With rents at an all-time high in the U.S., the rental market is an attractive option for people looking to invest. However, similarly-high property values and the surging popularity of accessory dwelling units (ADUs) as revenue-generating rental properties has made the choice between the two a difficult one for many hoping to get into the market.
Both options have distinct advantages and disadvantages for investors. The option that’s best for you will depend on a few key factors about your finances, the property you currently own, and your personal preferences. In the following article, we go over some of the main considerations to help you figure out the right investment option for you.
Buying an Additional Property for a Rental: What To Know
The more traditional model for acquiring a rental property is to purchase an existing home and put it on the market. This tried-and-true way of doing business has an established track record of providing rental income for property owners. It is still the most popular way for people to invest in a home that they hope can bring in additional revenue.
But while many people have found success through this model, it’s not a guarantee. Buying an existing property to use as a rental has many benefits, but also some notable downsides.
Advantages of Buying an Additional Property
There is a reason that buying a rental property that already exists is such a well-established model: it comes with some significant advantages.
Faster Return on Investment
Unless the home you buy needs significant repairs or upgrades, you can often start renting out an existing property soon after you buy it. This allows you to start generating revenue and recouping your investment quickly, limiting your exposure to your new debt.
However, this does depend on the condition of your property and the rental market where you invest. Some homes require a lot of work to bring them into the kind of shape they need to be to fetch the rent you hope to charge. In addition, there is no guarantee that you will rent it quickly, especially if the market in your area is saturated.
Cheaper Financing
Even though rates are at their highest point in a long time, a traditional mortgage is still likely to come with lower rates than the option you have to finance an ADU build. When you borrow tens or hundreds of thousands of dollars, even a half a percentage point can make an enormous difference in the total interest you pay over the lifetime of the loan.
Can Be Sold Independently
One of the biggest advantages of buying an independent property is that you have the option to sell at almost any time. This means that you can choose to sell when the market is hot to try and capitalize on your investment and cash out. It also gives you the option to cut your losses if things aren’t going so well.
Disadvantages of Buying an Additional Property
There are also some substantial downsides to buying another property as an investment vehicle compared to building an ADU.
Typically More Expensive
There is often a huge difference in price between buying a home and building an ADU – sometimes in the hundreds of thousands of dollars. For some, this could mean buying another property simply isn’t an option. But even for those who can afford it, there may not be enough of a difference in rent to justify that extra expense.
Mortgage Rates Are Very High Right Now
A larger investment is a major consideration in any market. But with mortgage rates currently at their highest level in decades, the extra expense of an independent property is compounded by those higher interest rates. In other words, the more expensive investment is even more expensive at this time.
Bigger Down Payment Required
Government agencies and even some lenders allow people to purchase their primary residence with a small down payment. But that’s not typically the case with an investment property. Purchasing an additional home for rental purposes will likely require a large down payment that you may not have available. And while you can borrow money to make that payment, the extra interest you pay on that loan adds significant cost to your investment.
Building an ADU for a Rental Property: What To Know
Over the last decade, ADUs have become an increasingly popular way to invest in a rental property. These secondary dwellings have allowed people to use the property they already own to start generating additional income.
This rise in popularity should serve as proof that building an ADU and renting it out has a lot of promise as an investment model. Still, there are some considerable disadvantages worth taking into account.
Advantages of Building an ADU
There are many upsides to building an ADU to use as a rental property that may make it an attractive option for you.
Typically Cheaper
In general, ADUs tend to be cheaper to build than an additional property is to buy. This is especially true in high cost-of-living areas where even a small home can be unaffordable for many people.
North Carolina is not among the most expensive states when it comes to home prices, but the average house price is still over $320,000. By comparison, our average ADU build costs between $80,000 and $300,000. This makes building an ADU a lower cost of entry as an investment and achievable for more people.
Can Drive Similar Rental Price
Despite costing less to build than a second home would be to buy, you can often charge a similar amount in rent for an ADU as you would for an independent home of a similar description. Especially in hot rental markets, a two-bedroom house is a two-bedroom house, regardless of whether or not it’s located on someone else’s property.
This means that you may be able to make more overall from an ADU, since your total cost is lower but your income is similar. If the market in your area has a high level of demand compared to the housing supply, an ADU could be more profitable.
Adds Value To Primary Residence
Adding an ADU to your property will also increase your property value. Upgrading your home or adding space will typically increase its value, but an ADU has the potential to offer an even higher ROI. That’s because in addition to adding square footage and amenities to your home, an ADU can also generate revenue. Essentially, when you hire an ADU contractor to build one on your property and sell it, you’re selling both a home and a business.
Disadvantages of Building an ADU
Building an ADU for rental purposes also has some downsides that you should consider seriously.
Often Can’t Be Sold Independently
One of the most significant downsides of building an ADU as a rental compared to buying an additional property is that you are often legally forbidden from selling an ADU as its own property. This means that as an investment vehicle, an ADU is much less flexible than an independent property.
Some states and cities have begun changing their laws to allow property owners to subdivide and sell off their ADU, but this still is not the norm. In most cases, if you want to sell your ADU, you’ll have to sell your primary residence along with it.
Higher Financing Rates
Unless you can pay for an ADU build in cash, you’ll have to find financing. In most cases, lenders will not issue a standard mortgage for an ADU like they would an additional property.
You do have a few options for ADU financing. One of the most popular is a home equity line of credit (HELOC) that uses equity built up in your home as collateral. While you can use this to pay for your ADU build, these loans typically come with much higher rates than mortgages.
Slower Returns
If you want to build an ADU – sometimes referred to as an in-law suite – to rent out, you’ll have to wait for it to be finished to start generating revenue. In general, an ADU can take six to eight months from start to finish to complete. For some investors, that’s a long time to have money out without any money coming back in. This is another affordability factor worth considering.
Should I Buy an Additional Property or Build an ADU to Rent Out?
Whether you should buy an additional property or build an ADU to invest in the rental market is entirely specific to your situation. There are many factors to consider when making this decision, some of the most important of which include:
- Budget: You can only invest in what you can afford to invest in. If you have the money to invest in an ADU but not in an additional home, you don’t have much of a choice.
- Local laws: You can build an ADU on your property in most places these days, but not all. Your local laws and, if you belong to one, your HOA covenants may prevent you from building a granny flat in your yard.
- Rental market: Every rental market is different, and how much you can make depends greatly on how quickly you can rent your home and for how much. In soft markets where supply is greater than demand, it may be easier to rent out an independent home.
- Income: If you want to build an ADU, you’ll have to wait months for it to start generating revenue. That means you’ll need to have an income that supports your investment while it isn’t bringing any money in.
- Competition: In areas where the housing market is highly-competitive, buying a home can be difficult and may require making a lot of offers and take a lot of time. Building an ADU, on the other hand, doesn’t require you to interact with that market.
- Privacy needs: Renting an ADU out on your property means you’ll have people you may not know living in your backyard. This is unappealing for some people, and it’s worth considering whether or not you can tolerate having people you don’t know that close to you.
An ADU is an Excellent Choice for Generating Rental Income
Buying an existing home as a rental unit is a relatively safe bet if you can afford it. However, an ADU typically comes at a much lower price point and may demand a similar amount in rent with comparable specifications. That means that it can be more profitable as an investment vehicle depending on the circumstances.
Additionally, building an ADU adds to your community’s housing supply without taking up more land. This contributes to increased density and can make a small contribution towards alleviating affordability issues in many areas.
Our team is happy to help you explore your ADU options and help you learn what you can build, how much it will cost, and what you might be able to earn from it. Click the button below to register for a free consultation to learn more.
Leave A Comment