One of the primary motivations and limitation when deciding to construct an Accessory Dwelling Unit (ADU) is finances. Let’s face it, why not build a backyard cottage? The uses are almost limitless, and here at New Avenue we’ve seen ADU’s being used for music studios, entertainment space, pool house, guest house, and most surprisingly, rental units.
It’s no secret that the San Francisco Bay Area is in the midst of a housing crisis with the influx of job growth, the supply of housing has diminished substantially. After lumping 1-, 2- and 3- bedrooms apartments together, average monthly rents are $3,057 in San Francisco, $2,187 in Oakland, and $2,066 in San Jose (1).
With affordable housing almost being non-existent for those trying to enter the bay area, we at New Avenue have decided to take it upon ourselves to do a study on the financial implications of building an Accessory Dwelling for the purposes of it being a rental unit in the San Francisco Bay area.
Based on New Avenue’s extensive experience and data we estimated that a 600 square foot, 2 bedroom ADU costs around $250,000 to design and construct. This is based on our data from completed projects, for example a 250 square foot “Casita” cost a client $112k, a 360 square foot “L-shape Cottage” cost $151k, and a 620 square foot Backyard Cottage cost $252k. Based on these three scenarios we are looking at a cost of approximately $415.00 per square foot. Keep in mind the square footage costs of your Accessory Dwelling can increase of decrease based on a number factors including:
For the sake of this study let’s assume you are building a 600 square foot ADU and the entire $250,000 is financed via a traditional 30-year fixed interest rate of 4.25%, you would see a monthly mortgage payment of $983.88. We estimate a 30% increase of ADU value upon completion of construction; similar to the sales prices of newly constructed homes compared to their costs to build. With that in mind your $250,000 investment would stand to be worth $325,000 after construction. Subtracting out your ending mortgage balance for the end of the first year amount leaves you with roughly $79,000 in immediate equity. Using a conservative home value growth rate of 2% and consistently paying off your mortgage you would realize roughly $577,000 in ADU equity by the end of the 30 year mortgage. (See Chart below)
Now that we covered the basic costs of building an ADU and its equity appreciation, we move onto the second component of this ADU study: Rental Income. After looking at the rental incomes the San Francisco Bay Area is charging, we assumed a modest $2,250 per month rent for your newly constructed ADU. At $2,2250 a month, that totals to $27,000 in the first year and from there we grow annual rent increases at a modest 3% compared the 18% YoY increase in San Jose and Oakland from 2013 to 2014 and 8% YoY increase in San Francisco for 2013 to 2014, slowing only because SF rents were already high in 2013 (2).
With $27,000 in your total first year rental income based on a $2,250 monthly rent already established, it is time to consider the costs associated with your ADU. Immediately you can deduct the $14,758.20 in total annual mortgage payments which will remain steady for the 30 year duration. We then factor in the property taxes at 0.5% of the assessed ADU value starting at $250,000 in year 1 to equal $1,250 in additional annual property taxes a homeowner with a new ADU would expect. Maintenance is another expense, set at 1% of the Market Value of the Home (Year 1 would $325,000 based on the 30% Equity increase previously discussed), making it $3,250 for the first year and increasing at the 2% ADU appreciation rate.
Finally you get a break on your Taxes when you factor in your mortgage interest payments. Based on Bankrate’s mortgage tax deduction calculator (3) for a person in a 20% tax bracket, we would see a tax savings of $2,109.00 in the first year, which would slowly decline as you pay off your mortgage.
Ultimately, after subtracting out the mortgage payments, maintenance expenses, property taxes from your annual rent, then including the tax savings from your mortgage you stand to Net $9,850.80 in supplemental income in just your first year of renting out your new ADU. Additionally the net ADU rental income increases annually as rents increase.
Furthermore when you take a long-term perspective look at where you would be at the end of the 30 years after paying off the mortgage you now have over half-a-million in ADU Equity, and close to $700,000 in cumulative rental income over that period of time. (See Chart Below)
Based on the assumptions we have provided you would have surpassed $1,000,000 in financial benefit by year 26.
Granted this is only a study, New Avenue plans on integrating a calculator into our website based people’s local conditions. Keep in mind construction costs, mortgage rates, and rents vary from person to person and region to region.
Also most people don’t fully intend to rent out their ADU for the duration of 30 years, the intangible benefits of having an ADU in your backyard can be far greater than the economic benefits we have illustrated. We have seen clients utilize a short term rental approach through the use of AirBnB to provide weekend or weekly rentals to travelers, while being able to enjoy their guesthouse when not being rented.
At the end of the day its reassuring to know that in the back of your mind, your backyard cottage can provide a source of additional income that would surpass its costs if needed.
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