Author Topic: Use Home Equity to Construct DADU Rental?  (Read 609 times)

Commodore

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Use Home Equity to Construct DADU Rental?
« on: December 03, 2018, 11:59:31 AM »
Hi everyone, I am a long time lurker but this is my first post.  I am located in a very hot rental and tourism market in location with high airbnb activity.  I am considering using home equity in my primary residence to construct (on the property) a garage on with a detached accessory dwelling unit over the top and airbnb it, with backup plan of renting as a standard rental if Airbnb is not a success.  I would have to pull out the max equity allowed by my bank to construct the unit and that makes me nervous, and I'd appreciate any advice you all have on whether this is a good or bad idea.  Here are some numbers I am considering:

Cost of constructing unit: $125,000 for a 2 car garage with 1 bedroom, 1 bath apartment over top w/ 700 sq. ft. of living space.This includes cost of design, permitting and a contingency for cost overruns, but does not include furnishing unit (estimated at $5,000).

Potential airbnb income - gross $30-32,000 year (after local occupancy taxes) based on my research into comparable units in my area, less 15% for a property manager as I cannot run it myself, so income before expenses of $25-27k.   

Potential backup rental income - I estimate $1500k/month as a regular rental, and would not use a property manager for a long-term rental, so $18,000/year gross before expenses. 

I should be able to finance construction completely with a HELOC at 1.5% over prime, though may have to come out of pocket for furnishing the unit.

What gives me pause here is that my wife and I currently have 75k in consolidated student loans at 2.5% interest as well as $24k in student loans at 5% interest.  We have no other debt but our mortgage ($450k, house worth $700k), and we have current retirement savings of 375k and a cash emergency fund of $30k.  We plan to wipe out the 5% loan by the end of 2019, and were planning on letting the remainder ride due to their low interest rates. 

Taking out another $125k in relatively high-interest debt feels bad and I worry we'd be putting too much of our assets into our primary residence.  However, I don't think there is another investment I can make that would have the same potential return (especially given the power of leverage) as the airbnb income potential on the unit, and it seems like even in the fallback position of long-term rental it would pay for itself while we also have a garage to use for ourselves.  Once paid off, Long-term we'd use the income to fund more property investments in hope of accelerating journey to FIRE.   

What do you think? Should we pursue this opportunity? Or are there additional things I should consider?

 

clifp

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Re: Use Home Equity to Construct DADU Rental?
« Reply #1 on: December 03, 2018, 12:30:54 PM »
Interesting idea. Some questions.

1. Is it legal? Note this is different than do people do it and they get away with it.  The questions is your area specifically zone to allow this.  I ask because where I live in Honolulu is also a hot vacation market, and lots of people AirBNB their homes, some have done exactly what you've proposed built ADU.  However, there is only a small area in the island it is legal, some places the home owners association makes it illegal, and in most of the island, you are allowed one rental every 30 days. At some point, hopefully, soon the city will crack down on the illegal renters.

2. Have you thought of the impact on the neighbors? Is their enough parking, will the ADU be close to the neighbors that the noise (and you will get noisy AirBnb renter they are on vacation) bother them?

3. Do you have cleaning services lined up and priced out?

4. How much would you get for a long-term rental?

All my negative comments aside, the general rule of thumb is rent should be 1% of the sales price at a minimum, 2% is very good and you are well over that mark, even if you have additional expense due to the short-term nature of it is still an excellent investment.

Finally, just a suggestion.  For several years I rented the downstairs of my place. The tax rules for doing so are complicated and potentially jeopardize your ability take the homeowners exclusion.  I talked to a CPA or least find out on a forum, if there is a way to depreciation your rental in a completely separate manner from your main house.

Commodore

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Re: Use Home Equity to Construct DADU Rental?
« Reply #2 on: December 03, 2018, 12:56:46 PM »
Clifp - Thanks for your response! My responses are as below:

1. definitely legal - I just need to get a permit, which are easily available for owner-occupied units in my area, and pay hotel taxes (considered in my income estimate).  There have been some rumblings about banning non-owner occupied airbnbs in my city but that would not impact me; I do realize there is some regulatory uncertainty here though, as city could always change its stance. No HOA.

2. ADU will have one off-street parking spot, though there is plenty of street parking available as well. 

3. ADU will be fairly close to one neighbor but would not impact the other (a rental house), and I talked it over with the one neighbor and he was fine with the concept. As we live on the property ourselves I think we'd be as impacted as the neighbor so we are planning to construct the thing with good sound insulation, keep guests to max of 4, and not allow it to be used for parties.

3. The property managers we are looking at handle cleaning as part of fee along with managing bookings and getting tenants in/out (they also keep the cleaning charge posted for the airbnb).  I still have some due diligence to do on the property managers though - there are quite a few services available. 

4. We think a long term rental would gross $18k/year, and I am trying to keep in mind in evaluating this as a potential fallback should the regulatory environment change or competition brings down airbnb returns, as I know there are likely to be many airbnb units coming on line in my city over the next few years.

Thanks so much for your response, and it does sound like I will need to visit a CPA before pulling the trigger here.

waltworks

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Re: Use Home Equity to Construct DADU Rental?
« Reply #3 on: December 03, 2018, 01:50:16 PM »
I ran an AirBnB in my basement apartment for about 18 months (ski resort) and I'm a little dubious of your numbers. Even in a hot market, you will have quite a bit of vacancy for AirBnB, something like 25-30 percent is pretty normal.

To gross $32k/year, you'd need to be *averaging* north of $100 a night. Are people in your area willing to pay that for an apartment above a garage?

I ask because we built a *nice* 2 bedroom full furnished apartment with a full kitchen and very nice bathroom (1000 square feet!) which only ended up making us about $18k/year before expenses. And the expenses and work added up, of course. Long term rental rate is about the same as yours would be $1300-1500 a month. And that's what we elected to do after the AirBnB experiment.

That said, it probably still makes sense as a long term rental, so there's no real harm in trying the AirBnB thing out.

-W

Commodore

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Re: Use Home Equity to Construct DADU Rental?
« Reply #4 on: December 03, 2018, 03:05:04 PM »
Waltworks,

Thanks! An analytics firms I have investigated forecast the unit at around $34k (avg daily rate of $128 with 73% occupancy), and a friend I know has an apartment over a garage in my neighborhood and professes to be pulling in ~$30k annually from airbnb, but I do worry that those are best case numbers, and I may not get that.  I am certain there would be a ramp-up period of at least 3-6 months before I get those numbers even in the best case.  I am glad to hear you think makes sense as a long term rental as I, like you, am worried the airbnb figures I am seeing are overoptimistic or inflated.     

waltworks

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Re: Use Home Equity to Construct DADU Rental?
« Reply #5 on: December 03, 2018, 06:03:05 PM »
I mean, it's a >1% rule property, and it'll be cheaper to maintain and insure than an offsite rental, and it'll be easy to manage it yourselves (as a long term rental). So IMO it's a no brainer. The AirBnB may or may not work out or be your thing, but assuming your numbers are right, it's still a great long term rental and I'd certainly spend the money on it over paying off low interest loans.

Keep us updated!

-W

feelingroovy

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Re: Use Home Equity to Construct DADU Rental?
« Reply #6 on: December 03, 2018, 08:12:30 PM »
We have a building like that. Detached garage with a 1br apartment above it.

The house had it already when we purchased but we did have to spend about $20k renovating.

We have stuck with long term rentals and it's very easy to rent and manage. There are very few 1 br apartments with no shared walls so we have found quiet people find it very attractive.

It's been great for us.

bacchi

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Re: Use Home Equity to Construct DADU Rental?
« Reply #7 on: December 03, 2018, 09:21:39 PM »
Have you checked your construction numbers? A very hot rental market surely has a lot of construction activity as well, right?

Our 600 square foot ADU cost ~$135k (including design work) and we did a lot of the work. There's a lot of construction going on here, though, so that had an effect.

bacchi

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Re: Use Home Equity to Construct DADU Rental?
« Reply #8 on: December 03, 2018, 09:27:56 PM »
Oh, re:what clifp mentioned above.

Renting out part of your property will affect your homeowner's capital gains exclusion and not in a good way. You can separate your property and depreciate only the rental part of it (like a duplex where the owner lives in one side) but any gain on the ADU's portion of the land is no longer excluded.

There's a good thread here: https://forum.mrmoneymustache.com/taxes/tax-implications-of-owner-occupied-2-flat/

waltworks

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Re: Use Home Equity to Construct DADU Rental?
« Reply #9 on: December 03, 2018, 09:40:28 PM »
Re: Capital gains - meh. A $125k addition is not going to appreciate *that* much, and if it does, and you have to pay some capital gains, that's a good problem to have!

The depreciation has to get paid back, sure. But it's money you saved up front. Net effect is zero.

Taxes are not a meaningful consideration here.

-W

bacchi

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Re: Use Home Equity to Construct DADU Rental?
« Reply #10 on: December 03, 2018, 10:24:04 PM »
Re: Capital gains - meh. A $125k addition is not going to appreciate *that* much, and if it does, and you have to pay some capital gains, that's a good problem to have!

The depreciation has to get paid back, sure. But it's money you saved up front. Net effect is zero.

Taxes are not a meaningful consideration here.

-W

It's not the ADU structure gain that's a problem (that's a good problem to have, as you wrote, and it's also based on the capital used to build it). It's splitting the land that's a problem.

The rental ADU takes a prorated part of the land and that is then subject to cap gains (rather, it's no longer excluded). If the land is worth more than the structures on it, that could be significant.

waltworks

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Re: Use Home Equity to Construct DADU Rental?
« Reply #11 on: December 03, 2018, 10:35:13 PM »
It's still not going to be meaningful. Assuming there's space/setback available to build the garage at all, it can't possibly be occupying more than about 15% of the land (assuming a small 4500 square foot lot and a 700 square foot footprint for the garage). Losing the capital gains exemption on that won't hurt enough to matter unless appreciation is just *insane*, and then, again, it's probably a good problem to have.

I mean, sure, it's worth looking at. But I'd be shocked if it made enough difference to scuttle such a slam-dunk of a project. Construction costs are the potential deal killer here.

-W

Villanelle

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Re: Use Home Equity to Construct DADU Rental?
« Reply #12 on: December 03, 2018, 11:11:59 PM »
 Are you building the garage portion because you really want a garage, or mostly because it would be part of the rental construction?

I ask because this seems like a fairly perfect set up for a tiny home, which could be done for waaaay less than $125k (see MMM's recent blog about the one he built, but even if you didn't DIY, it would be much cheaper than your numbers).  It would be smaller than what you are considering so likely make less in rental income, but the ROI seems like it would end up much higher. 

Seems like a better return and a smaller investment in case it doesn't work out, local laws change, etc. 

clifp

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Re: Use Home Equity to Construct DADU Rental?
« Reply #13 on: December 04, 2018, 02:26:05 AM »
Are you building the garage portion because you really want a garage, or mostly because it would be part of the rental construction?

I ask because this seems like a fairly perfect set up for a tiny home, which could be done for waaaay less than $125k (see MMM's recent blog about the one he built, but even if you didn't DIY, it would be much cheaper than your numbers).  It would be smaller than what you are considering so likely make less in rental income, but the ROI seems like it would end up much higher. 

Seems like a better return and a smaller investment in case it doesn't work out, local laws change, etc.

I guess it depends a lot on the area. A tiny house here cost $125-150K if it is on piece of land and 200K if it's on top of an existing garage.  It was not clear if the ADU was building on top of an existing garage or you got a 2 car garage also for the 125K. If it is the later then it is an even better deal, and will certainly add to property value.

Villanelle

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Re: Use Home Equity to Construct DADU Rental?
« Reply #14 on: December 04, 2018, 04:49:52 AM »
Are you building the garage portion because you really want a garage, or mostly because it would be part of the rental construction?

I ask because this seems like a fairly perfect set up for a tiny home, which could be done for waaaay less than $125k (see MMM's recent blog about the one he built, but even if you didn't DIY, it would be much cheaper than your numbers).  It would be smaller than what you are considering so likely make less in rental income, but the ROI seems like it would end up much higher. 

Seems like a better return and a smaller investment in case it doesn't work out, local laws change, etc.



I guess it depends a lot on the area. A tiny house here cost $125-150K if it is on piece of land and 200K if it's on top of an existing garage.  It was not clear if the ADU was building on top of an existing garage or you got a 2 car garage also for the 125K. If it is the later then it is an even better deal, and will certainly add to property value.

MMM built his for $3500*, so it can surely be done for far less than $125k, even if much (or all) of it is outsourced.

*His was admittedly missing some of the things one would probably want in a regular rental, and an AirBnB would need furnishings, but not so much that it would be 35x more expensive!

bacchi

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Re: Use Home Equity to Construct DADU Rental?
« Reply #15 on: December 04, 2018, 08:36:53 AM »
Municipal codes are different for tiny homes, though, if we're talking about a small structure that avoids IRC code by being on wheels. Cities often don't know what to do with them so they ban them outright or only allow them in trailer/RV parks.

If we're talking about a structure on a skid foundation that meets code and can get an occupancy certificate, that's just a very small house. To your point, it would be a lot cheaper than building a garage and building a unit on top. People are fine in hotel rooms, which are ~400-500 ft^2 -- no need to build it any larger.

Commodore

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Re: Use Home Equity to Construct DADU Rental?
« Reply #16 on: December 04, 2018, 10:51:10 AM »
Wow!  A lot of great feedback here. 

Re: construction costs, that is the estimate we have received from a design-build firm on similar structures they have done in the past but that is before we have actual plans.  Using the 1% rule, I''d guess I could go no higher than 150k or so in construction costs to make this not viable as a long-term rental?

Re: the garage, that is the cost to build the garage + the unit on top.  We currently have no garage and part of the attraction of the idea is getting a garage that pays for itself out of the deal.

Re: Tiny house, that is a very interesting idea and one that had not occurred to me, as having the garage is a bonus for us and this would be built on the location we currently use for off-street parking.  I'll have to think more on that.

I guess what I am hearing from you all is that the numbers check out on this being a good investment as a long-term rental, better for me than paying down the student loans, and if airbnb works out that is a nice bonus but not needed to make the project viable.

waltworks

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Re: Use Home Equity to Construct DADU Rental?
« Reply #17 on: December 04, 2018, 11:30:34 AM »
To really analyze how much you can spend and still have the rental be worthwhile, you'd want to sit down and figure out not just the construction costs but also:
-Property taxes (you'll pay a bit more)
-Insurance (again, you'll have to insure more structure and may also need extra insurance for the various rental situations)
-Maintenance - this will cost less to maintain than a full sized house, but it will still need new paint and carpet and roof and appliances periodically.
-Management cost (if any). If you self manage, put a value on your time and assume that you'll spend 20-30 hours a year on it (for a long term rental).
-Vacancy. I'd assume 10% just to be on the safe side, though I was always able to basically keep vacancy at 0 at my long term rentals. One drawn-out eviction would have put me right back up to that 10% averaged out over 5 years, though.

Remember that the 1% rule is just a rule of thumb. There are properties in New Jersey that cost $30k and rent for $1200 (4% rule!) that you don't want, because property taxes are $10k a year. There are places in UT that cost $150k and rent for $1000 a month (or, well, there used to be) that are great because property taxes are $1000 a year and insurance is dirt cheap.

Your specific costs will be the determining factor. For a unit that is on your existing property, both insurance and taxes should be less than they would be for a standalone house on it's own lot. Maintenance and management are both easier/cheaper when you can walk out the door and investigate a leak or a funny smell. So you can probably bend the 1% rule here and still end up with a great investment.

That said, I agree that if you're careful and thrifty, you should be able to do it for less than $125k.

-W

tralfamadorian

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Re: Use Home Equity to Construct DADU Rental?
« Reply #18 on: December 04, 2018, 01:43:03 PM »
It's still not going to be meaningful. Assuming there's space/setback available to build the garage at all, it can't possibly be occupying more than about 15% of the land (assuming a small 4500 square foot lot and a 700 square foot footprint for the garage). Losing the capital gains exemption on that won't hurt enough to matter unless appreciation is just *insane*, and then, again, it's probably a good problem to have.

I mean, sure, it's worth looking at. But I'd be shocked if it made enough difference to scuttle such a slam-dunk of a project. Construction costs are the potential deal killer here.

-W

+1 Don't let the tax tail wag the investment dog. It's silly not be build an apparently cash flowing investment that will also provide value to the OP through a garage for the chance that they will lose a sliver of primary residence cap gain exclusion.