Housing affordability continues to be a struggle throughout the country, and despite recent increases in new construction, there’s still a shortage of houses on the market. In the most expensive markets, people are struggling to afford rent, let alone a mortgage.
In the last five years, policymakers have turned to a niche market to help ease rental supply woes: accessory dwelling units, or ADUs. These units — and homes with these units already built — can be complicated to finance. But ADUs offer a new niche to dedicated originators who take seriously their role as financial advisers.
Eight states have passed laws broadly allowing homeowners to build ADUs, and bills have been introduced in several other locales, according to a report from George Mason University.
ADU laws are attractive to policymakers who want to increase housing density. They’ve been successful in California. Nearly 21,000 units were built in 2022, roughly 17% of the state’s total added housing supply for the year.
“Over time more and more municipalities will do what California has done, because quite frankly it’s politically acceptable higher density in a way that multifamily is not,” said Laurie Goodman, a fellow at the Urban Institute Housing Finance Policy Center. She’s seen rule changes in cities across the country, including Minneapolis, Seattle, Austin and Arlington, Virginia.
ADUs are also attractive to homeowners and homebuyers who want to generate rental income or provide housing for family members. The biggest obstacle is financing, according to research from University of California, Berkeley’s Terner Center for Housing Innovation.
Homeowners have limited conventional options when it comes to funding ADU construction or purchasing a home with an already-existing or future-planned ADU. Most ADUs are funded with cash, home equity loans or lines of credit, cash-outs or renovation loans. These can be difficult to qualify for without significant home equity, cash reserves, high income or good credit.
The government-sponsored enterprises (GSEs) and the Federal Housing Administration (FHA) have restrictive guidelines about counting rental income to qualify. In October, the FHA announced new rules allowing a percent of estimated rental income to count toward qualification for two loan types: FHA mortgages on properties with existing ADUs and FHA rehabilitation loans.
“I find the counting of income to be very, very restrictive in terms of what the GSEs are doing,” Goodman said. “The FHA’s program is much better… but they don’t allow rental income to count on cash-out refis either. So I think it looks visually like more has been done than what has actually been done.”
And if an owner or buyer can qualify, the loan amount might not be enough to cover the permitting and construction costs. The median construction cost of an ADU in California in 2021 was $150,000, varying widely by location, size and quality of the unit. The Terner Center found that 62% of homeowners surveyed depended at least partially on cash reserves or gifts to finance an ADU.
Several states and municipalities have offered grant programs to help lower-income homeowners bridge the financing gap. California offers up to $40,000; New York offers up to $125,000. Originators can check their local municipalities for grant programs and keep them in their back pocket for borrowers who qualify for a loan that doesn’t quite cover their costs.
Credit unions are also beginning to offer ADU construction loans that consider rental income. As financing for these units proliferates, other portfolio lenders may begin to see them as less risky.
The simplest financing solution lies in non-qualified mortgage (non-QM) products. Rental properties are frequently funded with non-QM products, so these lenders have a solid foundation to base ADU funding on. They can also count as much rental income as they like, since restrictive GSE rules don’t apply.
Shane Colson, a senior account executive at non-QM lender FundLoans in San Diego, offered several tips for brokers looking to branch into ADU funding. He said the agent relationship is an important place to start, because they’re knowledgeable about housing trends in their market and will know if there’s an existing ADU niche. This is helpful for finding comparable properties for appraisals, which can be an issue for a property with the only ADU in its neighborhood.
It’s vital to find the right lending partner. National and regional lenders are both options, and Colson said local lenders with knowledge of local trends are often good resources.
“Find the right partner that knows what they’re doing,” Colson said. “Find a seasoned rep who’s done a few of these deals before and has had the bumps and bruises.”
To further complicate matters (and offer another potential income stream), a new California law will allow ADUs to be sold like condos. Municipalities are still figuring out how to make that work, and Colson expects lending to take a couple of years to catch up.
Because the permitting, building and financing pieces are all complex, it’s important to serve as an adviser to clients looking to build or purchase an ADU property. Having knowledgeable referral partners — agents, builders, permit advisers — is preferable. ADUs present a whole new set of complicated guidelines and challenges, but for the right originators in the right markets, these units provide a new income stream with potential for exponential growth. ●
