This article originally appeared in the March 2025 edition of MortgagePoint magazine, online now.
If you are a fan of the 1970s sitcom Happy Days, then you are already familiar with Accessory Dwelling Units (ADUs). The independent living space that Arthur Fonzarelli, better known as “Fonzie,” lived in above the Cunningham’s garage, with its own entrance and bathroom, qualifies as an ADU.
If Full House is more your speed, the upstairs attic where Uncle Jesse and Aunt Becky lived and started their own family can also be considered an ADU.
ADUs have been in existence for centuries, often meeting different societal or generational needs. While ADUs have different parameters based on the lender, they are typically a secondary living space that is independent of the primary residence but located on the same parcel. They must have their own kitchen, bathroom and sleeping space, along with a separate entrance, while also being smaller and providing less value than the primary residence.
Today, ADUs are once again rising in popularity, as the housing shortage continues, and homeownership comes with a hefty price tag. With this, many cities and states are altering their regulations, and in some cases relaxing them to make it more feasible for property owners to add an ADU.
The National Apartment Association was recently following 12 bills across eight states that mentioned ADUs. They also reported that, as of 2023, at least eight states have policies that preempt local bans of ADU construction. A new policy announced through the Federal Housing Authority (FHA) in late 2023 also aims to make ADUs more accessible, allowing lenders to count income from these independent units when underwriting a mortgage.
A 2020 Freddie Mac study indicated there are 1.4 million properties with ADU’s across the United States. At that time, the study showed that ADU construction was rising by 8.6% per year over the last decade. Over the last few years, that number has skyrocketed. In California alone, John Burns Research and Consulting pulled data from the California Department of Housing and Community Development that shows ADU construction went from 3,000 units per year in 2018, to 23,000 a year in 2023.
Whether serving as an independent living space for family members or bringing in residual income through rent for the property owners, ADUs offer a wide range of advantages. But there is a lot that lenders need to be aware of, from complex zoning requirements that vary not only by state, but often down to the municipality, to ensuring they are working with the right appraiser who understands the ins and outs of the space. The rules for ADUs are ever-changing.
Key Benefits to ADUs
ADUs have become a popular way for families—whether it’s a child in their 20s or a grandparent—to live near one another while also having their own independent space. For borrowers, this is a big perk, as costs to build an ADU can be lower than a full-size home, as the size of the structure is smaller and requires less material. The smaller size also often means lower energy costs, and, if the ADU is newly built, it can also feature energy saving appliances to bring the operational cost down even further. With this, you can have your relatives close by at a lower cost, but still keep them at enough of a distance to function independently with your own space.
Instead of spending money to rent an apartment or buy a house, people are converting spaces in or around their home to ADUs for added space and to save money and avoid construction costs. A popular use for ADUs in the current market is also to rent out the space to earn additional income. This can be beneficial in several ways, including that the borrower, in some cases, can use the rental income to qualify for loans or specific programs.
For lenders, ADUs should be seen as an added opportunity for business in a volatile market. The GSEs are even taking notice of the trend and expanding policies for broader mortgage possibilities, with programs like Freddie Mac’s CHOICERenovation Mortgages and Fannie Mae’s HomeStyle Renovation program. For lenders, this also comes with the opportunity to educate borrowers. According to a 2023 survey by Freddie Mac, 71% of respondents were unfamiliar with ADUs. But, once they learned more about them, 32% of those who currently do not have an ADU on their property said they were interested in the prospect. During a difficult market, ADUs can provide a new space for lenders to enter that will benefit them financially.
Challenges and Obstacles
While ADUs serve a purpose with today’s tight housing inventory, they also come with numerous caveats, and there are things that both borrowers and lenders need to stay on top of. Regulations surrounding ADUs are ever-changing and with this rapid evolution, it is important to stay up to date on all local and state zoning laws, building codes and permit regulations. These differ not only by state, but by individual municipality. Restrictions can range from size requirements to height and setback rules. Not following local zoning regulations can lead to fines, penalties, and even possibly legal action. All of this could delay the project and end up costing the borrower money. Having a qualified contractor with experience in ADU construction who knows and understands the local regulations is vital to success.
Borrowers also need to be aware of occupancy requirements and regulations around renting, along with rental rates and laws that prohibit short-term rentals. Restrictions can range from requiring only family members to live in an ADU to prohibiting leases from being less than 30 days. Some regulations that we have seen even specify nuanced requirements, including prohibiting a storage shed from being turned into an ADU. Some municipalities also require ADUs to be registered and include an annual fee. HOA’s even often have their own requirements for ADUs that need to be followed. So, there is a lot to pay attention to.
For ADUs that are legal nonconforming or illegally built, there are many hurdles to overcome. In very extreme cases, the property owner could be required to tear down the structure. This does not happen often, but it is something property owners and builders alike should be mindful of. Rental income from an illegal ADU also cannot be used to qualify the borrower for a loan. For lenders, unnecessary delays due to material defects could end up jeopardizing their relationship with the borrower.
Choosing the Right Appraiser Matters
Working with the right appraiser who has experience with ADUs and their complexities also is key. There are additional rules that appraisers must follow for ADUs and appraisers with knowledge in this space often are in high demand. For appraisers, it is important to remember that as a part of their certification they must state that they are knowledgeable and experienced in the niche market they are appraising. This is a requirement that follows through the entire process.
The appraiser also must have a knowledge of comparable sales requirements. Automated Valuation Models (AVMs) are less reliable for ADUs and waivers generally are not accepted. Realtors and Multiple Listing Services (MLSs) are not consistent with their reporting of ADUs and this can create added challenge for the appraiser. Appraisers also must take extra steps when rental income generated from the ADU is used to qualify the borrower. Clear communication with the appraiser is key to avoid unnecessary delays.
What Lies Ahead?
ADUs likely will continue to grow in popularity over the next several years. With the national housing shortage, coupled with higher-than-average interest rates, and increasing home costs, there is a market for outside-the-box solutions, including ADUs and manufactured housing. Property owners do not even need to construct a new structure on their property and instead can turn existing basements, garages, and back yard structures into an ADU. ADUs continue to provide more affordable housing and opportunities for multi-generational living and that will help their popularity to continue to rise.
