California’s new ADU law leaves agents with more questions than answers

There could be gold in your backyard, but real estate professionals have a lot of questions about how to access it — and how it could change the housing market.

AB 1033, a new state law, allows the sale of accessory dwelling units, the “granny flats” built behind or next to single-family homes.

The law, which will take effect on Jan. 1, allows Californians to buy and sell ADUs separately from the primary residences to which they are connected. Previously, an ADU could only be rented out. The new law was sponsored by State Assemblyman Phil Ting of San Francisco.

Lawmakers believe ADUs will help solve the housing crisis because people can develop new homes literally in their backyards. For agents, the law may open the gates to a new wave of inventory in a market where homes for sale are scarce. But the new law also leaves many questions on the table.

Wilson Leung, a San Francisco Bay Area agent and founder of OWN Real Estate at Keller Williams, wonders how transactions for ADUs will be handled. Will they be handled like condominiums and townhomes?  Could they be handled with a tenant-in-common agreement, where two or more parties share ownership of a property? Or will they be handled like single-family homes? Lenders treat the categories differently, Leung noted.

“Because the roles are not clearly established, consumers, buyers and sellers won’t know exactly what they are buying and selling just yet,” Leung said. “It’s not something we’re actively selling yet.”

Omar Abich, founder of Simple Mortgage in Pasadena, forecast that ADUs will be treated like single-family homes. 

“You’re transferring real property here. They’re going to have their own address and their own gas and power meters. They are in essence a single-family residence,” he said.

Steve Clark, founder of agency Backbeat Homes in Pasadena, forecast that AB 1033 could transform neighborhoods — and potentially cause resentments.

“Let’s say my wife and I keep our house and sell our ADU for a reasonable price. Aside from the obvious increase in traffic — since we’re potentially doubling the population of a residential neighborhood — it could change entire neighborhood dynamics. People don’t buy with the anticipation that they might wind up with twice as many people crammed onto their block.”

Serial legislation

AB 1033 is the latest state law designed to develop a market for ADUs, and thus lessen California’s grinding housing crisis. However, past legislative attempts have not met with much success. 

In 2021, the legislature passed SB 9, which allowed homeowners to split their single-family parcel into two lots and build up to two units on each lot. It went into effect in January 2022.

Earlier this year, UC Berkeley’s Terner Center, a housing policy research group, released a study following the progress of ADU development after the passage of SB 9. It looked at 13 cities where developing ADUs seemed to make the most financial sense for property owners and “found that SB 9 activity is limited or non-existent in these 13 cities.”

However, residents of Los Angeles showed by far the most interest, with applications to build 211 units and 28 lot splits.

But now the market is ready for a change, according to Seth Phillips, founder of Los Angeles-based ADU Gold, a consulting firm that works with property owners and agents to build and sell the units.

With increases in interest rates and mortgage rates in the past year, there are fewer opportunities to develop revenue streams from homes. Phillips said the development of ADUs is one of the most painless, market-driven ways for Californians to develop out of the housing crisis. 

“People are looking for things to give them more economic certainty. This is a good option to invest in property they already own,” he said.

Financial options

Last month, the Federal Housing Authority announced a new policy to make it easier to buy or refinance a house with an ADU. According to media reports, previous rules for FHA-backed loans allowed lenders to consider rental income from duplexes but not ADUs. The new policy allows income for ADUs to be counted when underwriting a mortgage.

“The financing is getting better and better,” Phillips of ADU Gold said. 

Tom Arnold, associate professor of real estate at Chapman University in Orange, believes the new legislation will attract capital to the ADU market and stimulate incremental residential supply.

But he added that there isn’t much legal precedent for determining the appropriate rights, restrictions and levels of cooperation between a homeowner and a separate and distinct ADU owner situated in the middle of the primary homeowner’s lot.

 “This is the creation of a new divisible property right,” Arnold said. “There remain a lot of questions about exclusive possession, use and enjoyment. What easements are necessary for the possession of the ADU? How is access granted? Are there restrictive covenants encumbering the ADU? Can the ADU owner install a chain-link fence? Where can the ADU owner park vehicles? Is the ADU owner required to maintain the exterior of the ADU and related grounds?”

Meanwhile, entrepreneurs see a bright future in ADUs. Colton Paulhus founded Anchored Tiny Homes in 2020 to build ADUs in the Sacramento market. The company logged revenue of $49 million last year, Paulhus said. He forecast revenue would at least double this year. 

He also forecast that ADUs will take root in every segment of the residential market, but his company does most of its business in middle-class neighborhoods.

“If people don’t utilize their backyards, they can sell a plot of land for a big multiple return on investment,” Paulhus said.