Welcome back to our Accessory Dwelling Unit (ADU) series! Anyone who wants to build an ADU first needs to understand their financing options. As ADUs increase in popularity, so too have ways to finance these structures.
To get a better idea of what these options look like, we talked to Troy Williams, a lender with Northpointe Bank. Troy contributed to our original ADU series several years ago and is an expert in the field.
- This post is part of our Denver ADU Course. ADU’s are a hot topic! This series is to keep you informed and updated on the ADU scene. View our Colorado ADU Directory list.
- Listen to the podcast “#332: ADU #3: How the Hell Do I Finance My ADU?” on the Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
Three Learning Options:
Why Focus on Financing Specifically for ADUs?
Troy is relatively new to the loan space. He worked in software sales for 25 years, but it wasn’t very fulfilling. He decided he wanted to do something that changes lives and found that in lending. Helping someone close on a house is life changing for that person, whether it’s their first home or one of many.
However, the market is challenging and there are a lot of loan officers out there, so Troy turned his attention to ADUs. He personally learned about them when looking into alternative housing options for his mother and realized that he could help others get financing to build them.
What Is the Typical Borrower Profile of People Who Want to Build an ADU?
The first type of borrower is someone who has been in their home for a while and needs a place for a relative to live. Usually, they want to stay in their house and are looking for options for someone who is older and less mobile. Because ADUs are small and tend to be one floor, they’re a great option for people with mobility issues.
The second type of borrower is a new investor who wants to stick their toe in the water. They don’t necessarily want to buy a separate investment property and like the idea of having a home they can keep an eye on and easily manage. Troy often gets calls from people who want to turn an ADU into a short-term rental and like the idea that the property will come with a warranty and brand-new appliances, carpet, and paint.
What are Some Refinance Options I Can Use to Build an ADU?
As a loan officer, Troy has about nine or ten different products he can offer borrowers, but the two easiest loans to fund are construction and renovation loans. With both loans, borrowers get approved using the future value of the property with the additional beds and bathrooms from the ADU. Depending on the location of the house, he’s seen value increases anywhere from $200K-390K.
Both of these loans are a type of refinance. The refinance includes the current loan in place and securing funds for the project, which are put in escrow.
The first option is a Fannie Mae loan that conforms to the current loan limit of $625K. This is a 30-year fixed rate loan. Troy usually recommends borrowers go this route if the total cost of the loan is under that limit.
If the loan is greater than the limit, then they can do a combination loan that includes a second mortgage. Payments start right away with this loan, and the second mortgage is considered a portfolio loan and is a 7-year Adjustable-Rate Mortgage (ARM). In this case, the borrower will want to either pay off that ARM or refinance before the 7-year mark. There’s no pre-payment penalty.
How Can I Use a Construction Loan to Build an ADU?
With a construction loan, the borrower has 12 months to build and only has to pay interest, taxes, and insurance on the loan during that time. They will only pay on what’s been drawn by the builder, and the loan officer will release the funds after inspecting the property.
Once the borrower has a Certificate of Occupancy for the ADU, the loan automatically flips to a 29-year mortgage and the borrower starts to pay principal.
Should I use a HELOC to Fund My ADU?
Troy says that a Home Equity Line of Credit (HELOC) can serve a good purpose. Assuming he would get an influx of cash, he would consider using a HELOC to build an ADU. The benefit to using a HELOC is that borrowers don’t need to get their builders approved by the loan officer because they’re getting the cash directly from the HELOC.
The downside to using a HELOC is that they have variable interest rates. The automatic payment only includes interest, and the borrow needs to go above and beyond to make extra payments. A HELOC’s interest rate can go up four times within one year, so it’s important to consider your circumstances when taking out this type of loan.
How Can a Small Business Owner Get Approved for a Loan?
Small business owners often make decent money, but their income isn’t reflected on the documents traditionally used to approve loans. Troy has a program that allows small business owners to submit bank statements instead of tax returns as long as they have been in business at least two years. They also need to have a good credit score and debt to income ratio.
This type of loan won’t have the greatest interest rate; the spread is about 2-2.5%. However, it’s a nice option for those who won’t otherwise get approval using traditional methods.
Can a House Hacker Putting Down 5% Get a Loan to Build an ADU?
A lot of our clients are house hackers who only made a down payment of 5% using a conventional loan product. Building an ADU on the property they’re purchasing would be a good option for them to get rental income. Phil says it’s still possible for these types of buyers to get a construction loan, but it’s tricky because they need to have everything lined up ahead of time. While under contract for their house, they will need to get the builder for the ADU lined up and have the budget, plan, and specs worked out.
It takes about 45 days to close this type of loan. By the time they close, the buyer will have already applied for the permit and have the designs of the ADU complete. At that point, the buyer has 12 months to complete construction. When construction is complete, there is a close-out appraisal to make sure that everything turned out as expected.
Is it Common to Run into Issues with Appraisals when Funding a Loan for an ADU?
In order to complete the appraisal, clients need to come up with a budget, plans, and specs. The budget is the cost of the construction project; the plan is the updated bed and bath count; and the spec includes the breakdown of the quality of materials used.
Before an appraisal is performed, Troy reaches out to the appraiser and asks if they have any experience with ADUs. It they don’t, he explains the work being done and the outcome to ensure the appraisal will accurately quantify the ADU.
The hardest part of the appraisal is finding comps. It’s necessary to find at least one that has an ADU, though sometimes they need to make adjustments. For example, if someone converted their garage into a yoga studio or workshop, it likely has electricity and plumbing but not living quarters. The appraiser can use this as a comp and assign a higher value to an ADU with living quarters.
What is the Typical Price Range of ADUs?
That’s a tough question because ADUs can range in value quite a bit. Troy has seen really high-end ADUs with themes and top dollar finishes that cost $350-450K; he’s also seen cottages dropped into backyards for $220K.
What Is the Most Successful ADU Story You’ve Seen?
In 2019, a buyer put down 20% on a primary residence that cost $580K. The buyer wanted to build an ADU on the property and was in good shape to do it because he knew the builder and wanted the exact same model as an ADU a few blocks away.
He started the process at the beginning of 2021 and his house appraised for $860K. He used that appraisal to finance his loan and built the ADU to rent out as an Airbnb.
Since he started renting out the Airbnb in June, there isn’t a single day it hasn’t been occupied. In a three-month period, he grossed $23K. He decided to do another refinance which entailed getting an updated appraisal. Now, his property is worth $1M.
What Is an Example of a Typical ADU?
Troy recently worked with a gentleman who bought his house in Englewood in 2006. At the time, he paid less than $200K for the home and consistently paid his mortgage. As he started to get closer to retirement age, he began to worry about what his future would look like.
When he came to Troy, the man’s house appraised at $300K, and he owed $120K for it. In addition, he had a HELOC and significant credit card debt. All together, he was paying $2700 per month.
Troy helped him get a construction loan to build an ADU in the backyard. He also helped eliminate the HELOC and pay off the credit cards so that the man is now paying $1300 a month in total. The man decided to move into the ADU and rent out the main house for $2K a month. Now, he can retire while living for free in a brand-new home.
What Will the ADU Market Look Like in a Few Years?
Troy thinks the market in Denver is going to blow up. He looks at California as an example: the state recently changed their zoning laws so that every lot can build an ADU. Though ADUs there are a little different than Colorado, it’s a sign of how things could pan out.
Many cities within Colorado are trending in the direction of permitting ADUs. Englewood now allows ADUs, which is a change from two years ago. Littleton just passed an ordinance allowing them, and Castle Rock introduced one. When Troy started, only 11 cities allowed ADUs, compared to the 17 and counting that allow them now.
What Is the Biggest Takeaway for Anyone Interested in ADUs?
It’s most important to start with the financing side. It has to make sense to build an ADU, either by reducing the impact on someone’s monthly payment or generating income.
For those who are seriously considering it, the best time to build is now. It’s never going to be cheaper to build than now, as steel and lumber prices are steadily going up. It will be harder to find a builder over time, so don’t hold yourself up because you hesitated too long to pull the trigger.
Connect with Troy
Troy is a lender with Northpointe Bank who specializes in financing for ADUs. He also has a comprehensive website: financemyadu.com. Reach out to him with any questions on funding an ADU, and consult his website for more in-depth information on loans, zoning, and his construction partners.
Connect with Us
If you want to invest in your own property with an ADU, reach out to us. We’d be happy to present you with different scenarios and help form a strategy that’s right for you.
Be sure to check out our ADU Directory to learn more about the ADU rules in your area.