Making ADUs Pencil: Opening Up New Sources of Funding

California has made great progress in enabling more homebuilding by removing barriers to the construction of backyard cottages, also known as “Granny Flats” or Accessory Dwelling Units (ADUs). However, more work remains to be done, particularly to incentivize their construction by making financing options more easily available to moderate-income homeowners. The Terner Center looks at some of the progress on ADUs, and barriers that remain, in a new report.

Here are the key takeaways:

1. ADU production is up in California, but the distribution is uneven. Development of ADUs is concentrated in major population centers, and largely in areas with high incomes and rising rents, though Los Angeles is seeing more construction in poorer neighborhoods.
2. Financing ADUs is difficult for many homeowners who have limited means. If they don’t have enough cash saved, or can’t tap into their home equity, they may not be able to build anything in their back yard.
3. To enable more ADU financing, the Terner Center recommends a federal ADU construction loan program, and a state program to assist homeowners with construction loans.

How does a homeowner pay to build a backyard cottage? Let’s consider that there are fundamentally just two ways to finance ADUs if you are an ordinary homeowner: (1) cash on hand, or (2) home equity. Without a hefty savings account, homeowners would need to refinance, apply for a renovation loan, or take out a Home Equity Line Of Credit (HELOC). This may also prove difficult in areas with stagnant home values that would nevertheless benefit from more ADU construction.

Now let’s take a look at how this has played out so far.

With recent reforms to streamline ADU development, there’s good news: California ADU permitting and construction tripled between 2018 and 2019. In 2019, local jurisdictions approved over 15,000 ADU permits, and over 6,000 were completed. By far, most of these were built in Los Angeles County.

Now for the bad news: it’s mostly rich homeowners building them. The report found that “just two percent of property owners in the lowest quartile [of home value] have permitted or completed ADUs, compared with about 40 percent in the top two quartiles (or neighborhoods with above median home values).” While this pattern tends to be more evenly distributed when looking at variables such as racial diversity, the pattern is flipped on its head in Southern California. The report finds that Bay Area’s wealthiest zip codes tended to produce more ADUs, but “Los Angeles and Orange County experience most of their building in low resource areas, while moderate and higher resource areas see most ADU construction in other regions.”

This conundrum can be largely explained by access to credit and financing to actually complete an ADU project. When running regression models on ADU permitting and various demographic variables across the state, the Terner Center found that the wealthiest neighborhoods may not quite be chomping at the bit to build as many ADUs as possible—they’re simply better able to afford construction.

“ADU production is occurring in diverse, transit-accessible neighborhoods where a greater share of homeowners still have a mortgage,” the researchers observe. However, in a different model, they find “that ADU permitting and construction in Los Angeles, similar to the state, is less likely in high resource areas and more likely in low resource areas. Meanwhile, in the Bay Area, high resource areas are both permitting and building ADUs, while low resource areas are slower to actually complete ADU construction.”

Federal loan instruments currently do not make ADU construction any easier for homeowners in lower-resource areas. Notably, Fannie Mae does not underwrite mortgages based on anticipated future rents—if the ADU isn’t already built, with a tenant paying rent for at least a year, Fannie Mae won’t recognize that potential, but unrealized, value. “Fannie Mae has offered to waive their requirement for in-place ADU tenants in exchange for a variety of fairly onerous risk-mitigants,” the Terner Center notes, “including third-party corporate guarantees and/or professional property management.”

The Federal Housing Finance Agency (FHFA), which regulates Fannie Mae, would have to step in to reduce these barriers to ADU financing. So far, the current administration has shown little interest in doing so.

As with so many other crucial public services, California may have to step in where the federal government has failed. The Terner Center recommends “creating a financial product through the California Housing Finance Agency (CalHFA) and/or local housing finance agencies to cover a portion of losses to private lenders resulting from default, prior to a homeowner refinancing into a Fannie Mae, Freddie Mac, or FHA product.” Phil Ting’s AB-69 is a positive step in this direction, but there’s more work to be done.

Ultimately, lenders will need to see less risk in capitalizing ADU construction for less wealthy homeowners. In order for that to happen, state leaders will need to ensure that the California dream can be a self-fulfilling prophecy for all.