Build ADU Portfolios with Care

By Larry Manchester, Director of Construction Services  |  Partner Residential Consultants
Published in the 2025 (Q4) Private Lender (PL) Magazine by AAPL on October 23, 2025. For a PDF copy of the article, click here. 

Accessory Dwelling Units (ADUs) are making waves in the housing market, offering a practical solution for homeowners looking to maximize property value, generate rental income, or accommodate multigenerational living. Although ADUs have been around for decades—sometimes as legal conversions, other times as less-than-official backyard additions—state and local governments are finally catching up by providing more structured guidelines and incentives to support their development.

At its core, an ADU is a self-contained residential unit located on the same lot as a primary home, whether as a garage conversion, detached structure, or home extension. With a private entrance, kitchen, and bathroom, ADUs function as independent living spaces while remaining tied to the main property.

Their benefits extend beyond individual homeowners. Cities in California, Washington, Oregon, Vermont and others with housing shortages have embraced ADUs to increase density without expanding urban sprawl. For families, they provide a flexible living arrangement for aging parents, adult children, or caregivers. Additionally, long-term rental income from an ADU can help offset mortgage costs. And when properly designed and permitted, these units can significantly enhance a home’s resale value.

With growing demand and evolving policies, ADUs are emerging as a valuable asset class, presenting lenders with new opportunities to expand their portfolios while supporting housing accessibility and property value growth.

A Complex Regulatory Landscape

Not all ADUs are created equal, nor are their regulations. Some states, like California, Oregon, and Vermont, have actively encouraged ADU development by relaxing zoning restrictions, eliminating owner-occupancy requirements, and streamlining the approval process. Others, such as New Hampshire, Washington, and Massachusetts, have enacted laws allowing ADUs “by right,” meaning they can be built without discretionary approvals; nonetheless, localities retain control over development standards. Meanwhile, many states, including Texas, Florida, and Georgia, lack statewide ADU statutes and leave regulations largely up to local governments, resulting in inconsistent policies from city to city. Navigating these requirements often requires local expertise, particularly when regulations shift rapidly or vary across adjacent municipalities. In states where ADUs are permitted, keep the following key considerations in mind.

PERMITTING TIMELINES AND APPROVAL PROCESSES.

One of the biggest hurdles to ADU development is the permitting process, which varies widely by state and municipality since approvals are handled locally.

In California, state law requires cities to act on complete ADU applications within 60 days. Beginning in 2025, under California’s AB 1332, homeowners who use a preapproved ADU plan without changes can qualify for an even faster 30-day review. In practice, however, approvals in big cities such as Los Angeles or San Diego still often take several months due to high demand, multiple reviews, and resubmittals. By contrast, in states without streamlined laws, such as parts of New York or Colorado, the process can stretch six to 12 months. In some municipalities, ADUs are still not allowed at all.

ADU SIZE RESTRICTIONS.

ADU size limitations vary by state and municipality, often based on a percentage of the primary dwelling’s square footage or a set maximum size. In addition, some states also differentiate between detached ADUs, attached ADUs, and conversions of existing spaces, each with unique size limitations. For example, in Oregon, ADU sizes are capped at 800-900 square feet or 75-85% of the primary residence, whichever is smaller. In California, however, detached ADUs may be allowed up to 1,200 square feet, but attached ADUs are capped at 50% of the main home (never less than 800 square feet).

LOT SIZE AND SETBACK REQUIREMENTS.

Whether an ADU is feasible often comes down to the size of the lot and how close the unit can be built to property lines. Some states, like California, have eased restrictions by requiring only four-foot side and rear setbacks and prohibiting cities from mandating oversize lots that would block ADUs. In states without such protections, local governments may still require large minimum lot sizes or deeper setbacks, limiting ADU options on smaller parcels and/or denser neighborhoods.

RENTAL REGULATIONS AND OCCUPANCY RULES.

Rental and occupancy regulations for ADUs can significantly impact both the feasibility and the financial income potential of building one, making
them an important consideration for both lenders and borrowers.

Many states—including California, Washington, and Oregon—have lifted owner-occupancy requirements, meaning the primary home and ADU can be rented out independently. That said, some local jurisdictions may still require the homeowner to live on-site if renting out an ADU. The type of rental also matters; in Oregon, vacation rentals may trigger additional owner-occupancy or parking requirements depending on local ordinances. Short-term rental restrictions vary widely as well. For example, San Francisco prohibits ADUs from being used as short-term rentals (e.g., Airbnb), while other cities allow it under specific conditions. This makes it essential to review local rental codes before moving forward.

BULK PLANE RESTRICTIONS.

Many cities enforce height and volume limitations to protect neighborhood aesthetics and prevent view obstruction. These limitations often define the maximum allowable building envelope, which can impact the feasibility of two-story ADUs, especially in areas where maintaining sightlines is a priority.

UTILITY AND METERING REQUIREMENTS.

Utility connections and metering requirements vary significantly across states and even between utility providers, affecting project costs and feasibility. Some jurisdictions require separate electric, water, or sewer meters for detached ADUs, while others allow them to share utilities with the primary residence. Water and sewer connections can be a significant cost factor, particularly in areas with older infrastructure where capacity upgrades may be needed.

ENERGY EFFICIENCY AND SOLAR REQUIREMENTS.

Several states have begun incorporating sustainability mandates into ADU regulations. For example, California’s Title 24 mandates solar panels on newly constructed detached ADUs. Meanwhile, jurisdictions like Boulder, Colorado, impose local energy performance standards for ADUs that align with climate goals. In other areas, energy-efficient construction isn’t required but can unlock valuable incentives such as expedited permitting, additional height, or rebates, like in Seattle.

PARKING CONSIDERATIONS.

Parking rules for ADUs vary widely. Many states, including California, Oregon, and Washington, have removed parking requirements for ADUs in areas near public transit, making it easier for urban homeowners to add secondary units. However, suburban and rural areas, such as parts of Texas and Georgia, often require at least one off-street parking space per ADU. In some cases, municipalities mandate that if a garage is converted into an ADU, the homeowner must replace the lost parking space elsewhere on the property, which can present a challenge for smaller lots.

GOVERNMENT AND STATE INCENTIVE PROGRAMS.

Many states and municipalities offer grants, tax credits, or low-interest loans to support ADU construction, which can reduce reliance on traditional financing. For example, Washington state offers property tax exemptions for homeowners who rent ADUs to low-income tenants, subject to program requirements. In addition, Vermont provides 0% interest forgivable loans for ADU conversions in owner-occupied properties, provided the unit is rented at or below HUD Fair Market Rent for a compliance period.

ADU development isn’t a one-size-fits-all process. Homeowners must also navigate design considerations, material costs, and contractor selection, among many other factors, to ensure compliance with local building codes. Preapproved ADU plans—required by all California jurisdictions starting in 2025—are making design and permitting more streamlined. Prefabricated ADUs are also becoming an increasingly popular option, reducing construction timelines and costs while maintaining quality.

With regulations continuing to evolve, understanding state and local requirements is essential before moving forward with an ADU project as many of the above factors can significantly impact project feasibility, costs, approvals, and overall risk. For lenders, these variables play a critical role in assessing loan eligibility, structuring financing options, and mitigating potential risks associated with construction delays, budget overruns,
or regulatory noncompliance.

Building ADUs Takes Expertise

Although the benefits of ADUs are clear, financing has historically been less so. Traditionally, ADUs have been self-funded due to the lack of tailored financing options. As interest in ADUs grows and more lenders support their development, financing barriers are coming down. This is making ADU construction more accessible and affordable while ensuring ADUs are built to higher quality standards with proper permitting.

Due diligence is a critical step in the ADU development process, ensuring that projects remain financially viable, legally compliant, and structurally sound. Before construction begins, a thorough project feasibility study helps homeowners and lenders assess whether a property can support an ADU based on zoning laws, lot size, setback requirements, etc. Additionally, due diligence should include contractor vetting. Due to the smaller nature of these projects, contractor risks are common because they often involve less sophisticated general contractors.

By addressing these factors up front and before closing on the project’s loan, lenders can better evaluate the borrower’s risk exposure. At the same time, homeowners can avoid unexpected regulatory and infrastructure challenges.

Beyond preconstruction planning, due diligence is essential in post-close monitoring—such as draw inspections and funds control—to keep ADU construction on schedule and ensure funds are used appropriately. For lenders, this level of oversight minimizes the risk of unfinished projects, contractor disputes, or cost escalations that could impact loan repayment. Homeowners also benefit from structured monitoring because it helps maintain construction quality and ensures adherence to regulatory requirements.

As ADUs gain traction as a mainstream housing solution, lenders have a unique opportunity to support this growing market. Understanding financing options, regulatory considerations, and construction risks is key to mitigating exposure and ensuring successful projects. With demand rising, those who adapt their lending strategies to include ADU-specific due diligence and financing solutions will be well-positioned to capitalize on this expanding sector.

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About the Author

Larry Manchester

Director of Construction Services

Larry Manchester is director of construction services at Partner Residential Consultants, bringing over 30 years of experience in the construction risk management space. As an innovator and business owner, Manchester created the first nationwide construction draw assessment platform and earned the trust of many of the largest construction lenders in the country. During his career, Manchester has overseen more than 5,000 project feasibility studies and more than 100,000 real estate collateral examinations.