An ADU can increase your monthly rental income and help speed your path to financial freedom. However, they’re not completely without downsides. In this article, we explore the different types of ADUs and the many good reasons to have one. Including a few benefits you might not expect. We also discuss some of the things to look out for, along with ways to mitigate the risk.
The primary goal of owning investment property is to generate a profit. It wouldn’t be an investment otherwise! One important source of profit is monthly cashflow.
At Semi-Retired MD, we teach several ways of building out a robust stream of cashflow from a rental property portfolio. Among them, we include long-term, mid-term, and short-term rentals.
Today, let’s get a bit more specific and talk about one type of rental that could function in any one of those capacities: the Accessory Dwelling Unit (ADU).
Without getting too far in the weeds, an ADU is an independent living space that is self-contained and separate from the main living space.
That means an ADU must have, at minimum, a kitchen or other cooking area, a bathroom, and a sleeping area. It also must have its own entrance, even if it shares an entryway with another unit. (For example, two units may enter into a shared mudroom or hallway, then each have their own entryway into their respective living spaces.)
Duplexes and other multi-family dwellings already have their own categories and definitions, so they do not count as ADUs.
Different Types of ADUs
Broadly speaking, ADUs can be split into two basic categories: attached and detached. Within each of those, ADUs can be either pre-existing or new construction. That makes a total of four combinations.
A pre-existing, detached ADU might be something like a barn, carriage house, or detached garage that’s been converted into living space.
A tiny home built or moved onto a property would be common examples of a detached, new construction ADU.
Examples of attached, new construction ADUs might include something like an addition or even a second story built onto an existing home.
Finally attached, pre-existing spaces such as an attic or basement may be converted into an apartment to create an ADU.
Logistics of adding an ADU
For new construction, adding an attached ADU tends to be faster and less expensive. That’s because the plumbing, electrical, and even much of the structure is already in place.
It’s simply easier for contractors to work with what’s already there than to run all new utilities and build an entirely free-standing structure from scratch.
There can be a lot more variables with converting pre-existing spaces, depending on the condition and what utilities are already available in the space.
For example, an unfinished basement with stone walls and a dirt floor, or an attic that doesn’t have a high enough roof to stand upright, could be converted to living space, but it will be more costly and time-consuming to convert it into a livable space.
By comparison, partitioning off a spare bedroom will be faster and cheaper because the space is already finished. A well-placed kitchen or bathroom can also be easily added if the utilities are already in place.
The benefits of having an ADU
Forced appreciation on the property’s value
If you already own a rental property, adding an ADU is a great way to force a tremendous amount of appreciation on its value.
These extra units have a lot of appeal. Both home buyers and investment buyers are willing to pay a premium for a property that has an ADU already in place.
Forced appreciation is one of our favorite ways of building wealth. Adding an ADU to force appreciation can often give you some of the biggest bang for your buck.
Ability to collect two rents instead of just one
With an ADU, you can list each of the properties separately. That means you can collect two rents from the same parcel of land. One unit may rent for more than the other, but that’s okay.
Having two units increases the total amount of rent collected. It can also help smooth out income fluctuations since it will be less common for both units to be vacant at once.
Diversification by having two different types of rentals
Having an ADU can also help to diversify your portfolio if you make each unit a different type. For example, one as a long-term rental and the other as a short-term rental.
This way, you can more easily take advantage of the strengths of each type.
Long-term rentals offer predictable income. Short- and mid-term rentals generally bring in more income when occupied but require more work and the income can be sporadic or even seasonal.
Having a mix of both lets you enjoy the best of both worlds.
Use an ADU as a stepping stone in your investing journey
By adding an ADU to your primary residence, you could get started owning rental property and generating cashflow faster and with less up-front investment than with most other types of rentals.
The proximity to your primary residence means you could self-manage for even more cost savings.
One of our student’s accessory dwelling units in San Diego that was featured in our 2023 Fast FIRE to Freedom Summit
Leveraging an ADU to supercharge your tax benefits
If you want to use the tax benefits of real estate investing to help shelter some of the income earned by you or a spouse, having an ADU can help simplify this process by giving you easier access to accumulate the time investment required by the IRS.
Briefly stated, there are two different methods for using real estate investing to save on taxes.
The short-term rental tax loophole is more accessible for those who continue to practice medicine or work full-time in any non-real estate field as their primary occupation.
For those working only part-time, or not at all, it may be feasible to meet the IRS criteria for real estate professional status (REPS).
Each of these special statuses has its own requirements to qualify. In both cases, it mostly boils down to tracking and reporting time and effort spent working on your properties.
Things to be mindful of with an Accessory Dwelling Unit
While an ADU can have many benefits, there are some downsides to take into consideration.
One downside is less anonymity and privacy as a property owner if the ADU is on the same property as your primary residence.
If your ADU is located in an area governed by a homeowner’s association, realize that HOA rules can sometimes change with little or no advance notice. So added vigilance may be required to ensure you remain compliant with your HOA’s rules and restrictions.
Similarly, municipal zoning or other regulatory changes might adversely affect your ADU. These are less common, especially for already-established units, but it’s still something to be aware of.
Getting started with your new ADU
Assuming you have the physical space necessary, the next step would be to look into the permitting process and any regulatory requirements that may apply. Your contractor may handle this for you as part of their service.
Some cities, such as Seattle, are very accommodating and will even offer pre-made plans and other packages to make the process easier. Find out if the municipal authorities where your property is located might help shorten your path to getting an ADU.
We’ll be featuring a story of our student’s experience with building a detached ADU from the ground up at this year’s Fast FIRE to Freedom Summit, held annually in August. Sign up HERE for free.
Repeating your success
Like any other complex endeavor, these skills are transferable. Once you’ve added an ADU to one property, you can apply those skills and knowledge to much more easily add one to another property.
Especially if it’s in the same city or geographic area. Since you will already know the regulations, and have relationships with contractors and city officials, repeating the ADU process could go much more smoothly the second time around.
In fact, given enough space and assuming there aren’t local regulations prohibiting it, you might even be able to add more than one ADU to the same parcel of land.
At the very least, the added equity and cashflow from that first ADU can be put toward further investment in your rental portfolio.
Given all the benefits and the comparatively few downsides, will you be adding an ADU to your rental portfolio?
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