The ROI of an ADU

The ROI of an ADU

We are all aware that adding an ADU to a property is a great investment, but what is the actual ROI of an ADU?

“Landlords grow rich in their sleep without working, risking or economizing.”

John Stuart Mill, political economist

Real estate investing is a great way to diversify one’s investment portfolio. There are many ways one can invest in real estate. Common strategies include REITS, purchases of residential, commercial buildings, and land. Lesser known strategies include fix-and-flip, “house-hacking”, wholesaling, live-in flip…the list goes on. However, one option truly claims the title of “tried and true”: rentals.

Renting can generate great cash flow and bolster one’s net worth, even while you sleep. 

ADUs (“in-law suites”, “casitas”, “granny flats”) have made rental properties more accessible than ever. With much smaller purchase prices than a full home, these units can still fetch generous monthly rent. Below, we walk through a few examples of what this rental means in terms of a return on investment (ROI).

A. The ROI of an ADU for Cash Transactions

The ROI of a cash purchase is straightforward. Below is an example of an ADU rental purchased with cash:

Example #1: No Appreciation

  • You pay $225,000 in cash for the ADU.
  • You collect $2,500 in rent every month.
  • Your tenant covers their own utilities.

One year later:

  • You earned $30,000 in rental income for those 12 months.
  • Expenses outside of utilities include property taxes, insurance, and maintenance totaled $3,60
  • for the year, or $300 per month.
  • Your annual return is $26,400 ($30,000 – $3,600).

To calculate the property’s ROI:

  • Divide the annual return ($26,400) by the amount of the total investment, or $225,000.
  • ROI = $26,400 ÷ $225,000 = 0.117 or 11.7%.
  • Your ROI was 11.7%.

Example #2: 4% Annualized Appreciation

  • You pay $225,000 in cash for the ADU (assume the property appraises at that value).
  • You collect $2,500 in rent every month.
  • Your tenant covers their own utilities.

One year later: 

  • You earned $30,000 in rental income for those 12 months.
  • Expenses outside of utilities include property taxes, insurance, and maintenance totaled $3,600 for the year. or $300 per month.
  • The property has increased in value by 4%, or $225,000 x .04 = $9,0000.
  • Your annual return is the $26,400 from rent plus the $9,000 from appreciation, or $35,400.

To calculate the property’s ROI: 

  • Divide the annual return ($35,400) by the amount of the total investment, or $225,000.
  • ROI = $35,400 ÷ $225,000 = 0.157 or 15.7%. 
  • Your ROI was 15.7%.

B. The ROI of an ADU for Financed Transactions

Calculating the ROI on financed transactions is more involved. Below is an example of an ADU rental purchased with a loan:

For example, assume you bought a $225,000 ADU rental property as above, but instead of paying cash, you took out a mortgage.

  • The downpayment needed for the mortgage was 20% of the purchase price, or $45,000 ($225,000 sales price x 20%).
  • For a 30-year loan with a fixed 3.5% interest rate. On the borrowed $180,000, the monthly principal and interest payment would be $808.
  • Expenses outside of utilities include property taxes, insurance, and maintenance totaled $3,600 for the year. or $300 per month.
  • Total expenses = $1,108
  • Rental income of $2,500 per month totals $30,000 for the year.
  • Monthly income is $1,392 ($2,500 rent – $808 mortgage payment).

One year later:

  • You earned $30,000 in total rental income for the year
  • Your annual return after expenses was $16,704 ($1,392 x 12 months).

To calculate the property’s ROI:

  • Divide the annual return by your down payment of $45,000 to determine ROI.
  • ROI = $16,704 ÷ $45,000 = 0.371.
  • Your ROI is 37.1%.

With our hypothetical 4% appreciation, this number is much, much higher.

Caveats

Now to be clear, the above is a simplification of renting. One should surely tuck away money for a rainy day fund. Expenses one month may be lower but in other months may be higher. Tenant turnover impacts rentals and can be the cause of a month or two (or more) without that income. However, it’s not all bad news. There are a number of tax benefits that come from owning residential real estate.

Takeaways

Renting out an ADU can be a very profitable endeavor. An ADU can generate great income, appreciate in value, and increase the overall value of one’s home.

“Don’t wait to buy real estate. Buy real estate and wait.”