ADU’s are still uncommon in the Seattle market (and in the country in general), so there is not much evidence from actual sales to establish the value of an ADU.
There are several methods used to value real estate. In this article, we’re going to take a look at each of them.
In order of most common use for small residential property, the valuation methods are…
- Sales Comparisons (“Comps”)
- Income Valuation
- Residual Analysis
- Present Value Analysis
- Replacement Cost
For the examples below, let’s make the following assumptions:
- The primary house is worth $650,000
- You can rent the primary house for $3,000 / month
- You can rent the ADU for $1,900 / month
Sales Comparisons
The sales comparison method looks at what comparable properties in the area (generally called “comps”) have sold for recently, and assumes that your property will sell for a similar price. This is great for selling a house, and is generally the only method used for a typical transaction.
But…
You probably haven’t seen any properties with ADU’s selling in your neighborhood recently. There just aren’t enough of them to provide reliable comps for this type of analysis.
So, moving on…
Sales Comparison: ???
Income Valuation
This is the method that investors use to value a property. They look at how much the property will rent for and apply a formula to determine how much they are willing to pay for that future income.
This is based on a simple formula:
Price = Net Operating Income / Cap Rate
“Net Operating Income” just means rent minus expenses to operate the property. This does not include the mortgage. Typically, operating expenses includes property tax, insurance, utilities, vacancy, maintenance and repairs, and property management. A good rule of thumb for a new ADU is that operating expenses will be 30% of the annual rent, making Net Operating Income 70% of the annual rent (side note, you can do better than this as a homeowner if you manage the property yourself and provide most of the labor to fix and maintain the ADU yourself; this figure is just how an outside investor would look at it).
“Cap Rate” is an investment term that describes the rate of return an investor inspects to get on that type of property. Think of it like the Price to Earnings ratio for a stock. In Seattle, investors are quite happy with a 5.5% Cap Rate (this is a conservative assumption – most apartments trade at less than a 5% Cap Rate in Seattle today).
Using our assumptions from the start of this post, let’s do the calculation.
If you were to rent out both the main house and the ADU, the total annual rent would be ($3,000 / month + $1,900 / month) * 12 months / year = $58,800.
The Net Operating Income will be 70% of this amount, or $41,160.
Dividing the Net Operating Income by a Cap Rate of 5.5% gives a value of $748,364.
Subtract the value of the primary house, and you get ($ 748,364 – $650,000) = $98,364.
That’s nearly $100,000 that the ADU added to the property value, based on conservative assumptions. And keep in mind that investors usually aren’t willing to pay as much for a property as a homeowner would.
This sets a minimum value for your new ADU, since you can be reasonably confident of making a quick sale to an investor at this price.
Income Valuation: $100,000 +
Residual Analysis (“Mortgage Qualification”)
What if you want to sell the property to a future homeowner? They’re willing to pay more than an investor, right? Let’s figure out how much more.
When you buy a property that produces rental income, you are generally allowed to count part of that rental income toward your total income for qualifying for a mortgage (75% is a typical requirement, which is close to the amount used for our “Net Operating Income” calculation above).
Let’s look at our theoretical buyer. This couple earns $135,000 per year. They want to keep their mortgage payments under 28% of their income (their bank also won’t let them borrow more than this). They have $65,000 available to put toward a down payment.
This couple could afford to buy the $650,000 primary house without any trouble (the mortgage payments would be $3,116 / month, just under 28% of their income).
But this property has an ADU that generates extra income. $22,800 per year extra, in fact.
So let’s add this to the couple’s income. Actually, we need to take off 25% first, because the bank only lets them use 75% of the rental income to qualify for a loan.
The couple’s new income is $157,800 per year. With this income, they can afford a mortgage payment of $3,682 / month, which translates to a loan of $685,889. Add their down payment of $65,000, and this couple can now afford to pay just over $750,000 for the property. Again, that’s $100,000 over the price of the original home.
But let’s look at what that does to the mortgage payments of the buyer. They’re paying $3,682 / month on their mortgage, but they can rent out the ADU for $1,900 / month. Even after accounting for the extra expenses of maintaining and operating the rental (that 30% operating expense), they are still only paying an effective mortgage of $2,352 on the property. Compare that to the $3,116 they would be paying without the ADU, and it becomes clear this is actually a really sweet deal for our new buyer.
So $100,000 may be the limit to what the bank will loan, but any potential buyer for your property would be happy to pay more than that if they can.
Income Valuation: $100,000 +
Present Value Analysis
The next way to look at the value of your ADU is to calculate what all those monthly rent payments are worth over the life of the building. I’m not going to get into the math here. If you’re curious, a quick google search will help you out.
Let’s assume the ADU lasts 50 years and is worth nothing when that time is up. Let’s also assume that rents grow at an average rate of 3% per year. This is conservative, given Seattle is still a rapidly growing city with high demand for housing.
Also, I’m going to assume that the maintenance expenses go up after 15 years as the ADU starts to get old. Instead of a 30% operating expense, I’m going to use 50% from year 15 on.
This analysis requires you to pick a “Discount Rate,” which is best thought of as the opportunity cost of your money. What else could you be spending the money on if you didn’t put it toward the ADU project. I’m going to use a Discount Rate of 9%, since that is comparable to the long-run average for the stock market.
Using these assumptions, I calculate that the income stream from the ADU is worth $213,000 today. That is the price someone would pay if they were expecting a 9% return on their investment.
Present Value Analysis: $230,000
Replacement Cost
Finally, the last way to figure out how much a building might be worth is based on the cost to replace it. People aren’t willing to buy something for more than they would have to pay to get a brand new version (assuming the new version is available, and factoring in the cost of time, convenience, etc.)
Think about it – if you had a choice between buying a house for $1,000,000 when you could buy the land next door and build a brand new house for $700,000, which would you do?
Unlike the primary houses, ADU’s are not land-restricted. You probably can’t find a new empty lot in your neighborhood to build on for any reasonable price, but you could probably build an ADU in the backyard of the house next to yours just as easily as in yours.
So replacement cost gives a reasonable maximum price for the ADU. If it costs you $200,000 to build an ADU (including all costs: design, permitting, construction, fees, and sales tax), the maximum value shouldn’t be much higher than that. The reality, however, is that there is a lot of time and energy that goes into building an ADU, along with risk of cost overruns, not to mention actually needing to have the cash or financing available to do it. Those things are all worth a premium. Maybe as much as $100,000. So the maximum value of your new ADU probably won’t be any higher than $300,000.
Replacement Cost: < $300,000
Final Thoughts
So there you have it. To sum up, here’s the value we got with each of the methods:
Sales Comparison: N/A
Income Valuation: $100,000 +
Residual Analysis: $100,000 +
Present Value Analysis: $230,000
Replacement Cost: < $300,000
Clear as mud?
ADU’s are still a new item on the Seattle housing menu, and the market hasn’t decided what it thinks yet. Over time as they become more common, I believe you can expect their value to move closer and closer to the Present Value Analysis amount.
But for today, I’d recommend taking the conservative approach and expecting you’ll only get $100,000 of resale value out of the ADU, even though whoever buys it for that price will be getting a killer deal.
All these numbers are in today’s dollars. When projecting into the future, be sure to add appreciation (4.6% historically for Seattle), or at least inflation (3%) to figure out how much your ADU might be worth when you sell it.
tl;dr
Your ADU is probably worth $100,000 today. Some day it will likely be worth closer to $230,000 (in today’s dollars) once the market catches on to how good an investment this really is.
