Addressing Affordability and Housing Supply while Investing in Your Residential Property
Updated: Mar 30, 2020
Urban density and affordability are familiar issues for many Austinites. Building an Auxiliary Dwelling Unit (ADU) has become a creative project. Homeowners can pursue ADU construction to address these issues while increasing their home value and/or adding rental income. Homeowners with an ADU can subdivide their lot and sell either property, or they can rent out the property to long-term or short-term tenants.
What you can build
In 2015, the City of Austin relaxed restrictions that had previously made ADU construction more challenging. Currently, the size of your ADU must be less than 1100 square feet and less than 30 feet tall, so two stories maximum. If you build a second story, that floor is limited to 550 square feet. All in all, you’re looking at a 0-, 1-, or 2-bedroom unit.
The size of your lot affects the size of the ADU you’re allowed to build. The ADU must be at least 10 feet away from the primary dwelling. Because Austin is prone to flooding, there are restrictions on how much permeable surface you must leave on your property. So, the enclosed livable area of your ADU cannot exceed 15% of your lot size, and total constructed livable space on your land must be less than 40% of your lot.
Example: I have a 1,000 square foot house on a 4,000 square foot property. I can construct a 600 square foot ADU. This is 15% of my lot size and 40% of the constructed space on my property.
Depending on the location of your property, you may be required to add a parking space for your ADU. If you decide to subdivide your lot and sell your property, you’ll also want an independent route for the owner to access their property. But, if you’re centrally located or close to CapMetro service, you may not be required to add parking to your property. Look here to see if you reside in an activity corridor.
Now that we’ve talked about what’s possible for your ADU, let’s explore the process of constructing it.
Permitting & Construction
Everyone gets warm fuzzies when it comes to permitting; City of Austin is no exception. To construct an ADU, your property must be zoned as SF-3, and your plan must meet all City of Austin requirements. A survey of your property is typically required, denoting all trees, buildings, setbacks, and easements. If there are large trees on the property, a separate tree plan may be required, and you may need to consult an arborist.
The costs of planning and building an ADU can be significant throughout the process. Expect architect fees in the ballpark of $5,000 for an ADU plan. Permitting fees, including survey and tree plan, will cost around $2500. Construction costs for this type of project can meet $150 per square foot but can vary based on selected fixtures, unforeseen construction barriers, and city requirements. What’s especially challenging is bringing electricity and sewer, along with separate metering to your ADU. A contingency budget for all of these costs could add up to 30% of further construction costs. This brings the estimated project costs for our 600-square-foot ADU to $125,000, give or take. Or, to more simply estimate your budget, expect $200 per square foot for total project costs.
To finance these costs, you may consider refinancing your mortgage to take advantage of the existing equity in your home. Keep in mind that your loan balance will need to be less than 80% of your home value to avoid PMI. PMI, or mortgage insurance, can add an additional $200-300 to your monthly mortgage payment, which could make your investment cash-flow negative for a period of time.
Other costs include an increase in property taxes and energy costs, both of which you’ll pass on to renters. You’ll probably also want to consider adding an umbrella policy to your insurance if you intend to have people living on your property in an ADU.
Before constructing an ADU, you should understand your goal for the unit. You could rent the unit out for long-term use to a tenant, keep the property as a guesthouse with limited short-term rental use, or subdivide your property and sell the main residence or ADU.
If you intend to rent your ADU to a long-term tenant, you should research rents for comparable units in your area to find out what you’re likely to generate in monthly income. There may be periods of time when your ADU is cash flow negative: during construction, when you’re in between tenants, if you have PMI, or if your construction project costs are higher than market-rate rents in your area. Prepare to have enough cash available to cover your costs during these times.
To evaluate this investment, we should look at its cap rate. The cap rate compares the annual net income from the property to its costs.
Compare your net operating income to your purchase price to determine your cap rate. In this example, $8,800 net operating income / $124,500 unit value= 7% cap rate, or annual return on your investment. The current risk-free rate is less than 1.6% for 3-month US Treasury Bills, so you would earn an additional 5.4% as a premium for the risk you take on this investment.
The changes to ADU regulations in 2015 limited the number of days you can rent out new ADUs short-term for Austin visitors. ADUs constructed after 2015 are limited to 30 days of short-term rental use per year. This limitation makes it pretty unlikely that you’ll generate positive cash flow on constructing an ADU for short-term use. This option works best if you intend to keep the ADU as a guesthouse for your personal use, with the option for short-term rental use. That way, you benefit from the additional space while you live on the property and capital appreciation from the ADU when you sell the property.
Selling the ADU outright requires some additional work. Specifically, you have to subdivide your property. This process entails an optional development assessment, required completeness check, and formal review process, along with some fun fees. In addition to the subdivision review process, you’ll have realtor fees for the sale of the ADU, and you may have some additional requirements such as parking and independent access to the ADU.
To sum up, affordability and housing supply continues to be an issue for Austin residents. Many folks see their primary residence as an opportunity to improve density, add income, or make an investment, all while addressing our community housing issues. Of course, this is a big decision, with lots of rules, options, and factors to consider before making the investment. If you have a specific idea for an ADU on your property, I’m happy to help you talk through your options to determine if this type of investment is right for you.