According to data from U.S. News and World Report, California holds the unenviable title of being the least affordable state for housing. Consumers and lawmakers are urgently seeking inventive solutions as the housing crisis spirals out of control.
For many, the answer lies in the backyard. Of all the houses built in California in 2022, one in six weren't traditional houses at all. They were Accessory Dwelling Units (ADUs), commonly called granny flats, in-law units, backyard homes, or guest cottages.
These types of dwellings are on the rise as an answer to the struggle between affordability and availability. As rental properties, they provide a much-needed income boost to homeowners struggling with affordability. ADUs also offer opportunities for multi-generational living and serve as a housing option that falls between a single-family home and an apartment.
Why Build an ADU?
John Dealbreuin, 44, is an early retiree and personal finance expert who writes for Financial Freedom Countdown. He looked for an ADU to allow for multi-generational living in a high-cost-of-living area. He built his San Francisco Bay area ADU so his parents, ages 78 and 83, could live closer to him.
Recent state legislation in California has made the process easier, since local cities or neighbors can no longer object to the building of the ADUs. Dealbreuin says, “For homeowners, adding additional living space is always a wise choice given the arbitrage between the construction costs and price of new homes.”
When it comes to leveraging an ADU as extra space for the family, Dealbreuin has a lot of company. Whitney Hill, co-founder of SnapADU, notes that roughly half of the homeowners who reach out to her company plan to use their ADU for multi-generational living or as a flex space for work or hobbies.
The other half of Hill's clients will use their ADU as a much-needed income stream in a tight economy. About 44% intend to rent out the ADU itself, while 6% plan to downsize into the ADU and rent out the larger main home.
Dealbreuin agrees this is a smart financial move. “Even if you do not have family members who use [the ADU],” he says, “it is a great investment as a rental property. When I ran the numbers for my ADU, it can easily meet the 1% rule of thumb for rental properties, which is impossible in the San Francisco Bay Area.”
Better Financing Options
While the potential for rental income from ADUs is promising, the up-front cost is still a barrier for many homeowners and those looking for their first home. However, Hill sees hope on the horizon in the form of financing. She explains, “In a promising update for ADU financing, both Freddie Mac and the Federal Housing Administration (FHA) have implemented policies that acknowledge the value of ADUs.
“Freddie Mac now backs mortgages that consider rental income from an existing ADU, while the FHA allows up to 75% of estimated ADU rental income to be counted when underwriting a mortgage. These changes significantly broaden financing options and reaffirm ADUs as viable solutions for housing and investment.”
These changes are also good news for buyers who rely on income from their ADU to pay the mortgage on their property. However, despite increasingly favorable regulations, there is still a significant gap between the number of ADUs that are permitted and the number of completed structures.
Hill noted that about 15% of SnapADU clients decide not to construct their ADU sometime between agreeing to the project and the actual building of the structure. Typically, she explains, this is due to financing or unexpected changes in family circumstances.
SnapADU's success rate far outpaces that of the overall ADU market. According to Cottage's ADU Impact Report, only about one-third of the ADU permits submitted since 2017 resulted in a completed structure.
“The process of designing, permitting, and building an ADU is more complex than many homeowners expect,” says Kris Lippi, real estate broker and owner of ISoldMyHouse.com. “There are layers of regulations involved. Many of these regulations are new, and cities are still working on how to interpret state regulations. Roadblocks pop up often, and sometimes they're too costly or complex for the homeowner to navigate alone.”
A Brighter Housing Future
While these roadblocks are undeniably frustrating, the possibilities offered by these structures are exciting. The number of single-family homes constructed in California continues to decline year-over-year, but the number of ADUs that are built is increasing. If every ADU permit submitted in 2022 resulted in a completed structure, California would add 50% more homes annually. That's an undeniable bright spot in a challenging housing market.