Adding Backyard Shed

Is adding a backyard shed apartment a good investment?

Background
A friend is renting their primary residence on the weekends. They wanted to add an efficiency shed they could live in during weekends when the main house is rented.

Existing Shed Configuration
There is a current shed structure in the backyard from a prior owner. It was used for storage but is dilapidated and barely standing. The two existing sheds are side-by-side and total 250 square feet. In this locality, it is easier to legally construct an efficiency if you are improving an existing structure.

Requirements
They decided on an efficiency shed with a stand-up shower, a cooktop and microwave, and a futon that worked as a bed. It had to roughly match the characteristics of the house and be legally permitted. Electricity and water were required. There is no separate closet space.

Getting and Analyzing Bids
My friend contacted their local neighborhood association for referrals. They got 3 bids from contractors. They came in at $9k, $17.5k, and $30k.

The $9k bid did not include water, electricity, or legal permitting. This bid was not considered.

The $30k bid included everything from an experienced contractor.

The $17.5k bid included everything from a local contractor in the neighborhood. He also agreed to let my friend observe the process so they could learn. He tried to match the shed to the character of the house so it would fit well. This was the winning bid.

Shed Construction
The total construction ended up taking almost three months. Some of the delays were due to the house being rented and not available for the workers, and there were some unexpected rain delays.

The general contractor subbed-out the work and managed the process. It’s estimated that being your own general contractor could save 20% in project management costs. My friend does not have construction experience or have enough relationships with experienced subcontractors so having the oversight and management proved valuable.

Financial Analysis
We estimated the monthly benefit of the shed at about $600 per month. This is estimate is composed of 1) costs to relocate when their house is rented of roughly $30 per night and 2) the additional rental possibility.

How much should be budgeted for the shed? One way to think of this is the payback period. I’ve heard of landlords who only invest in upgrades that payback within 24 months. With that calculation: $600/month * 24 months = $14,400. If the shed could be built for this amount it would be a great investment.

There are several other ways to consider this investment. Let’s assume you could invest this money in a 5 year note and earn 7% instead. The benefit is still $600 per month or $7,200 per year. Over 5 years, the NPV in Excel comes to $12k. Another way is to look at the profitability index — in this case, every $1 invested generates $1.69 in cashflow (present value). This sure seems optimistic, and doesn’t even count for the long-term value of the shed.

For a future buyer of the property the shed could make a great home office. We estimated it added 70% of the average price-per-square-foot in the neighborhood to the house. If the average was $100/ft, a 250 sqft shed might be worth 70% * $100 * 250 sqft = $17,500.

Adding the $17,500 and $12k present value together gets a stunning $29.5k estimate of value. But is the $600 per month cashflow really right? We aren’t discounting the wear-and-tear to the property, the maintenance, or the time spent renting out the property.

Let’s say it takes 2 hours per weekend to run and maintain this property. Let’s say the labor costs $25 per hour, or $50 per weekend or $200 per month. Suddenly the expected cashflows go down and the NPV is $2k. Only $1.12 in cashflow is earned for every $1 invested. For help calculating NPV in Excel check here.

Let’s add some more risk. What if the project ends up costing $25k and we still need to pay the labor to run the rental? The NPV is negative by $5k. If we could have received a 20% return on our investment elsewhere then it’s -$10k NPV. Once the property is sold you might recover the $17.5k above, or might not. The profit might also be subject to taxes, and the increased value of the property could raise your property tax.

Another back-of-the-envelope way to think of the cost is per square foot. At $17.5k, adding 250 square feet of living space would cost $70 per square foot.

My friend only used these estimates to ballpark the appropriate amount to spend. There was also some “gut feel” required — how long the structure might last, if they would get the value back on selling the house, if they would actually still be renting the unit five years from now, and so on. They thought the shed was a good long-term investment if it cost less than $25k.

Actual Results
The shed construction took longer than anticipated. The project was on budget for the initial scope, but a few items were added that increased the total bill. Some of the overages were optional, such as upgraded countertops. A few overages were deemed necessary, such as protecting the wood floors with polyurethane and adding a privacy fence.

The shed has been lived in for only a few weeks so can’t say how it worked out financially yet. It seems like it will allow the main house to have a higher occupancy rate, and the $600 per month estimate of value seems right so far.

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