciation for $14,545.
Therefore the investor will actually get money back (in form of credit) to offset other passive income sources. If the investor doesn't have any other passive income sources, the loss will be rolled over for the future years indefinitely until it is being able to be used.
For our example, let's assume the investor has other passive investments and he can use the loss to offset the income from those investments.
As our previous example, the rent in the area increase by 5% annually and the mortgage payments are staying the same.
As we can see, that even after getting tax credits for loss, the investors will need to spend $36,269 from their own pocket throught the entire 10 years.
Which mean that they will have nothing to reinvest in the stock market.
However, the big payout comes when the investor is selling the property in year 10.
With an average annual growth of 5.35%, the property will be valued at $842,006. The mortgage balance will only be $343,249 and the taxable amount is $487,460, or tax liability of $117,965. Therefore after reimbursing themselves for the money spent during the decade, paying taxes, and covering their mortgage balace the investors will have $344,522, with net profit of $244,522.
This is $145,000 more than buying real estate without leverage. And with an average annual return on their cash (Cash on Cash Return) of 24.4%.
As we can see that the entire profit come from the increase in property value. And although the total return are phenomenal the investors carry greater risk.
During those 10 years the investors must pay certain amount of the mortgage payment out of their pocket, because the rental income is not sufficient. Therefore if during that decade they losses their job and can no longer afford the additional payment on their mortgage the bank will enforce them to forclose on the second property. Furthermore the 5.35% increase is based on average real estate growth. Which mean some years can be higher and some years could end up with a decrease in property value. Which exacerbate the risk involved in leveraged real estate investing.
But what if there was a way to enjoy all the benefits of leveraged real estate without the risks?
If you guessed ADU must be the answer you are right!
So how all of this relevent to building and ADU?
It might be apparent but, ADU and real estate share many of the same advantages.
They're both enjoy the rental income, increase in rental, profit reinvestment option, tax benefit, increase in property value.
However, building an ADU have one major advantage; The cost of building an ADU or JADU is significantly cheaper than buying a rental property.
While in real estate cost may vary widely, the construction cost of building an ADU or JADU is pretty much the same and will not vary dramatically between the cities.
What will influence the construction cost are: the size of the unit, the slope, any mechanical issues, finishing materials, and etc.
For the our example, let us take an approximate costs:
An average garage conversion to 1-bedroom JADU for about $100,000;
and an approximate cost for new construction two bedrooms apartment ADU for $200,000.
As we mentioned before on of the biggest advantage of ADU is that the cost to build one is nearly fixed between the cities in California, and only with a small difference between states.
And while costs stay the same the expected rental income vary greatly between states, cities and even neighborhoods.
For example the average rent for a 1-bedroom apartment in Los Angeles, CA, is currently $2,200. This is a 13% increase compared to the previous year. (Zumper)
While the average rent for an apartment of the same size in San Francisco $3,045 (Zumper)
While for 2-bedroom apartment in Los Angeles, CA, a renter will pay $2,969, which is an increase of 10% the previous year. In SF they will pay $4,125.
Without even calculating anything we can learn 2 major things.
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That the return will vary mostly by the location while the cost stay the same
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That virtually in all cities in California ADU will provide more income than buying a second property of the same value, while in other state where the average cost per house is cheaper it might be more economical to buy a house than build an ADU.
So, while $100,000 worth of real estate is expected to generate only $6,000 a year in rental income (based on the 6% expected return); JADU of the same cost will provide much higher base returns. For a $100,000 JADU garage conversion to 1-bedroom, the homeowner is likely to generate about $26,400 a year in Los Angele.
Also, the expenses are much smaller than a rental property, primarily since the unit is a brand new construction for the most part. Therefore the homeowner should expect much fewer repairs and malfunctions. Most of our partners provide ten years warranty for the entire project. Thus the expense ratio for repair and maintenance should be reduced.
In addition, property taxes expenses should be reduced as well. For a property valued $100,000 the property taxes are about $1,250 a year, however out of the $6,000 rental yield they take about 20%.
And, although that for $100,000 ADU the owner will still pay the same $1,250 in property taxes the percentage out of the $26,400 rental yield is less than 5%.
Also, homeowners can choose not to use a property manager because their tenants are just next door to them and not on the other side of town. So theoreticallythe homeowner can save the 11% for the property manager and have an expense ratio of less than 10%..
How ADU and JADU depreciate?
We love tax benfits, and as we said before ADU share many of the same tax benefits as real estate investing.
And the last benift for JADU and ADU compare to standard real estate is deprisiaction; While in real estate a property can only depriciate the value of the structure without the land for 27.5 years. JADU and ADU are too depriciate for 27.5 years however you do not need to reduce any cost for the land.
Which means that 100% of the construction cost is depreciable
By how much JADU and ADU will increase the property Value? How to calculate by how much ADU and JADU will increase the Property Value?
As you probably know, calculating precisely how much a property value will increase by building an ADU or JADU is the job of appraisals. It is more art than science, and they are still debating it. Therefore the information in this next part should be discussed with a professional and might change once there is clarity in the market.However, with that said, we can safely assume that a good guideline for ADU or JADU value will be some sort of combination between the price per sqft method to the 6% rule in reverse.
The Price per Sqft Method for appreising by how much ADU will increase property Value
Easy as it sound, the price per sqft method is as simply as taking current property value and dividing it by the current size of the livable space in sqft (exclude garage, attic, and basement).
For example: 2,000 sqft house that cost 1 million dollars will have a price of $500/sqft.
Then once the owner decide to add 800 sqft ADU the new size of the property will be 2,800 sqft. Assuming that price per sqft didn't change due to the construction , the new house value will be 1.4 Million dollars. Meaning that the ADU added $400,000 to the property value.
6% rule in reverse / Cap Rate Method for appreising by how much ADU will increase property Value
As we mentioned every area has its exected rental yield, some expect lower return than others. The national average shows that the expected return on renal property is about 6%. Meaning if the rental yield expected from the property is $6,000, the value that the average investor will be willing to pay should be around $100,000.
For our example if the 800 sqft 2 bedroom ADU is expected to generate $35,628 a year ($2,969/month * 12 months)
The 6% in reverse method will determine that this ADU will add $593,800 to the property value.
With that said, two opposing forces influence the property value regarding ADU and JADU.
The positive force; is the increase in property value due to an increase in square footage, increase in rental yield, etc.
And the opposing force; which is the decrease in property value due to loss of parking space, privacy, and others.
The effect of each force will change depending on many factors. For example, if the property has a long driveway and it is possible to park cars in the driveway, the loss of garage space will be minor compared to a property with no driveway and no street parking.
It means that because there is some trade between comfort and profitability, investors will adjust the number based on the level of discomfort expected from the additional units.
If those calculation makes you dizzy or you would like to get an exact estimate for the cost, rental yield and you expected property value increase book a quick 15 minutes free consultation with our ADU spcilist and they will help you determine if ADU is a good fit for you
So how does ADU or JADU compare to Real estate?
Let's take our investor once more. This time the investor takes the $100,000 and builds a JADU garage conversion, and pays for it in cash.
The investor finds tenants that will pay $2,200 a month, or $26,400 a year.
Since the JADU is brand new, our investor will only keep 10% for reserve and maintenance (a number that is probably too high), 11% for property management, 5% for property taxes, and 4% for utilities (because JADU shares the same water and electric line). That means that he will have a 30% expense rate.
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The area has a standard rent growth rate of 5%. They must pay a 22% federal tax rate for their income, 15% for long-term capital gains, and 9.2% state tax.
Lastly, our investor will follow the same rule, and whatever cash he has left, he will reinvest it into the stock market for an 8% annual average growth.
With JADU, the investor will have much higher returns than a rental property.
In year 1, for example, the Net Cash flow is $15,766 compared to $3,564 for buying a rental property, nearly five times as much.
During those 10 years, the investor will collect $171,263 as rental income, and because they reinvested their rental income from each year back to the market, their portfolio will have a total net amount (after taxes) of $224,174. $52,910 out of them are net profit from their investment in the market
But how about the increase in property value?
Let us assume that at the time of construction, the investor figures out that there will be some discomfort because the investor loses their garage. However, they still have a driveway where they can park their cars there. In addition, they have enough space in the backyard to build a small shed for storage.
Considering all those factors, he figures that the reverse 6% rule will be adjusted upward to 9% to account for the changes.
After building the JADU in Year 1, the property value is expected to increase by $293,333. And with the increase of the JADU rental income every year, by year 10, once the investor decides to sell their house, the contribution for the JADU alone to the property value will be an increase of $455,056.
On that increase, the investor will need to pay $94,722 in taxes (at the time of sale), and it will leave the investor with $360,332 net proceeds, or net profit from the sale of the JADU alone of $260,332 (excluding any portion belonging to the main house)
Therefore the total Net profits for ten years is $484,507, with an outstanding average ROI of 58.4%
Or 19.3% compound return rate.
If those calculation makes you dizzy or you would like to get an exact estimate for the cost, rental yield and you expected property value increase book a quick 15 minutes free consultation with our ADU spcilist and they will help you determine if ADU is a good fit for you
So what is ADU and JADU ROI when you add leverage?
To calculate the ROI of ADU and JADU with leverage, let's take our investor.
They have $100,000 to invest. As we mentioned the cost for both the ADU and JADU combined is about $300,000.
To make things equal our investor will use the maximum leverage allowed in real estate investing of 1 to 4 (to learn how to build an ADU without any money upfront Click Here).
This means that the investors will only need to use $60,000 from their own money and the remaining $240,000 they will be borrowing. The remaining $40,000 from their initial investment will invest in the stock market with an 8% return.
Once the construction is completed the investor will have a one-bedroom JADU that generates $2,200 a month and a 2-bedroom ADU that generates $2,969 a month, to a total rental income of $62,028 in year 1. The rate of rent increase will be 5% annually every year after.
The expense rate will stay at 30%, as in the previous example.
Lastly, the investor still needs to pay federal taxes of 22%, state taxes of 9.2%, and long-term capital gains of 15%.
Here we can see that the investor put into his pocket in year 1 - $14,384. They will now reinvest that amount alongside any future cash from his rental units, in addition to the $40,000 cash they had.
The investors will secure 30 years loan for building the ADU and JADU with 7% interest. Their payment will be $1,596.
After 10 years the investors will collect a total of $206,838 in net cashflow from their rental unit. However due to the power of compound interest, the investors will have $372,490, And their net profit from their portfolio will be $95,243.
The investors also determined that with will be to price the ADU and JADU with a cap rate of 11%, much higher than the 4% standard in LA, which make the property very appealing to potential buyers.
That means that both of the units had a net positive effect on the property value at the time of construction and appreciated it by $563,890.
Ten years later, as the income from those units grew.
After paying their taxes and their loan balance, the investors keep $834,341 from selling the property, in addition to his $302,082 in his stock portfolio.
The investors made a net profit of $1,136,423.
Our investor made over 1 million-dollar or 27% annual average return in only one decade.
This is the mind-blowing return of ADU.
And today nearly all homeowners in California can build ADU and JADU on their property, and if you're thinking it sounds really good but I don't have the $100,000 to start.
Don't worry our mission is to help anyone who is looking to build an ADU and take their finance to the next level to do it. Click on the link below and book a quick call with our ADU specialist to learn about our No Money Down Program and put yourself on the path to financial freedom!