Getting into the rental game? Consider this before building an apartment over the garage

• With home prices sky high, demand for rental units is soaring.
• Now, a growing number of homeowners, particularly in high-cost areas, are converting a portion of their properties into garage apartments, granny flats or guest houses for short- or long-term rentals.
• Here are some things to consider first.

Many things have been in short supply during the coronavirus crisis, and that includes housing.

When the country went into lockdown, Americans were on the move. The sudden shake up caused a spike in home prices.

Even now, potential buyers continue to be shut out of the housing market as prices head higher and higher.

At the same time, the pandemic-induced run on housing has put even more pressure on the demand for rentals, which are generally more affordable than ownership.

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Anyone with a little extra space can turn that room into a rental. For some, this is an investment opportunity.

As the nation's housing crisis intensifies, a growing number of homeowners, particularly in high-cost areas, are converting a piece of their property into a garage apartment, granny flat or guest house for short- or long-term rent.

So-called accessory dwelling units, or ADUs, are now a popular way to add an income-generating rental property on the same lot as a single-family home, according to a recent research note by Freddie Mac.

"We're in the midst of a huge housing crisis; that leads to classic economic supply and demand," said Caitlin Bigelow, the CEO of Maxable, a startup that connects homeowners with resources to build rental units from start to finish. "Homeowners are looking at ADUs as low-hanging fruit." (Each Maxable project begins with an evaluation for $199.) 

In 2018, Amy O'Dorisio, 40, turned a stand-alone garage into a one-bedroom, one-bath unit. In the last year, demand for those types of apartments has only grown, O'Dorisio said — particularly in San Diego, where she lives and works as a residential realtor.

"I knew that it would catch on and it has," she said.

O'Dorisio said she spent $130,000 on the conversion, including permits and some furniture. She now rents the unit for roughly $2,000 a month. She is currently working on converting another portion of her property into an additional ADU.

"My goal is to have enough rental income that I don't have to work as hard," she said.

In fact, after a year of record low interest rates and soaring home prices, real estate became the most preferred way to invest over the long run, according to a recent Bankrate.com report — topping savings accounts or certificates of deposit and the stock market.

But there are many factors to consider. For starters, whether you can add on an accessory dwelling unit depends on the ordinances, or rules, in your jurisdiction. The scarcity of affordable housing is driving more cities to adopt ADU-friendly legislation, making these units legal in many neighborhoods; however, it's not across the board.

And turning spare rooms into rentals isn't cheap. Garage conversions start at about $100,000, according to Maxable's Bigelow. Building a separate stand-alone structure is even more.

Once a unit is built, there are two main ways to make money: cash flow and appreciation, according to Tendayi Kapfidze, chief economist at LendingTree, an online loan marketplace.

"If your goal is cash flow, you'll need to know if you can lease the property for enough to earn more than you spend on the mortgage and maintenance," he said.

The rental income should cover your monthly costs, including insurance and some amount of vacancy.

"All that has to average out," Kapfidze said.

"If you're more interested in appreciation, you have to estimate whether the property will be worth more several years down the line," Kapfidze added.

Like all things in real estate, much of that comes down to location, location, location.

Notoriously expensive cities like Chicago, Miami and Seattle have seen a growing number of these rental units over the last decade while homeowners with ADUs in more affordable cities like Austin, Texas; Nashville and Phoenix could benefit going forward from a sudden increase in rent prices due to Covid.

Vacation towns may be even more lucrative.

Properties in exclusive enclaves, such as Kiawah Island near Charleston, South Carolina; Key Biscayne, Florida; Park City, Utah; Rehoboth Beach, Delaware; Nantucket, Massachusetts and the New Jersey beach towns of Stone Harbor and Avalon, have the highest value as investments, according to another report by MagnifyMoney.

Still, potential rental income can also vary from block to block, Kapfidze cautioned.

"It's something that's very, very local," he said. "Before you figure out the finances, it's very important to understand the level of demand in a very small geographic area where your home is." 

Further, it can be hard to access your cash once you've locked it up in real estate. These days, "even if the property appreciates in value, you can't usually access the equity with a home equity loan or line of credit," Kapfidze said.

Since the start of the pandemic, the banking industry has tightened lending standards to reduce risk and several large banks stopped offering HELOCs or cash-out refinances altogether. 

There are tax and insurance implications, as well. "Your insurance needs will also be different, so you should evaluate that cost ahead of time," Kapfidze said. 

On the flipside, some of those additional insurance costs could be tax-deductible, on top of the potential tax benefits of making home improvements, he added.

"That's definitely something you'll want to talk to a tax expert about."

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