How appraisals and “GSEs” make financing an ADU challenging

(Update January 2013: please note that the research on which the following piece was based has now been published in Appraisal Journal.   Please read the full text of that article for a deeper treatment of this material.)

So you’ve bought the whole argument about an ADU being a good thing for your family, lifestyle, finances, and/or environment.  You want one on your property.   It’s going to cost a sizeable amount of money.  You don’t have that much cash on hand. Now, how do you finance it?

picture by doug88888 (Creative Commons)

Kol has written a good list of options to try, but to sum up, financing an ADU can be a major challenge.  In this post I’d like to dig a little deeper to explain why that is the case. Warning: I really get into the weedy details here. 🙂

First, ADUs are expensive to build.  They are major construction projects, often costing in the range of $30,000-$150,000.   That means you need a lot of security for your loan.  Security usually comes from equity — the difference between the theoretical value of your property, which is set by an appraisal, and what you owe on it.

Second, appraised values, and therefore equity, have gone down, way down, with the recent real estate slump (or correction, depending on your point of view).   So that means you probably have a lot less equity to play with now than you would have five years ago.

But wait a second, you might say– after my ADU is built, won’t my property be worth a lot more?  Couldn’t that be the basis for a bigger loan?

No. Yes. Sort of.   No matter whether you borrow based on the present value of your property, or the future value, an appraiser will have to provide that crucial number.  And appraisers struggle to provide quality numbers for properties with ADUs (to see some examples, lurk in this forum).

Sometimes they struggle because they are unsure that legal, permitted ADUs can even exist (there is a widespread presumption that they are unpermitted).  However, the bigger problem is their typical method of placing a value on a single-family property: the “sales comparison method.” This method of valuation requires multiple examples of similar properties which have recently sold, and ADUs are rare enough that such “comps” are simply too hard to find.  As a result, estimates of the contributory value of ADUs can vary wildly– on my own property, appraisers have said my ADU adds $10,000 of value, and $100,000.

But it’s not fair to blame appraisers.  No matter how smart and good they are, they work by somebody else’s rules, and those rules don’t acknowledge the reality of legal ADUs.   And the rules are not set by the local bank. Mortgage lending is not a face-to-face affair anymore.  Even if you go to a local bank branch and obtain a loan from an actual human being there, it’s very likely the bank’s intention is to quickly resell the loan to another institution, and that the loan will end up owned, insured, or guaranteed by a gigantic government-sponsored enterprise (GSE) such as Fannie Mae, Freddie Mac, or the FHA.

So, the bank can’t really follow its own impulses and policies about lending, no matter how great you or your project are; rather it has to follow rules set by the GSEs.  And, to make matters worse, the GSEs have their own confused vocabulary and standards regarding ADUs.

• Fannie Mae does not use the term “ADU” in its single-family Selling Guide, but will purchase loans on properties with illegal “accessory units,” a scenario for which it (oddly) provides detailed guidance. It will also purchase loans on properties with legal accessory units, “if the value of the legal second unit is relatively insignificant in relation to the total value of the property.” (see page 502 and 531 here).
• Freddie Mac says that “a property may have an incidental accessory unit that is incidental to the overall value and appearance of the subject property.” (yes, they use the word “incidental” twice.  See their Single-Family Seller/Servicer Guide, Section 44.15).
• HUD uses the term “accessory dwelling units,” and also emphasizes their subordinate nature; if the ADU is too similar in size, it is a “secondary unit” requiring a different appraisal form, and likely a different lending program.  (See page 15 here).

Taken together, these guidelines create a strong suggestion for loan originators and the appraisers that work for them: if an ADU is encountered, it is likely to be illegal, and it may (and perhaps should) be given only insignificant or incidental contributory value. The case of a legal ADU is barely addressed.

One of the crucial qualities of a legal ADU is that (in most places that allow them) it can be rented for income.  And rental income is a very useful tool for appraising properties, because rental income is probably a more fundamental indicator of value than market price (which swings up and down wildly).  In fact appraisal via the “income approach to value” is a cornerstone of commercial real estate practice.

However, residential appraisers struggle to utilize the income approach on properties with ADUs.  It’s not standard for them, and worse, GSE policies discourage it.  Freddie Mac states that “appraisals that rely primarily on the income or cost approaches to value in order to estimate market value are unacceptable”.  (See their Single-Family Seller/Servicer Guide, Section 44.15.)

So, it’s all a big mess, but I’m proud to announce a piece of research that might help appraisers, lenders and GSEs start sorting things out.  With appraiser Taylor Watkins and the support of the Appraisers Research Foundation, I have been studying the effect of the income method on appraised values for properties with ADUs.  Taylor and I will present the results of our work for the first time on December 16, at the Metro government center in Portland.  Look here for the full details, and stay tuned to this site for ongoing discussion.

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Postscript, January 2013: our research paper has been published in Appraisal Journal… read here.

About Martin John Brown

Martin John Brown is a researcher and consultant on environment and housing. Find out more at http://martinjohnbrown.net.

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