April 12, 2019: The Economics of Granny Flats

People have various reasons for wanting to build a granny flat. Some families need to care for an aging relative. Others need a separate and private space for a teenager or young adult. Still others might be planning for a time after their kids have flown the nest and thinking about down-sizing. Today I’d like to focus on the economics of building a granny flat as a financial investment because the fact is, in places like the Southern Highlands of NSW (Greeny Flat country) where land is expensive and rents are high, a granny flat can offer exceptional security and Return on Investment (ROI).

A new granny flat under construction in the Southern Highlands.

A new granny flat under construction in the Southern Highlands.

Regular readers will know that Cintia and I have spent quite a bit of time over the last year up at Russell Island in Queensland building a house on some very cheap land that we found only 35km from Brisbane CBD (new or occasional readers are welcome to view all our previous Newsletters describing that project [among many other things] by clicking here or on the Newsletter tab at the top of the page). We would have liked to buy or build something in the Southern Highlands but simply couldn’t afford the price of land. So we bought on Russell Island and completed the 3 bedroom/2 bath house a little over a month ago. At this point we have invested a total of approximately $185,000 and a lot of time into the project. If we had bought a similar, new house in a similar location we would likely have paid about $275,000 (including stamp duty and closing costs) and if we were to rent it out we would likely get about $270 p.w ($14,040 p.a). This would give us a gross rental return of 5.1%.

However, we wouldn’t receive the gross return… we would have to pay rates ($2,800 p.a), landlords insurance ($1,200 p.a), property management fees (approx. $1,500 p.a.) and maintenance costs (estimated at $1,000 p.a). That would reduce our income to about $7540 p.a. and our net ROI to about 2.7%. That’s still not bad in our current low-interest environment. We could get a similar return from a RAMS Online Saver account however the house on Russell Island has the potential for capital gain (as well as the risk of capital loss) whereas a bank deposit does not.

In the Southern Highlands of NSW, we would be lucky to find an older investment property for $500,000 and to rent it for $450 p.w. That would give a gross rental return of 4.6% and a net ROI of about 3.2%. That’s still not bad if you’ve got half a million bucks to invest and it too offers the potential for capital gain over the long term.

But let’s have a look at how a granny flat would perform in the Highlands. For this exercise we’ll assume that you could build a 60sqm, two-bedroom granny flat for $160,000 and rent it out for $350 p.w. (reasonable estimates for this region). That would give a gross rental return of 11%.

Gross Rental Return of 11%

Seems too good to be true doesn’t it? And it gets better because, with a granny flat built on the same property as a primary residence, you don’t have to pay extra rates, so the ongoing costs are less than they are for a single dwelling. Also, for many people, they wouldn’t need to pay a property manager to manage the rental because it is right there in their back yard. This means the annual costs could just include insurance (approx $1000 p.a.) and some maintenance (estimated at $1000 p.a.). In that case the net ROI comes out at 10%.

Net ROI of 10%

So why is the ROI on a granny flat SO much better than for a house? It’s because the land is already paid for and because the ongoing costs are significantly lower. So, in places like the Southern Highlands where land prices and rents are high, a granny flat can offer a remarkably good ROI for an investment that is very secure. A new, well-built and insured granny flat in your own backyard is about as secure as an investment can get. And with a potential 10% ROI it’s no wonder that there is a boom in granny flat construction going on around the greater Sydney region.

Another Energy-positive, Low-maintenance Granny Flat Going Up

The photo at the beginning of this newsletter is of another new granny flat currently under construction near the Greeny Flat. This is one that I designed for a friend of mine. It has the same footprint as the Greeny Flat but slightly higher walls and ceilings in order to provide a large loft storage area. It has a similar passive solar design with large, north-facing windows and the correct eave overhand to shade the north-facing windows in summer while allowing the low winter sun to fully enter and warm the dwelling.

A new granny flat that I designed for a friend in the Southern Highlands currently under construction.

The new granny flat under construction. This view is from the North-west showing some of the Passive Solar Design features.

The roof and wall cladding is Colorbond steel in a ‘CustomOrb’ profile. In this case the client chose to use ‘Shale Grey’ for the roof and window frames (I’m a big believer in using light colours for roofs and windows because it helps to reduce heat gain in summer and thermal stresses in the building components) and ‘Woodland Grey’ for the walls. In the heat of Queensland you wouldn’t want to use a fairly dark wall colour but in the cool of the Highlands it should function well and I think it looks great.

This granny flat also includes a large verandah on the south side and a carport on the west. Apart from offering a sheltered place to park the car and to enter the granny flat under cover, the carport on the west side will also provide excellent shade for the west wall which could have been a big heat source in the summer with the high walls and dark cladding.

The carport on the west and the big verandah on the south will provide lots of summer shade and shelter from the rain.

The carport on the west and the big verandah on the south will provide lots of summer shade and shelter from the rain. This view is from the South-west.

 Add to that good insulation, air-sealing, thermal mass, double-glazing and a solar power system and I am very confident that this granny flat will be well-and-truly energy positive like the Greeny Flat. It’s also designed and built to be fire resistant as there is a BAL29 rating for part of this property. All told I this is shaping up to be a very successful owner-built project and a good example of how building a granny flat can be a sound financial decision. I’ll report back after it’s finished.

Thanks for reading.

2 comments to April 12, 2019: The Economics of Granny Flats

  • trevor

    Reading this article I realise you do have not sought financial advice. Your example of the house in Russel Island does not take into account a depreciation schedule which depreciates the building costs each year on your tax and also all the interest on the home loan can be offset against your income. These things along with all costs associated with the property whould make the property negatively geared (proabably around $20000) and result in a very large tax refund.This would make the overall property returns much higher than you quoted. This would also apply to the granny flat if it was rented. With the right financial advice rental properties can be a great investment and completley cost neutral to the owner with the use of gearing.

    • admin

      Thanks Trevor for your comments. You’re correct that depreciation and mortgage interest payments can improve the financial returns for some people in some situations. However you’re not correct when you say I have not sought financial advice.

      On the issue of depreciation, yes it can increase the amount of deductions you can claim against the income from a rental property however (please correct me if I’m wrong here) it also reduces the Cost Basis by the amount depreciated meaning that, if and when you sell the property, you will be liable for more Capital Gains Tax. So it can be a short-term tax benefit but a long-term tax detriment. We are investing in property for the long-term not the short-term.

      Regarding mortgage interest… we did not borrow money to build our house on Russell Island. Yes you’re correct that, for people with a tax burden, negative gearing can provide healthy tax benefits. But we do not have a tax burden and are not interested in losing money or in giving our hard-earned money to a bank.

      So your points might not apply to everyone’s situation but yes, for most people, depreciation, mortgage interest and negative gearing can dramatically improve the financial returns on investment properties. Then again… negative gearing is subject to political whim. We could find ourselves in deep trouble if we set up an investment property to negatively gear and then Bill Shorten got in an did away with negative gearing.

      I’m very interested to hear your thoughts on the above. Cheers, Andy

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