Technical Report: ADU Financing Issues in Unincorporated ... · High Home Equity Cash-Out Refinance or Home Equity Loan/HELOC Special FHA, Reverse Mortgage, or Fannie Mae Loan Products

Technical Report: ADU Financing Issues in Unincorporated San Mateo County Center for Community Innovation—University of California, Berkeley

July 28, 2017

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TABLE OF CONTENTS

EXECUTIVE SUMMARY ............................................................................................................................................................. 3

Key Findings ......................................................................................................................................................................... 3

INTRODUCTION ........................................................................................................................................................................ 5

METHODOLOGY ....................................................................................................................................................................... 5

Literature Review and Interviews ........................................................................................................................................ 5

Demographic Data ............................................................................................................................................................... 5

Home Equity Data ............................................................................................................................................................... 5

Household Type Pro Forma Analysis ................................................................................................................................... 5

ADU DEVELOPMENT COSTS ..................................................................................................................................................... 6

LENDER ADU FINANCING CHALLENGES .................................................................................................................................... 7

Valuation Issues ................................................................................................................................................................... 7

Small Scale Inefficiency........................................................................................................................................................ 8

Concerns of Risk .................................................................................................................................................................. 8

Knowledge and Communication Gaps ................................................................................................................................. 8

HOUSEHOLD ADU FINANCING CHALLENGES ............................................................................................................................ 9

Debt-to-Income Ratio .......................................................................................................................................................... 9

Home Equity ...................................................................................................................................................................... 10

Credit Score ....................................................................................................................................................................... 10

EXISTING ADU FINANCING SOLUTIONS .................................................................................................................................. 11

ADU Financing Methods .................................................................................................................................................... 11

Cash savings and personal resources: ........................................................................................................................... 11

Cash-Out Refinance: ...................................................................................................................................................... 11

Home Equity Loan or Line of Credit: .............................................................................................................................. 11

Renovation Loan: ........................................................................................................................................................... 12

Reverse Mortgage: ........................................................................................................................................................ 12

Unique Loan Products for ADU Financing ......................................................................................................................... 12

FHA 203(k) Loans: .......................................................................................................................................................... 12

Fannie Mae HomeStyle Renovation Loans: ................................................................................................................... 13

Fannie Mae HomeReady Loans: .................................................................................................................................... 13

FINANCING METHODS BY HOUSEHOLD TYPE ......................................................................................................................... 14

High Income/High Home Equity ........................................................................................................................................ 15

Financing Method.......................................................................................................................................................... 15

Demographic Analysis ................................................................................................................................................... 15

Pro Forma Summary: Cash-out Refinance ..................................................................................................................... 15

High Income/Low Home Equity ......................................................................................................................................... 16

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Pro Forma Summary: Renovation Loan ......................................................................................................................... 17

Low Income/High Home Equity ......................................................................................................................................... 18



Pro Forma Summary: Special Loan Products ................................................................................................................. 19

Low Income/Low Home Equity .......................................................................................................................................... 20



FINAL RECOMMENDATIONS ................................................................................................................................................... 20

REFERENCES........................................................................................................................................................................... 22

APPENDICES ........................................................................................................................................................................... 23

Appendix A: List of Interviewees ....................................................................................................................................... 23

Appendix B: Interview Topic Guide ................................................................................................................................... 23

Appendix C: Household Typology Proformas (See Attachment) ......................................................................................... 0

Assumptions .................................................................................................................................................................... 0

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EXECUTIVE SUMMARY

Even when jurisdictions have adopted favorable zoning regulations to increase the physical feasibility of ADU construction, lack of financial feasibility inhibits ADU development. Different ADU construction types have a wide range of associated costs, and homeowners may find that the type of ADU that physically makes sense with their property and project goals is not necessarily within their financial means. Without sufficient cash savings to fund an ADU outright, homeowners must seek private loan products to cover upfront costs. Yet, the universe of loan options to finance ADU construction is limited, and a number of factors affect a household’s ability to qualify for those loans, including insufficiently high income, home equity, and credit scores. The following memo will analyze the range of development costs based on ADU construction type, describe the challenges of financing ADU development from both a lender perspective and a household perspective, discuss existing financing solutions and the household types they best serve, and conclude with recommendations for further solutions to ADU financing. Appendix C contains proformas for various household typologies; these proformas demonstrate that for households that can secure financing, an ADU can provide positive cash flow in the first year and pay for itself. Key findings from each section are provided here.

Key Findings Total ADU development costs can range from $20,000 to $350,000 depending on the type of ADU being

constructed, with about 70% going towards hard construction costs and 30% towards soft costs of professional services, permits, and fees. The least expensive ADU project often entails the conversion of existing interior space of the primary residence into an attached ADU and the most expensive is the construction of a new detached backyard structure.

Loan products designed specifically for ADU construction financing currently do not exist, and traditional mortgage products that can be used to cover upfront costs are limited. Specific challenges that lenders currently face or anticipate in financing ADUs include:

o There is a lack of clarity around the true market value of ADUs, which can vary widely depending on the appraisal method used. The appraisal approach for single family residential properties with or without an ADU remains the sales comparison approach nation-wide, which can undervalue ADUs due to a lack of comparable properties. This points to the need for more loan products that allow homeowners to borrow based on the projected rental income from an ADU.

o The relatively small loans that would be needed to finance ADUs independently from the primary residence are inefficient for lenders: The cost of servicing a loan is the same regardless of the loan amount, but lower fees are gathered on smaller loans. Thus, a new loan program for ADUs would realistically need to set a minimum loan amount and would be more feasible for more costly construction types, such as the detached ADU.

o Some lenders are concerned with issues of risk when it comes to financing particular ADU construction types. For example, when a homeowner is borrowing against the value of an existing property to construct an attached ADU, some lenders are concerned that the collateral is being compromised in the process.

o Communication gaps exist between government-sponsored enterprises (GSEs), banks, and other local lenders. Lenders can be hesitant to create new loan products for ADUs without assurance that GSEs will purchase or insure those loans. Additionally, GSEs experience difficulties in communicating potential loan options for ADUs at the local level.

Without cash savings or support, households must have sufficiently high incomes, home equity, and credit scores to qualify for the limited pool of traditional mortgage products that could be used to construct an ADU. These household-level barriers are exacerbated in a still tight lending environment in the aftermath of the foreclosure crisis, in which financial institutions are focusing on the most creditworthy borrowers.

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Homeowners who have managed to build ADUs despite the above challenges have typically used one of four financing methods: existing cash savings or support, cash-out refinance, home equity loan/line of credit, or renovation loan. The following table defines which the homeowner conditions under which each of these financing methods is most ideal:

Table 1. Financing Methods and Homeowners Best Served

Financing Method Who is best served by this method?

Existing Cash Savings or Support

Owners with sufficient cash saved outside the value of their home or have cash support from family and friends, and do not wish to take on additional debt.

Cash-Out Refinance Loan Owners with significant home equity built up who want to refinance anyway to take advantage of lower interest rates or to extend the length of their repayment term.

Home Equity Loan or Home Equity Line of Credit (HELOC)

Owners with significant home equity built up but don’t want to refinance with higher interest rates. If interest rates are high, taking out a smaller second mortgage may make more sense than refinancing the first mortgage at a higher rate.

Renovation Loan Owners with high income but without significant home equity, buyers looking to purchase “fixer-uppers,” or those who wish to leverage financing without liquidating savings.

When analyzing the accessibility of the above financing options based on both a household’s income level and its home equity level, it is clear that lower-income households in general, with or without significant home equity built up, are underserved by most traditional mortgage lending. These households also stand to benefit the most from the potential rental income generated by an ADU, so the County should carefully consider how a new loan program could fill this financing gap.

High Income Low Income

High Home Equity Cash-Out Refinance or Home Equity Loan/HELOC

Special FHA, Reverse Mortgage, or Fannie Mae Loan Products

Low Home Equity Renovation Loan Cash savings and personal resources

Level of Difficulty Finding and Qualifying for Loan Products:

Least Difficult Most Difficult

Recommendations for the County based on this analysis include: o Develop financing tools accessible to lower income borrowers by allowing them to utilize a diverse set of

assets, including home equity, potential rental income, or other personal resources, in order to qualify o Explore the creation of a local revolving loan fund to provide more short-term, smaller-scale loans for

ADUs. Because loans must be paid back before new loans can be issued, a revolving loan fund could be cost-efficient for the County and can have short payback periods compared to the 30-year home mortgage.

o Tap into existing public assistance programs for affordable housing such as the Affordable Rental Housing Preservation Fund and seek private investment to increase the pot of money for ADU financing tools.

o Collaborate with other mission-driven lenders such as CalHFA to develop new loan products for ADUs. o Communicate with other jurisdictions that have attempted ADU loan funds, such as Santa Cruz, to gain

great insight into lessons learned and why it has had reportedly poor usage.

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INTRODUCTION Lack of financial feasibility inhibits ADU development. Different ADU construction types have a wide range of associated costs, and homeowners may find that an ADU is not necessarily within their financial means. Without sufficient cash savings to fund an ADU outright, homeowners must seek private loan products to cover upfront costs. Yet, the universe of loan options to finance ADU construction is limited, and a number of factors affect a household’s ability to qualify for those loans, including insufficiently high income, home equity, and credit scores. This memo provides the range of development costs based on ADU construction type, describe the challenges of financing ADU development from both a lender perspective and a household perspective, discuss existing financing solutions and the household types they best serve, and conclude with recommendations for further financial solutions.

METHODOLOGY

Literature Review and Interviews Qualitative research for the following memo was obtained through literature review and interviews with housing finance professionals from six different organizations that are either seeking or considering the provision of new financing options for ADU development. Please see Appendix A for a full list of interviewees and Appendix B for the interview topic guide.

Demographic Data Demographic census data about households in Unincorporated San Mateo County was pulled from our Demographic Analysis Technical Report, which provides a more thorough description of the methodology used to generate estimates from the American Community Survey Public Use Microdata 2011-2015 dataset.

Home Equity Data Additionally, home equity level data was obtained from PropertyRadar.com. PropertyRadar provides detailed information on foreclosures and home equity level for all properties in Arizona, California, Nevada, Oregon, and Washington and allows users to generate filtered lists of all properties within those states that match specific criteria. For this analysis we filtered properties by location to include only those in San Mateo County and by property type to include only Single Family Residences (SFR). It is important to note that SFR reported on PropertyRadar include both renter- and owner-occupied units and do not include condos. Within the filtered list, we then searched for the number of properties in foreclosure and the number of properties that fall within graduated buckets of home equity level: less than 0%, 0-24%,25-49%,50-74%,75-99%, and 100%. Once these numbers were obtained, we were able to determine the share of properties in each home equity level bucket over the total number of SFR properties in San Mateo County. We then multiplied these percentages by the total number of SFR in Unincorporated San Mateo County to provide estimates for just the Unincorporated communities. The total number of SFR in Unincorporated San Mateo County was obtained from the American Community Survey 2011-2015 5 -Year estimates by subtracting the total number of "1-family detached" units in the 21 incorporated cities of San Mateo County from the total number of "1-family detached" units in entire county. This yielded a total of about 18,000 1-family detached units in Unincorporated San Mateo County.

Household Type Pro Forma Analysis The memo also includes a discussion of different household types and the financing methods that best serve them. The methodology for this section’s analysis is as follows:

A typology of households for different financing methods was developed along two spectrums: o level of household income and o level of home equity.

This resulted in the identification of four household types: o High Income/High Home Equity o High Income/Low Home Equity o Low Income/High Home Equity, and

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o Low Income/Low Home Equity.

Appropriate financing methods were assigned to each household type and modelled through a series of proformas to exemplify:

o the loan terms that the household type is likely to qualify for o the ADU development cost that the household type is likely to be able to afford, and o the operating cash flow that the household type can expected from an ADU

Assumptions for the proformas were guided by a 2016 ADU financing report put out by the University of Texas at Austin, and inputs informed by a number of online sources, including Zillow, accessorydwellings.org, and New Avenue Homes. Please see Appendix C Attachment for a full list of model assumptions.

ADU DEVELOPMENT COSTS The cost to construct an ADU varies depending on the size of the unit, amenities, material quality, permit costs, and use of existing structures and spaces. Costs could easily vary between $20,000 and $350,000 (Casey 2017, Brown 2014). For example, a basement already mostly functioning as an independent space—with a separate bathroom, kitchen, and entrance--may require simple modifications to turn into an ADU (Peterson 2017). However, an entirely new, separate ADU cottage in the backyard may cost well above $200,000, depending in part on how much existing infrastructure can be reused (Casey 2017). Not surprisingly, attached ADUs are typically less expensive than detached backyard ADUs, and different construction methods within these broad structure types inherently incur a wide range of costs even after controlling for unit size. The following construction methods are listed in order of least expensive to most expensive based on the cost per square foot (Spevak 2014):

1. Converting an unpermitted internal apartment into an ADU, which may just mean getting a permit and performing minor code compliance work

2. Converting the attic or basement of a primary dwelling into an ADU 3. Converting an attached or detached garage into an ADU 4. Creating an ADU by adding on to an existing home or garage 5. Building a new house and an ADU (detached or attached) simultaneously 6. Building a detached ADU on the lot of an existing home 7. Building a detached ADU over a new garage on the lot of an existing home

It is also important to note that ADUs generally cost more per square foot than full sized homes for a number of reasons. For one, the small size of ADUs reduces the efficiency of scale for labor and materials. As a result, it makes sense from an economic standpoint for homeowners to build up to the largest allowable ADU size (1,200 square feet in Unincorporated San Mateo County, depending on the size of the main residence) because it is only marginally more expensive to add square footage (Peterson 2017). Additionally, ADUs have proportionally more kitchen and bathroom space, which is more costly, and less bedroom and hallway space, which is less costly (Spevak 2014). Finally, ADUs are more likely to be built in tight locations that require careful protection of existing structures and landscaping (Spevak 2014). While hard construction costs make up the bulk of ADU development costs, there are, of course, other expenses that must be factored into the total cost of building. These soft costs include:

Design

Planning and building permits

Impact fees

Loan financing expenses

Other project-specific professional services, such as surveyors, structural engineers, environmental assessment/clean-up, or project managers

Altogether, these soft costs can account for up to 30% of the development budget (City of Santa Cruz 2003). Permits and fees differ depending on the jurisdiction and additional utility connections needed, but they can generally add about $10,000 to the development budget (Gray 2016). Design and other professional services vary according to the size and complexity of the project, as well as the homeowner’s level of sweat equity (Peterson 2017) As a rule of thumb, general

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contractors collect 10% of total costs for soft costs, also referred to as overhead (United Policyholders 2014). Upfront closing costs for financing depends on the specific loan product, and can reach $3,000-$5,000 for cash-out refinance and renovation loans (Palermi 2014).

LENDER ADU FINANCING CHALLENGES Given these development costs and the fact that ADUs are not yet a common enough building type, homeowners often must use existing cash savings or find creative mechanisms within traditional bank financing to access capital for the upfront costs of ADU development. Traditional single-family mortgage instruments do not readily accommodate accessory units, whether internal or external. The following section will describe some of the challenges associated with ADU financing from a lender’s perspective, including a lack of clarity around the true value of ADUs, the small-scale inefficiency of ADU financing, concerns of risk around collateral damage and foreclosure, and communication gaps among different types of financing institutions.

Valuation Issues Historically, it has been difficult for national and local lenders to provide loans specifically targeted at financing ADUs due to a lack of clarity around the prospective value that ADUs add to a single family residence (Wegmann 2016, Brown and Watkins 2012). The market value of ADUs is largely impacted by the perceptions of ADUs in a particular locale. If the local market views the presence of an ADU as providing increased square footage of livable space and potential rental income, this will increase the value of the overall property (Wegmann 2016). On the other hand, some NIMBY communities may view ADUs as contributing to greater density, a loss of privacy, or generating additional traffic or parking frustrations, in which case, the presence of an ADU could be perceived as having a negative effect on property value (Wegmann 2016). Our feasibility and demographic analyses of San Mateo County point to the fact that the region already has a significant number of ADUs, as well as a substantial market of both potential tenants and owners of ADUS, so negative local perceptions likely pose less of a challenge in this context. What is perhaps more inhibitive is the conventional appraisal method used to value ADU properties nation-wide. ADUs are most typically appraised using the same sales comparison approach that is used for single family residences (Brown and Watkins 2012). In order to be reliable, this appraisal method requires multiple recent sales of very similar properties, but given the fact that there are so few permitted ADUs in existence, it can be difficult to find sufficient comparables (Brown and Watkins 2012). According to representatives from Fannie Mae, as of 2016, less than one percent of all 22 million appraisals in their database included properties with ADUs. Under Fannie Mae’s current policy, if an ADU is permitted by the local zoning, only one comparable sale is required to demonstrate marketability and if ADUs are not permitted, three comparable sales are required. While these conditions for a sales comparison approach offer some benefit in not being overly strict, they can result in arguably arbitrary or unduly low valuations of properties with ADUs (Brown and Watkins 2012). For this reason, ADU advocates have called for an income-based valuation of ADUs instead, which relies on the relationship of market rents to sale prices, data for which is relatively abundant. Fortunately, one unique Fannie Mae product, the HomeReady loan, has emerged, which could allow financiers to lend to low and moderate income borrowers on the potential rental income stream of an ADU (described in greater detail below). However, in general, most loan products for single family residences do not allow homeowners to borrow on the project’s projected rental income. One expert from a credit union attributed this reservation to fluctuations in the rental market and the potential of unexpected vacancies. For this reason, they would likely only consider lending based on the ADU rental income value if 1) the projected income assumed some period of unit vacancy 2) the project is in a location with very low vacancy rates and 3) the borrower has a relatively high income and level of home equity. Unfortunately, the third condition strikes out many low to moderate income homeowners, who otherwise would benefit the most from a rental income valuation approach by increasing the loan amount they could qualify for.

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Small Scale Inefficiency Currently, there are no loan products that allow homeowners to finance an ADU independently from the primary residence, and the main barrier to creating such a tool is the issue of scale. Financial institutions generally have less incentive to provide loans at a small scale because the cost of underwriting and processing is the same regardless of the loan amount, but the fees gathered on a smaller loan are significantly less. For this reason, any new product that fills this financing gap would likely only be possible, if at all, for detached ADUs, whose costs are more substantial and reach closer to $250,000.

Concerns of Risk Some lenders have expressed reservations about financing particular ADU construction types due to potential impacts to the primary residence on a property. For example, experts from a national bank claimed that they would be hesitant to issue a cash-out refinance or second mortgage to a borrower that is planning to build an attached ADU because these financing methods use the primary home as collateral and major structural renovations to that home may compromise the collateral. This would be less of a concern for a detached ADU, but even then, they likely would not lend to a homeowner based on the after-built value of the property.

A representative from a credit union believed that it would be difficult to develop a loan product to finance a detached ADU separately from the main home because it would create complications in the event of foreclosure. If there are two separate structures on the same property each with its own loan, it would be difficult to foreclose on the main home without foreclosing on the ADU as well. The credit union would also be more willing to fund ADUs if the County could take on some of the risk of default.

Knowledge and Communication Gaps One final challenge is a lack of knowledge among banks and local lenders about the loan products that national government-sponsored enterprise (GSEs) are willing to purchase, insure, or guarantee. Representatives from Fannie Mae expressed that while there may not be enough national demand for ADUs for GSEs to create a separate product for them, other lenders could be well positioned to do so because they can aim their products at more specific customer bases. However, one reason this may not be more common is that there are a number of uncertainties about what types of mortgages GSEs will or will not accept. As a result, lenders may be hesitant to offer loans for unconventional property types, like those that include ADUs, because they are unsure if they will be able to resell those loans to another institution. This sentiment was echoed by a representative from a national bank, who said that larger financial institutions tend to be weary of loose interpretations of Federal Housing Administration (FHA) products and that they would likely offer renovation loans that cover the construction of a new ADU if they could be sure that Fannie Mae would allow for it. Yet, according to Fannie Mae representatives, they are not particularly prescriptive about whether or not a loan can include an ADU; they generally just treat it like any other mortgage for a single family residence. Fannie Mae representatives also mentioned that it can be difficult to get the word out about new loan products that may work for ADUs, such as the recently launched HomeReady loan, from the industry to the public. However, an expert from a credit union suggested that Fannie Mae products may not be used as often in the California market less because of inadequate marketing and more because they have maximum loan balances that are too low for a market with such high housing costs. In addition to these challenges, County staff should try to identify any other potential communication gaps that may exist between national GSEs, banks, and local lenders that only make it more difficult to provide borrowers with diverse and viable options to finance an ADU.

“There is probably no LTV that we would be comfortable with that would let you get around the ‘compromised collateral’ problem. If there’s going be construction on the [main home], you would need to it have done to then take out a permanent loan.”

-National Bank Expert

“If it’s prospective income from grass, there’s too much risk”

-National Bank Expert

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HOUSEHOLD ADU FINANCING CHALLENGES These challenges faced by financial institutions translate into limited ADU financing options at the individual household level. In a small universe of loan products appropriate for ADU financing, households face a number of additional barriers in terms of qualifying for that small pool of products. Household characteristics that can pose the greatest challenge to accessing capital for ADU development costs are debt-to-income ratio, home equity level, and credit score, described here in further detail.

Debt-to-Income Ratio Generally, individuals are unable to secure loans that would increase their monthly debt beyond 45% of their monthly income because lenders make loans based on the borrower’s ability to repay them over time (Casey 2017, Wegmann 2016). Banks can consider higher ratios if the borrower has compensating factors, such as significant cash reserves, job stability, or some other demonstrated ability to handle the housing payments (Casey 2017, Wegmann 2016). Freddie Mac now allows for a signed lease to contribute to monthly income, but it is unlikely that signed lease would be secured prior to ADU construction (Casey 2017). Figure 1 shows that lower-income households (including the entire county) are more likely to be severely burdened by existing home loan payments, paying greater than 50% of their household income on monthly owner costs. Fortunately, a significant portion of lower-income homeowners in unincorporated San Mateo County own their homes free and clear (see Figure 2), which allows these households greater flexibility to take on additional debt to finance ADU.

Figure 1. County-wide Monthly Owner Cost Burden by Income

Source: ACS PUMS 2011-2015 5-Year Estimates, ACS 2011-2015 5-Year Estimates

Note: ‘Burdened’ is defined as paying greater 30% of household income on monthly owner costs and ‘Severely Burdened’ is defined as paying greater than 50% on monthly owner costs; See Demographic Analysis.

12.8%27.4% 30.5%

15.8%4.9%

44.6% 21.1%4.4%

1.9%

0.1%0%

20%

40%

60%

80%

100%

≤ $49,999 $50,000 - $99,999 $100,000 -$149,999

$150,000 -$199,999

≥ $200,000

Burdened Severely Burdened

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Figure 2. Mortgage Status of Households by Income in Unincorporated San Mateo County

Source: ACS PUMS 2011-2015 5-Year Estimates, ACS 2011-2015 5-Year Estimates Note: See Demographic Analysis for methodology to generate estimates for Unincorporated San Mateo County

Home Equity Securing a private loan often requires substantial equity or collateral to borrow against. The effect of this is that a low or middle-income individual must have substantially paid back their original home mortgage, or have experienced significant home value appreciation, before a cash-out refinance or home equity line of credit (HELOC) would provide sufficient financing to construct an ADU. Households with limited home equity may be able to take advantage of renovation loans, which allow homeowners to borrow against the higher after-renovation value of the home. Prospects for sufficient home equity among households in San Mateo County are positive: Table 2 shows that three fourths of all households in the county have relatively high levels of existing home equity, above 50% of the property value.

Table 2. Equity Levels for Single Family Residences, San Mateo County and Unincorporated San Mateo County San Mateo County Percentage of County-

wide Total Unincorporated County Estimates2

Total Single Family Residences1 160,009 100% 18,198

In Foreclosure 275 0.2% 31

Equity < 0% (Underwater) 3,480 2% 396

Equity 0%-24% 7,843 5% 892

Equity 25%-49% 29,364 18% 3,340

Equity 50%-74% 52,458 33% 5,966

Equity 75%-99% 43,238 27% 4,918

Equity 100% (Owned outright) 23,626 15% 2,687

Source: PropertyRadar 2017; ACS 2011-2015 5-Year Estimates 1 All owner- and renter-occupied 1-family detached units; 2 See the Methodology section above for process used to generate estimates from Unincorporated San Mateo County

Credit Score A good credit score is necessary to qualify for a loan and to secure preferable interest rates, and has become more important than ever after the foreclosure crisis. Lending regulations have significantly tightened since the crisis and have yet to be eased, leading banks to focus on the most credit-worthy borrowers. Many households have significant home equity built up that they would like to liquidate or borrow against but are unable to do so after being burned by defaults during the bust (Rugaber 2017). Banks are now demanding nearly pristine credit, requiring, for example, an average credit

< $49,000$50,000-$99,000

$100,000-$149,000

$150,000-$199,000

> $200,000 Total

Own Free and Clear 1,276 1,206 568 331 572 3,938

Own with Mortgage 1,150 2,393 2,281 1,964 2,522 10,325

0%10%20%30%40%50%60%70%80%90%

100%

Co

un

ty-w

ide

Pe

rce

nta

ge

Unincorporate County Estimates by Household Income*

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score of 780 in order to qualify for a cash-out refinance, up from 730 before the crisis (Rugaber 2017). FHA loans will accept borrowers with lower credit scores but these products also come with mortgage insurance premiums.

EXISTING ADU FINANCING SOLUTIONS Given these financing challenges among both lenders and households, San Mateo County residents will have to pull from their existing assets or find ways to navigate traditional mortgage financing in order to build an ADU. ADU development costs are currently supported through the following five financing methods: cash savings and personal resources, cash-out refinancing, home equity loans or lines of credit, renovation loans, and reverse mortgages. These methods, as well as specific loan products that fall within them, are described in the following section.

ADU Financing Methods Cash savings or personal resources most commonly used for ADU projects either in part or entirety, and the least common financing method is the renovation loan. UC Berkeley’s recent survey of ADU builders in Portland, Seattle, and Vancouver found that 45% of respondents used only their own cash or drew entirely on other personal resources such as credit cards, 40% borrowed against the existing equity in their property through a cash-out refinance, home equity loan or HELOC, and 4% borrowed at least in part, against the future expected value of the unbuilt ADU to help finance its construction (Chapple et al. 2017). When homeowners were able to borrow, it was typically from a credit union or regional bank rather than a national bank (Chapple et al. 2017).

Cash savings and personal resources: A homeowner uses their savings, investments outside the value of their home, cash support and gifts from family and friends or credit cards, to build an ADU outright. It is fairly common for family or friends to either lend directly to a homeowner looking to build an ADU or to borrow against their own home (Casey 2017). It also common for homeowners to invest sweat equity into an ADU project by conducting predevelopment and even construction work themselves instead of hiring consultants and contractors (Peterson 2017).

Cash-Out Refinance: A homeowner can liquidate some of the equity built up in their home to finance the construction of an ADU with a cash-out refinance. The borrower replaces the current mortgage with a new loan that is of higher value than the amount owed, taking the difference between the amount owed and the new loan value in cash. Existing home equity must be higher than 15% of the property value in order for a homeowner to make any proceeds from a cash-out refinance (Palmeri 2014). Cash-out refinancing can have a number of advantages, including the opportunity to take advantage of lower interest rates, lower credit score requirements than home equity loans or home equity lines of credit, and less restrictions on how funds can be used than renovation loans (Kingston 2015). However, because a cash-out refinance often extends the original loan term over a longer time period, savings on monthly payments due to lower interest rates can be offset by greater cumulative interest payments over the full life of the loan. Additionally, refinancing is not a viable option when interest rates have gone up since the origination of the existing first mortgage. Another drawback is that cash-out refinancing often has higher closing costs than most second mortgages, such as a $3,000 to $5,000 administrative fee associated with ADU financing (New Avenue 2014, Peterson 2015). Finally, it is important to note that cash-out refinancing, along with other forms of borrowing against home equity described below, has become more difficult to do since the foreclosure crisis. GSEs now view cash-out refinancing as riskier than they used to and have imposed higher fees to guarantee them, making such loans costlier for banks and consumers (Rugaber 2017).

Home Equity Loan or Line of Credit: A homeowner with an existing mortgage can get an additional loan, or second mortgage, to finance the construction of an ADU. This can take the form of a home equity loan or a home equity line of credit (HELOC). A home equity loan is a one-time lump sum that is paid off over a set amount of time, with a fixed interest rate and monthly payments. A HELOC allows a homeowner to borrow up to a certain amount as needed throughout a time period set by the lender with an

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adjustable interest rate. As they pay off the principal, their credit revolves and they can use it again. The application process for a home equity loan or HELOC can be easier and fees can be lower than those for a cash-out refinance (Palmeri 2014, New Avenue 2014). Home equity loans and HELOCs also have less restrictions on eligible uses of funds than formal renovation loans (Kingston 2015). However, in most cases, fixed rate home equity loans have higher interest rates than first mortgages and adjustable rate HELOC have greater interest rate risk.

Renovation Loan: With a renovation loan, homebuyers and owners can use one loan to finance both their primary residence and renovation costs associated with constructing an ADU. A renovation loan allows a buyer to purchase a new home or refinance an existing home based on the increased value of the property expected after the construction of an ADU. In addition to considering “after rehab value” in the LTV, equity requirements for renovation loans are much lower than first or second mortgage cash-out requirements. Renovation loans have fairly similar interest rates to refinance loans, but they have higher closing costs and more application requirements, including a general contractor that is willing to take draws from the lender and permitted drawings to help convey future value, making them the most difficult to obtain (New Avenue 2014, Palmeri 2014). Additionally, there tend to be more restrictions on how funds are used with a renovation loan.

Reverse Mortgage: The Home Equity Conversion Mortgage (HECM) is an FHA product designed for homeowners age 62 and older looking to age in place, which allows the borrower to convert their home equity into liquidated income or a line of credit. Unlike other FHA loans, there are no income or credit qualifications for this type of loan and the amount of the mortgage is based on the home's existing value. The reverse mortgage gives older homeowners supplemental income to make home improvements, removing an initial barrier to ADU construction.

Unique Loan Products for ADU Financing Through our interviews with financing and housing professionals, three existing loan products within the broad methods described above were identified as particularly convenient for ADU construction financing, including FHA 203(k) loans, Fannie Mae’s HomeStyle Renovation Loans, and Fannie Mae’s HomeReady loans. In addition to the three existing loan products described in this section, lenders are beginning to explore new avenues for ADU financing. For example, California Housing Finance Agency (CalHFA) announced in April 2017 that it would begin accepting rental income to qualify first-time homebuyers for the purchase of a home with an existing ADU (CalHFA). This change will increase the financing options available to new low- and moderate-income homebuyers. Another example is equity sharing: shared-equity mortgages, which allow an investor such as a parent, family member, or other entity to co-invest in the property, are a potential ADU financing option. Companies such as Landed and Point are exploring equity share loans for ADUs as a possible investment area.

FHA 203(k) Loans: The FHA 203(k) loan is a renovation loan insured by the FHA that enables homebuyers and homeowners to finance the purchase or refinancing of a house alongside the cost of its rehabilitation through a single, long term, fixed or adjustable rate mortgage. Homes that are purchased or refinanced with FHA 203(k) loans must be at least one year old and the extent of the rehabilitation covered may range from relatively minor repairs to virtual reconstruction. For example, a home that has been demolished or will be razed as part of rehabilitation is eligible as long as the existing foundation remains in place. It can also cover the conversion of a property of any size to a one- to four- unit residential structure. These parameters around the rehabilitation component make it possible to use an FHA 203(k) loan to finance attached ADU construction that builds off of the existing foundation. What is most unique about the FHA 203(k) loan is that it covers both acquisition and rehabilitation activities, making it particularly ideal for borrowers looking to purchase “fixer uppers” and construct an ADU as part of broader renovation plans for a property. FHA 203(k) loans also protect the lender by allowing them to have the loan insured before the condition and value of the property may offer adequate security.

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A portion of the loan proceeds is used to pay the seller, or, if a refinance, to pay off the existing mortgage, and the remaining funds are placed in an escrow account and released as rehabilitation is completed. The cost of the rehabilitation must be at least $5,000, but the total loan balance must still fall within the FHA mortgage limit for the area ($636,150 for San Mateo County in 2017). The value of the property is determined by either (1) the value of the property before rehabilitation plus the cost of rehabilitation, or (2) 110 percent of the appraised value of the property after rehabilitation, whichever is less. Many of the rules and restrictions that make FHA's basic single family mortgage insurance relatively convenient for lower income borrowers apply here, but lenders may charge some additional fees, such as a supplemental origination fee, fees to cover the preparation of architectural documents and review of the rehabilitation plan, and a higher appraisal fee. Under FHA 203(k) loan requirements, borrowers must be occupants of the home being financed, must have a minimum FICO score of 640, and must pay a minimum down payment of 3.5%.

Fannie Mae HomeStyle Renovation Loans: This is another renovation loan product put out by Fannie Mae that permits borrowers to include financing for home improvements in a purchase or refinance of an existing residential property of 1 to 4 units. With HomeStyle Renovation, borrowers can make renovations, repairs, or improvements totaling up to 50% of the as-completed appraised value of the property with a first mortgage, rather than a second mortgage or other more costly financing method. Unlike the FHA 203(k) loan, allowable repairs are flexible enough to finance the construction of either an attached or detached ADU and borrowers can be either owner-occupants or non-occupant investors. HomeStyle renovation requires that owner-occupants of 1-unit properties have a minimum FICO score of 660 and must pay a minimum down payment of 5%; investors need a FICO score of 680 and a minimum down payment of 25%. Per Fannie Mae guidelines, gift funds can be used for down payment and closing costs. For purchase transactions, loan-to-value (LTV) ratio is based on the lesser of: 1) purchase price and cost of renovation, or 2) the “As-Completed” value. For refinance transactions, the LTV ratio is determined by dividing the original loan amount by the “as completed” appraised value of the property. This financing option can be more appropriate than a FHA 203(k) loan for borrowers with higher credit scores.

Fannie Mae HomeReady Loans: Fannie Mae describes its HomeReady loan as their “premier affordable lending product” to meeting the diverse needs among borrowers looking to purchase or refinance a single family home. Launched in 2016, it is designed for creditworthy low- to moderate-income borrowers by offering expanded eligibility for financing homes in low-income communities. In San Mateo County, a family of four would earn between $105,350 and $138,350 annually in order to be eligible for a HomeReady loan (County of San Mateo). The most important feature of this product in terms of its utility for ADU financing is its use of underwriting flexibilities to expand access to credit. One such flexibility is allowing potential rental income to contribute to a borrower’s debt-to-income, and Fannie Mae’s informational documents explicitly include ADU rental income as an eligible source: “HomeReady recognizes that income from accessory units and boarders can be a steady source of income for many homeowners, from millennials to seniors. That’s why HomeReady includes both types, with proper documentation, as a part of qualifying income.” The program allows the owner to claim 75% of the monthly rent listed in the lease agreement as rental income, or if the borrower does not have a lease, then they may use Fannie Mae-determined estimated market rent for an accessory unit. HomeReady also allows for of non-occupants to be borrowers, such as parents on behalf of their adult children that will be occupying the home. Additionally, income from non-borrower household members can be considered as a compensating factor to allow for a debt-to-income (DTI) ratio greater than the typical 45%, up to 50%. The HomeReady loan has income limits based on the location of the property: Properties located in low-income census tracts have no income limit, but all other properties require that the borrower earn no more than 100% of the Area Median Income (AMI). These income eligibility limit may help lenders meet their Community Reinvestment Act (CRA) requirements. The minimum credit score for a borrower is 680 and the down payment can reach as low as 3%. Another benefit is that the HomeReady loan can be used in conjunction with the HomeStyle Renovation loan. Finally, the loan also has a mortgage homeownership education requirement designed to help borrowers gain knowledge to prepare for sustainable homeownership and successful navigation of the loan process.

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Figure 2. ADU Rental Income Scenario from Fannie Mae HomeReady Fact Sheet

FINANCING METHODS BY HOUSEHOLD TYPE The ADU financing methods and loan products described above will be most accessible and useful to different types of households. Here, we develop a typology using the two of the most important financing qualifiers: household income level and home equity level. This resulted in four general household types, each with appropriate financing methods given their characteristics. The four household types are: high income/high equity, high income/low equity, low income/high equity, and low income/low equity. Given this typology, summarized in Table 3, proformas were developed for the first three household types to illustrate 1) the general type and cost of ADU they would likely construct 2) the loan terms they could get using one the financing methods identified as most appropriate for that household type and 3) the cash flow from a rented ADU over the course of the loan. Please see the Appendix C attachment for full pro forma analyses and amortization schedules.

Table 3. Household Typology for ADU Financing

High Income Low Income

High Home Equity Cash-Out Refinance or Home Equity Loan/HELOC

Special FHA, Reverse Mortgage, or Fannie Mae Loan Products

Low Home Equity Renovation Loan Cash savings and personal resources

Level of Difficulty Finding and Qualifying for Loan Products:

Least Difficult Most Difficult

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High Income/High Home Equity

Financing Method Owners with sufficiently high income and existing equity built up in their homes are in the best shape to borrow against the existing value of their property and to qualify for favorable loan terms. Either a cash out refinance or home equity loan/HELOC typically makes the most sense for this type of household. If a homeowner wants to refinance anyway to take advantage of lower interest rates or to extend the length of their repayment term, the cash-out refinance will be the most ideal option. If interest rates are currently higher than that for the existing mortgage, taking out a smaller second mortgage with a home equity loan or HELOC may be more preferable than refinancing the first mortgage at a higher rate.

Demographic Analysis According to our Demographic Analysis, there are about 5,400 relatively high income homeowners in Unincorporated San Mateo earning $150,000 or more annually. These higher income households are more likely than lower income households to support household members beyond the nuclear family, with 316 Unincorporated households or about 6% being extended family households. They are also more likely to include at least one adult child as a household member (1,064 households or 20%). These factors could motivate such households to build a detached backyard ADU in order to expand their living space and provide greater privacy for sub-families or non-relative household members. While the detached ADU tends to be a more expensive construction type, these higher income households are, fortunately, less likely to be burdened by housing costs: 563 high income households, or 10%, pay more than 30% of their income on monthly owner costs. Many of these households may also have the desire and option to build an attached ADU using existing interior space, such as for home health aides or companionship: there about 2,498 underutilized high income households, or 46%, with more rooms than household members. PropertyRadar data show that there are approximately 75% of single family residences in Unincorporated communities have relatively high home equity levels of 50% or more. While we do not have detailed data that shows the overlap between high income households and high home equity households, we do know that 970 of all high income households, or 18%, own their homes free and clear with 100% home equity built up.

Pro Forma Summary: Cash-out Refinance To illustrate an example of an ADU financing scheme for a high income/high home equity household, we modelled the potential ADU cash flow for a household with the following characteristics:

Household Type High Income/High Home Equity

Annual Income $150,000

Home Equity 80%

Property Value $1,000,000

Mortgage Balance $200,000

Interest Rate 4.25%

The model assumes market rate rents, however, given the demographic analysis above, we assume they would like to build a spacious detached backyard cottage to better meet the needs of their family. If this is the case, it will take longer for the owner to capture cash flow. They want to want to hire a designer and use high quality materials, so we assume their dream ADU will cost about $300,000 to build. We also assume that since a high income household has less need for rental income, they will stop renting it out when the unit breaks even and the cumulative rental income exceeds the loan balance. At this point, they may use the ADU for an adult child, caretaker, or elderly parent. With high income, high home equity, and a high credit score, this household is well positioned to qualify for a number of traditional mortgage loan products to cover this cost. Average interest rates for a cash-out refinance in 2017 are lower

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than the interest rate that the household is currently paying on its first mortgage, so we assume they will opt for a cash-out refinance instead of a home equity loan or home equity line of credit (however, this type of loan becomes less attractive to borrowers as interest rates rise). Here are the terms for such a loan:

Financing Method Cash-Out Refinance

Loan Amount for ADU $300,000

Loan Interest 3.8% fixed

Loan Term 30

Monthly Loan Payment -$1,398

Annual Loan Payment -$16,774

To show that the household would likely be competitive for this loan given common industry debt limits, we check for the geographic loan limit, maximum debt-to-income ratio, and maximum LTV and find that this household is well below the maximum for all three factors. The debt-to-income ratio in this model refers only to mortgage debt.

Debt Limits Check Maximum This Household

Loan Amount $636,150 for SMC $500,000

Debt-to-income Ratio 45% 11%

LTV 80% 50%

Finally, we calculate the cash flow for a rented ADU on the property over the course of the 30 year mortgage. The model assumes an initial rent of $1,915, the 2017 FMR for a studio in San Mateo County, that increases by .5% each year. There is positive cash flow starting immediately in Year 1. By Year 19, their cumulative ADU income exceeds their remaining mortgage balance. By the time they pay off your mortgage in Year 30, the ADU has generated $64,530 of income for the property.

ADU OPERATION CASH FLOW Year 1 Year 19 Year 30

ADU Rental Revenue $22,980 $55,304 $0

Vacancy Allowance -$1,915 $0 $0

Operating expenses -$460 -$1,106 -$0

Capital replacement reserve -$412 -$1,084 -$0

Property tax on ADU -$3,000 -$3,588 -$4,004

Debt service for ADU -$16,774 -$16,774 -$16,774

ANNUAL ADU INCOME $448 $32,751 -$20,778

CUMULATIVE ADU INCOME $448 $290,971 $64,530

AMORTIZATION SCHEDULE Year 1 Year 19 Year 30

Mortgage Balance $490,885 $251,030 $0

High Income/Low Home Equity

Financing Method If a homeowner is gainfully employed but does not have sufficient home equity built up to borrow against the existing value of the property, a renovation loan may make the most sense to finance an ADU. Renovation loans allow homeowner to get larger loans based on the increased property value expected after the ADU is built; they are ideal for owners who can demonstrate ability to pay but may not have other assets or significant home equity. Particular renovation loan

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products like the FHA 203K are ideal for buyers looking to purchase “fixer-uppers” and construct an ADU alongside the renovations to the primary residence. Finally, these types of loans are ideal for homeowners those who wish to leverage financing without liquidating their savings.

Demographic Analysis Households of this type fall within the same pool of 5,400 relatively high income homeowners in Unincorporated San Mateo earning $150,000 or more annually described above. They therefore have the same motivations to build a detached backyard ADU, such as a desire for additional space for extended family or a live-in home health aide, as well as sufficient monthly income to afford loan payments over time. What distinguishes this second household type from the first is its low level of home equity, which ultimately limits viable financing options to renovation loans. PropertyRadar data shows that there are about 4,232 single family residences in Unincorporated communities with lower home equity levels of between 0% and 50%. While we do not have detailed data that shows the overlap between high income households and low home equity households, we do know that the majority of high income households, about 4,419 households or 82%, own their homes with a mortgage.

Pro Forma Summary: Renovation Loan To illustrate an example of an ADU financing scheme for a high income/low home equity household, we modelled the potential ADU cash flow for a household with the following characteristics:

Household Type High Income/Low Home Equity


Home Equity 38%

Property Value $800,000


Interest Rate 4.25%

We assume that this high income household would also like to build a detached ADU in the backyard, which will cost about $200,000 to build. However, unlike the example above, this household has relatively low home equity, which makes a traditional cash-out refinance, home equity loan, or HELOC less viable as options. This household will instead take out a Fannie Mae HomeStyle Renovation Loan, which allows them to refinance and borrow up to 50% of the after-renovation value of their property to cover the construction costs for the ADU. It should be noted that refinancing becomes less attractive to borrowers as interest rates rise. Because they have very high, stable income, they are willing to pay higher monthly payments for a shorter loan term that will save them on interest payments in the long run.

Financing Method Renovation Loan

Loan Principal $100,000


Loan Term 15

Monthly Loan Payment -$730


Again, we check for the geographic loan limit, maximum debt-to-income ratio, and maximum LTV to ensure that this household would be within their debt limits. The debt-to-income ratio in this model refers only to mortgage debt. We also make sure that the loan this household would like to take out is no greater than 50% of the after-renovation value of the home.

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Debt-to-income Ratio 45% 4%

LTV 95% of after-ADU value 83% of after-ADU value

Construction Loan 50% of after-ADU value 16% of after-ADU value

The cash flow for a rented ADU on the property over the course of the 15 year mortgage is summarized here. Assuming an initial rent of $1,915, there is positive cash flow starting immediately in Year 1. By Year 14, the cumulative ADU income alone exceeds the overall mortgage balance for the property more than five times. By the time they pay off they pay off the mortgage in Year 15, the ADU has generated $310,821 of income for the property.


ADU Rental Revenue $22,980 $43,332 $45,499


Operating expenses -$460 -$867 -$910

Capital replacement reserve -$412 -$849 -$892



ANNUAL ADU INCOME $9,437 $30,584 $32,642

CUMULATIVE ADU INCOME $9,437 $278,180 $310,821



Low Income/High Home Equity

Financing Method While high home equity is a valuable asset, homeowners without sufficient income will not qualify for very many loan products because banks generally lend based on the borrower’s ability to pay. There are, however, some financing options specifically geared towards low income borrowers through FHA and Fannie Mae. For example, Fannie Mae’s HomeReady loan described above could be ideal for this type of borrower, as it targets borrowers earning up to 100% of AMI and allows rental income from an ADU to contribute a borrower’s debt-to-income. FHA also offers the Home Equity Conversion Mortgage (HECM), a reverse mortgage designed for homeowners age 62 and older looking to age in place, which allows the borrower to convert their home equity into liquidated income or a line of credit. Unlike other FHA loans, there are no income or credit qualifications for this type of loan and the amount of the mortgage is based on the home's existing value.

Demographic Analysis Relatively lower income homeowners earning less than $100,000 annually add up to about 6,050 in Unincorporated San Mateo County. Our demographic analysis concluded that these households are more likely than higher income households to have at least one person age 60 and over (4,051 households or 67%). This points to a significant market among lower income households who may wish to build an ADU in order to be able to age in place. These households could use an ADU to house a caretaker or to downsize by moving into the ADU and renting out the primary residence. Lower income households also have a higher rate of underutilized living space in their homes: 3,928 lower income households, or 65%, have more rooms than household members. This means that this type of household may have extra interior rooms that they could convert into an attached ADU. When necessary upgrades to these existing spaces are not overly complicated, this can be a more affordable construction type than a detached ADU.

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What will help boost these households’ ability to finance an ADU is their high home equity. As explained above, there are 13,571 single family residences in Unincorporated communities with relatively high home equity levels of 50% or more. Again, we do not have detailed data that shows the overlap between low income households and high home equity households, but we do know that 2,482 of all lower income households in Unincorporated San Mateo County, or 41%, own their homes free and clear with 100% home equity built up.

Pro Forma Summary: Special Loan Products To illustrate an example of an ADU financing scheme for a low income/low home equity household, we modelled the potential ADU cash flow for a household with the following characteristics.



Home Equity 80%

Property Value $1,000,000


Interest Rate 4.25%

The demographic data points to the fact that many low-income households have underutilized space in their existing homes that could potentially be converted to an ADU, so we assume this household would like to build an attached interior ADU that costs $100,000 to build. While their income may be too low qualify them for many industry loan products, Fannie Mae offers the HomeReady loan for purchase or refinance. This loan is open to borrowers living in low-income census tracts or earning less than 100% AMI ($115,300 for an individual in San Mateo County). One thing to note is the additional monthly mortgage insurance payment required by Fannie Mae for this loan.

Financing Method HomeReady Refinance



Loan Term 30


Mortgage Insurance -$100


We check for the geographic loan limit, maximum debt-to-income ratio, and maximum LTV to ensure that this household would be within their debt limits. The HomeReady loan allows rental income from the ADU, demonstrated by a lease agreement, to count towards the debt-to-income ratio helping to insure that it is below the maximum allowable ratio.



Debt-to-Income Ratio 45% 10%

LTV 97% 30%

The cash flow for a rented ADU on the property over the course of the 30 year mortgage is summarized here. Assuming an initial rent of $1,915, there is a significant positive cash flow of almost $12,000 starting immediately in Year 1. By Year 12, the cumulative ADU income alone exceeds the property’s overall mortgage balance. By the time they pay off their mortgage in Year 30, the ADU has generated over $1,000,000 of income for the property. HomeReady loans provide a

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significant opportunity for households who would otherwise be unable to construct or benefit from an ADU; programs targeting low- and moderate-income ADU owners should publicize the HomeReady program.


ADU Rental Revenue $22,980 $39,304 $94,589


Operating expenses -$460 -$786 -$1,892

Capital replacement reserve -$412 -$770 -$1,854



ANNUAL ADU INCOME $12,090 $29,528 $82,405

CUMULATIVE ADU INCOME $12,090 $251,492 $1,216,545



Low Income/Low Home Equity

Financing Method Homeowners without sufficient income or home equity will not be able to qualify for traditional banking finance methods. These households would need to have significant amounts of cash savings, external assets, or support from family or friends to even consider building an ADU, and will very likely be limited to a simple and inexpensive attached ADU renovation project. It is important to note that while these homeowners may not be able finance an ADU within the current mortgage financing infrastructure, they stand to benefit the most from additional income generated from renting out an ADU. For this reason, the County of San Mateo should consider ways to use public financing to empower these household types to enter the ADU ownership market as well.

Demographic Analysis These households fall among the 6,050 households earning less than $100,000 annually and the 4,232 single family residences in Unincorporated communities with lower home equity levels of between 0% and 50% described above. While we do not have detailed data that shows the overlap between low income households and low home equity households, we do know that over half of lower income households, about 3,543 households or 58%, own their homes with a mortgage. Households in this pool of properties may have low or high home equity compared to their mortgage balance, but certainly do not have the maximum home equity associated with owning a home outright. These households also have the highest rate of monthly owner cost burden: 3,137 lower income households, or 52%, pay more than 30% of their income on housing. Potentially pointing to already high debt-to-income ratios, some of these households will experience difficulty finding loan options. We did not prepare a proforma for this type of household as they typically are unable to qualify for traditional and income-restricted loan products. However, low-income, low-equity households stand to benefit the most from homeownership and rental income; these households are fertile ground for public investment from socially driven investors, philanthropy, and partnership with mission-driven lenders such as CalHFA. New programs or investment should focus on inclusion of this historically excluded demographic in new homeownership opportunities.

FINAL RECOMMENDATIONS As the County explores new financing options for ADU construction, a concerted effort should be made to address the lender and household-level challenges described in this report. Additionally, financing tools should be developed with an eye for the demographic and socio-economic composition of households in Unincorporated San Mateo County to expand

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opportunities that are currently unserved or underserved by existing loan products. Final recommendations to this end include:

Develop financing tools through the County or community development financing institutions (CDFIs) that are accessible to lower income borrowers, such as a community land trust, shared equity mortgage program, or bridge loan funds. CDFIs—private financial institutions such as banks, credit unions, loan funds, and venture capital funds—are mission-driven lenders that provide financing to community-serving nonprofits, particularly those providing affordable housing. Our analysis points to a financing gap for low income households without sufficient home equity, and limited options for those with high home equity. New financing tools should be tailored towards different household types and allow them to utilize a diverse set of assets such as home equity, potential rental income, or other personal resources, in order to qualify.

Promote the use of income-based valuation of ADUs in developing new financing tools and encourage local lenders to offer existing loan products that used an income-based approach, such as the HomeReady loan.

Publicize new products such as the HomeReady loan to ensure that low- and moderate-income borrowers are aware of their options for ADU financing.

Explore the creation of a local revolving loan fund to provide more short-term, smaller-scale loans for ADUs. Revolving loan funds are pools of capital that regenerate themselves through the payback of previously issued loans. Because loans must be paid back before new loans can be issued, a revolving loan fund could be cost-efficient for the County and can have short payback periods compared to the 30-year home mortgage.

Explore the use of both public money and private investment to create new ADU financing tools. For example, ADU construction for or by low- to moderate-income residents could be added as an eligible use for public assistance under broader existing affordable housing construction and preservation programs such as the Affordable Housing Fund. There is also an opportunity to work with mission-minded investors or to give banks an avenue to fulfill their Community Reinvestment Act (CRA) requirement through ADU financing. The CRA requires lenders to serve all segments of their communities as a way of revitalizing neighborhoods that have historically been excluded from credit and banking services, and has been an important element of community development financing since it was enacted in 1977.

Communicate with other jurisdictions that have attempted ADU loan funds for lessons learned. Santa Cruz

offered an ADU loan program in conjunction with the Santa Cruz Community Credit Union, offering $70,000 loans

at 4.5% interest in exchange for a covenant requiring units to be rented to low-income tenants; however, the

program proved unpopular. The County might explore whether a less restrictive program would prove more

viable.

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REFERENCES Brown, Martin John. 2014. “How Much Do ADUs Cost to Build?” Accessory Dwellings. June 25.

https://accessorydwellings.org/2014/06/25/how-much-do-adus-cost-to-build/. Brown, Martin John, and Taylor Watkins. 2012. “Understanding and Appraising Properties with Accessory Dwelling Units.”

The Appraisal Journal. CalHFA. 2017. “Homeownership Program Bulletin.” April 17.

http://www.calhfa.ca.gov/homeownership/bulletins/2017/2017-03.pdf. Casey, Kevin. 2017. “What Are the True Costs of an Accessory Dwelling?” New Avenue Homes. March 3.

https://www.newavenuehomes.com/kb/Costs%20of%20an%20Accessory%20Dwelling. City of Santa Cruz. 2003. “Accessory Dwelling Unit Manual.” Chapple, Karen, Jake Wegmann, Farzad Mashhood, and Rebecca Coleman. 2017. “Jumpstarting the Market For Accessory

Dwelling Units: Lessons Learned From Portland, Seattle, And Vancouver.” Terner Center for Housing Innovation. https://ternercenter.berkeley.edu/more-ADUs.

County of San Mateo Department of Housing. 2017. “Income and Rent Limits.” http://housing.smcgov.org/sites/housing.smcgov.org/files/2017%20Income%20and%20Rent%2006%2019%2017.pdf.

Gray, Lucas. 2016. “How Much Will My Accessory Dwelling Unit (ADU) Cost?” January 15. https://www.linkedin.com/pulse/how-much-my-accessory-dwelling-unit-adu-cost-lucas-gray.

Fannie Mae. 2016. “Accessory Unit and Boarder Income Flexibilities.” https://www.fanniemae.com/content/fact_sheet/homeready-boarder-accessory-unit-income.pdf.

Kingston, Vince. 2015. “Financing ADUs.” presented at the Build Small Live Large Small Housing Summit, Portland State University, November 6. http://buildsmall-livelarge.com/program/.

New Avenue. 2014. “Financing Your Accessory Dwelling – Insights from 100+ Customers and a Few Bankers.” November 18. http://blog.newavenuehomes.com/index.php/2014/11/18/financing-your-accessory-dwelling-insight-from-umpqua-banks-greg-loberg/.

Palmeri, Jordan. 2014. “Guide to Financing an Accessory Dwelling Unit | Accessory Dwellings.” Accessory Dwellings. November 3. https://accessorydwellings.org/2014/11/03/finance-guide-for-adus/.

Peterson, Kol. 2017. “Calculating The Costs of Building an ADU.” Building an ADU. http://www.buildinganadu.com/cost-of-building-an-adu/.

Rugaber, Christopher S. 2017. “U.S. Home Equity Is Back, so Why Aren’t More People Borrowing?” USA TODAY. May 30. https://www.usatoday.com/story/money/personalfinance/2017/05/30/us-home-equity-back-so-why-arent-more-people-borrowing/102160012/.

Spevak, Eli. 2014. “Stradivarius Violins and Cigar Box Guitars (Making Sense of ADU Construction Costs).” Accessory Dwellings. May 1. https://accessorydwellings.org/2014/05/01/stradivarius-violins-and-cigar-box-guitars-how-much-does-an-adu-cost/.

The Alley Flat Initiative. 2017. “Financing: Does an Alley Flat Make Good Economic Sense for You?” http://thealleyflatinitiative.org/?page_id=13.

United Policyholders. 2014. “What’s UP with Overhead and Profit?” June 3. http://www.uphelp.net/pubs/what%E2%80%99s-overhead-and-profit.

U.S. Department of Housing and Urban Development. N.d. “Frequently Asked Questions about HUD’s Reverse Mortgages.” https://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/sfh/hecm/rmtopten.

Wegmann, Jake. 2016. “Strategies to Help Homeowners Finance Accessory Dwelling Units in Austin: A Report on Findings from a Student-Led Research Project.” University of Texas at Austin.

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APPENDICES

Appendix A: List of Interviewees

10/11/16: Forsyth Street; Michael Freedman-Schnapp, Senior Associate

11/10/16: Tentmakers Inc.; Joe Serrano, Executive Director

11/17/16: Fannie Mae Policy and Access to Credit Team Members; o James Anderson, Director in Policy Research o Jodi Horn, Credit Policy Team o Zack Johnson, Director of Collateral Policy and Strategy o Jude Landon, Credit Policy Team o Anne Mckalick, Access to Credit Team o Lial Radke, Manager in Collateral Policy

11/18/16: Hello Housing; Jennifer Duffy, Director of Business Development

12/02/16: Wells Fargo; Brad Blackwell, Executive Vice President of Housing Policy & Homeownership Growth Strategies

12/22/16: Technology Credit Union; Jennifer Wilkinson, Vice President of Mortgage Lending

Appendix B: Interview Topic Guide Existing ADU Financing Methods:

What are the most common methods/loan products people have used in the past to finance their ADUs o Existing savings o Cash-out refinancing of first mortgage o Getting a second mortgage or home equity loan o Renovation loans (FHA 203K)

Which methods have been most appropriate for which homeowners?

What are the limitations or drawbacks of these existing financing methods? Potential Programs and Products for ADU Financing:

What potential programs could be developed or adapted to finance an ADU independently from the primary residences?

o San Mateo County Innovation Fun o Housing trust fund $ from inclusionary in lieu funds o Tax Credits for ADUs o PACE Funding for ADUs o CDBG $ for cities that want to facilitate ADUs

To what extent is scalability a problem? (How big does the loan have to be for it to work?)

What are policy changes that could lower the cost of building an an ADU? o Amend Mitigation Fee Act to require that all mitigation fees be charged on a PSF basis, not a per unit

basis. Units smaller than 500 sqft should pay no mitigation fees

Appendix C: Household Typology Proformas (See Attachment)

Assumptions

ADU OPERATION CASH FLOW Year

ADU Rental Revenue

Monthly rent x 12 months, increasing annually by .5%. Because ADUs tend to be relatively small and more affordable to low and moderate income renters, we assume here that the monthly rent is $1,915 in Year 1, which is the 2017 fair market rent (FMR) for a studio apartment according to a joint study by San Mateo County, Marin County, and San Francisco. It is important to note that this is a conservative figure for what would be an "affordable" unit in the SMC market; according to the joint study, the SMC area median income (AMI) is $115,300, so a household earning 100% AMI could afford a rent of $2,882.50 (30% of household income). Also note that in the "High Income High Equity" scenario, rent is set to $0 in Year 20 to model the assumption that higher income householders who want to age in place may rent out to family members or caretakers for free as they reach old age

Vacancy Allowance One month’s rent. This is assumed to be $1,915 in Year 1

Operating expenses One month’s rent. This is assumed to be $1,915 in Year 1

Capital replacement reserve 2% of revenue – vacancy allowance – operating expenses

Property tax on ADU Cost of ADU construction x California's 1% property tax rate, increasing by 1% annually

Debt service Monthly payment for the ADU loan amount x 12 months

ANNUAL ADU INCOME Annual ADU Income: revenue – vacancy allowance – operating expenses – capital replacement reserve – property tax on ADU – debt service

CUMULATIVE ADU INCOME Sum of Annual ADU Income for all years leading up to this year

Source: Wegmann, Jake. 2016. “Strategies to Help Homeowners Finance Accessory Dwelling Units in Austin: A Report on Findings from a Student-Led Research Project.” University of Texas at Austin.

1

High Income/High Equity Household

HOUSEHOLD

Household Type High Income/High Equity

Household Characteristics Before Construction After Construction


Home Equity 80% 62%

Property Value $1,000,000 $1,300,000

Mortgage Balance $200,000 $500,000

Interest Rate 4.25% 3.8%

ADU DEVELOPMENT

ADU Construction Type Detached Backyard ADU

Total Development Cost $300,000

FINANCING

Financing Method Cash-Out Refinance


Loan Interest 3.8% Fixed

Loan Term 30

Monthly Loan Payment -$1,398

Mortgage Insurance $0




Debt Ratio 45% 11%

LTV 80% 50%

2

3

High Income/Low Equity Household

HOUSEHOLD




Home Equity 38% 50%

Property Value $800,000 $1,200,000



ADU DEVELOPMENT

ADU Construction Type Detached Backyard ADU


FINANCING

Financing Method Renovation Loan



Loan Term 15


Mortgage Insurance $0




Debt-to-Income Ratio 45% 4%

LTV 95% of after-ADU value 83% of after-ADU value

Construction Loan 50% of after-ADU value 16% of after-ADU value

4

5

Low Income/Low Equity Household

HOUSEHOLD

Household Type High Income/High Equity



Home Equity 80% 73%

Property Value $1,000,000 $1,100,000



ADU DEVELOPMENT

ADU Construction Type Interior Attached ADU


FINANCING

Financing Method HomeReady Refinance



Loan Term 30


Mortgage Insurance -$100




Debt Ratio 45% 10%

LTV 97% 30%

6

Documents

Technical Report: ADU Financing Issues in Unincorporated ... · High Home Equity Cash-Out Refinance or Home Equity Loan/HELOC Special FHA, Reverse Mortgage, or Fannie Mae Loan Products