DSCR Loans for ADUs and Accessory Dwelling Units - Financing Guide

Accessory Dwelling Units (ADUs)—also known as granny flats, in-law suites, backyard cottages, or casitas—have exploded in popularity as housing affordability challenges intensify across the United States. These secondary dwelling units on single-family residential lots offer homeowners and investors additional rental income streams, but financing them through DSCR (Debt Service Coverage Ratio) loans presents unique challenges that differ from both traditional single-family rentals and multifamily properties.

Understanding ADU Types and Structures

ADUs come in several configurations, each with different implications for DSCR financing:

Detached ADUs

Separate structures on the same lot as the primary residence:

• Backyard cottages or "casitas"
• Converted garages (with separate entrance and living space)
• Purpose-built rental units
• Tiny homes on permanent foundations

Attached ADUs

Connected to the primary structure:

• Basement apartments
• Garage conversions with interior access
• Additions to existing homes
• Upper-floor apartments with separate entrances

Internal ADUs

Carved from existing space within the primary home:

• In-law suites
• Converted rooms with kitchenettes
• Junior ADUs (smaller units, often without full kitchens)

Detached vs. Attached: The DSCR Difference

The physical relationship between the ADU and primary residence significantly impacts financing:

Detached ADUs are easier to treat as separate rental units because:

• Clear physical separation
• Independent utilities (or easily separately metered)
• Distinct addresses (in some jurisdictions)
• Can be marketed and rented independently

Attached/Internal ADUs face more scrutiny because:

• Shared walls and systems complicate separation
• Harder to verify as truly independent dwelling
• May be seen as bedrooms rather than separate units
• Tenant screening becomes more critical (shared property access)

The Fundamental DSCR Loan Challenge with ADUs

Standard DSCR loans are designed for properties classified as single-family (1 unit) or 2-4 unit residential. A property with an ADU creates classification ambiguity:

Appraisal classification question:

• Is it a single-family home with an ADU?
• Or a two-unit property (duplex)?

This distinction matters enormously because:

If classified as single-family with ADU:

• Some lenders won't count ADU rental income at all
• Others will count ADU income but apply significant discounts
• Property may not qualify for standard residential DSCR loans
• Financing becomes more restrictive

If classified as two-unit property:

• Both units' rental income counts toward DSCR
• Standard multifamily DSCR loan products apply
• Easier underwriting and more lender options
• Better loan terms in most cases

The classification depends on local zoning, lot configuration, and how the appraiser interprets the property.

How Lenders Approach ADU Income

DSCR lender policies on ADU rental income vary dramatically:

Lenders Who Won't Count ADU Income

Conservative lenders may:

• Only recognize income from the primary dwelling
• Ignore ADU rental income entirely in DSCR calculations
• Treat the ADU as incidental space like a finished basement
• Require the property to qualify based solely on main house rental potential

Why they take this position:

• ADU regulations vary wildly by jurisdiction
• Concerns about legal conformity and permitting
• Uncertainty about sustained rental demand
• Difficulty verifying ADU income separately from primary residence

Lenders Who Count ADU Income with Restrictions

Many DSCR lenders will recognize ADU income if:

• The ADU is legally permitted and inspected
• It has separate utilities (or separately metered)
• A certificate of occupancy exists for the ADU
• Zoning explicitly allows ADU rentals
• The ADU meets minimum size requirements (typically 400+ sq ft)
• There's demonstrated rental history (6-12 months preferred)

These lenders may apply income discounts:

• 25% reduction in ADU income for DSCR calculations
• Higher overall DSCR requirements (1.25 vs. 1.0 minimum)
• Larger down payment requirements (30% vs. 25%)

Lenders Who Treat Properties as Two-Unit

Specialized lenders experienced with ADU markets will:

• Classify the property as a duplex/two-unit residential
• Count both units' rental income fully
• Use standard multifamily DSCR underwriting
• Apply normal vacancy factors (5-10%)
• Offer terms similar to other 2-unit properties

Finding these lenders requires research and often working with mortgage brokers familiar with ADU-friendly lenders.

DSCR Calculation Example: Single-Family Home with ADU

Let's examine how ADU income impacts DSCR:

Property details:

• Purchase price: $650,000
• 3-bedroom main house + 1-bedroom detached ADU
• Down payment: 25% ($162,500)
• Loan amount: $487,500
• Interest rate: 7.25%
• Monthly payment (PI): $3,327
• Property taxes: $540/month
• Insurance: $180/month
• Total monthly debt service: $4,047

Scenario 1: Lender ignores ADU income

• Main house market rent: $2,800/month
• ADU income: Not counted
• DSCR = $2,800 / $4,047 = 0.69 (FAILS)

Scenario 2: Lender counts ADU income with 25% discount

• Main house rent: $2,800
• ADU rent: $1,400
• Discount on ADU: $1,400 × 0.75 = $1,050
• Total countable income: $2,800 + $1,050 = $3,850
• DSCR = $3,850 / $4,047 = 0.95 (FAILS at 1.0 minimum)

Scenario 3: Lender treats as two-unit property

• Main house rent: $2,800
• ADU rent: $1,400
• Total monthly income: $4,200
• DSCR = $4,200 / $4,047 = 1.04 (PASSES)

This example demonstrates why finding ADU-friendly lenders is essential—the same property fails with two lenders but qualifies with a third.

Legal Permitting: The Non-Negotiable Requirement

Regardless of lender policy, almost all DSCR lenders require:

Proper permits and approvals:

• Building permits for ADU construction
• Final inspection and certificate of occupancy
• Compliance with local ADU ordinances
• Proper zoning classification

Why lenders demand this:

• Unpermitted ADUs create legal liability
• Municipalities can force removal of unpermitted structures
• Insurance may not cover unpermitted dwelling units
• Property value could be impaired if ADU must be removed

What happens if your ADU is unpermitted:

Most lenders will either:

1. Decline the loan entirely
2. Require you to bring the ADU into compliance before closing
3. Ignore the ADU's existence (and income) completely
4. Require removal of the unpermitted structure

Don't assume you can hide an unpermitted ADU—appraisers document all structures, and title companies often flag unpermitted improvements.

Financing ADU Construction vs. Purchasing Property with Existing ADU

The financing path differs significantly:

Purchasing Property with Existing ADU

Advantages:

• ADU is complete and permitted
• May have rental history to demonstrate income
• Appraisal can verify condition and value
• Faster path to DSCR financing

Process:

1. Verify ADU is properly permitted during due diligence
2. Obtain rental history if property has been investment property
3. Get appraisal classifying property (1-unit or 2-unit)
4. Apply for DSCR loan with ADU-experienced lender
5. Close on property with both units counted in DSCR

This is the straightforward scenario where DSCR loans work best.

Building ADU on Property You'll Purchase

Challenges:

• No rental history for ADU that doesn't exist yet
• Construction financing required before DSCR refinance
• Higher complexity and risk
• Longer timeline to stabilization

Typical approach:

1. Purchase property with traditional mortgage or DSCR loan based on main house only
2. Obtain construction loan or HELOC for ADU construction
3. Build ADU with proper permits and inspections
4. Rent both main house and ADU for 6-12 months
5. Refinance into DSCR loan counting both units' rental income

This two-stage process requires significant capital and patience but can create substantial value.

Building ADU on Property You Already Own

If you own your primary residence and want to build an ADU for rental income, converting to a DSCR loan is complex:

The challenge:

• Most DSCR loans require the property to be non-owner-occupied
• You can't get DSCR financing while living in the primary residence
• Construction loans for ADUs require personal income qualification

Possible path:

1. Finance ADU construction through HELOC or personal loan
2. Move out of primary residence (rent elsewhere or buy new primary)
3. Rent both primary residence and ADU
4. After 6-12 months of rental history, apply for DSCR refinance
5. Use DSCR loan to pay off construction debt and remove personal income obligation

This scenario is complex and often not economically viable unless you were planning to move anyway.

Geographic Considerations: ADU-Friendly Markets

ADU financing availability and regulations vary dramatically by location:

ADU-Friendly Markets (Easier Financing)

California:

• Statewide ADU laws streamline permitting
• High rental demand supports ADU income
• Many lenders experienced with ADU financing
• Strong rent levels justify ADU construction costs

Oregon (Portland):

• Progressive ADU regulations
• Established ADU rental market
• Lender familiarity with ADU properties

Washington (Seattle):

• Growing ADU acceptance
• High rents support ADU economics
• Increasing lender comfort

Colorado (Denver, Boulder):

• ADU-friendly zoning in many areas
• Strong rental markets
• Growing lender acceptance

Challenging Markets

Markets where ADUs face obstacles:

• Areas with restrictive zoning preventing ADU construction
• Suburbs with large minimum lot sizes
• HOA-controlled communities (often prohibit ADUs)
• Markets with very low rental rates (ADU income doesn't justify costs)
• Jurisdictions with complex or expensive permitting processes

Before investing in ADU properties, research local regulations, permit costs, and timeline. Some jurisdictions approve ADUs in 2-3 months with minimal fees; others take 12-18 months and cost $50,000+ in fees and requirements.

Separate Utilities and Metering

Lenders strongly prefer (and some require) separately metered utilities:

Benefits of separate meters:

• Clear distinction between two dwelling units
• Easier to charge tenants for actual utility usage
• Supports classification as two-unit property
• Simpler accounting and management

Typical utility considerations:

Electricity: Usually easy to separately meter, even for attached ADUs. Cost: $1,000-$3,000.

Water/Sewer: More complex and expensive to separately meter. Some jurisdictions don't allow it. May need to include utilities in rent if shared meter.

Gas: Similar to water—possible but may not be cost-effective for small ADU.

Internet/Cable: Easy to separate—tenant gets their own service.

If separate metering isn't feasible, you can:

• Include utilities in ADU rent
• Charge flat monthly utility fee
• Use utility allocation methods (RUBS - Ratio Utility Billing System)

Lenders prefer separate meters but will accept included utilities if documented in the lease.

ADU Size and Livability Standards

Lenders typically require ADUs to meet minimum standards:

Minimum size: Most lenders want ADUs to be at least 400 square feet. Smaller units may be classified as "junior ADUs" and face more restrictive financing.

Required features:

• Full kitchen (refrigerator, stove/oven, sink)
• Full bathroom (toilet, sink, shower or tub)
• Separate entrance (not through main house)
• Adequate heating and cooling
• Egress windows (safety requirement)

Junior ADUs (smaller units, often 200-400 sq ft with efficiency kitchens) face additional challenges:

• Many lenders won't count them as separate units
• Rental income may be discounted more heavily
• May not qualify for multifamily classification

If targeting DSCR financing, focus on ADUs that meet full dwelling unit standards.

Strategies for ADU DSCR Success

1. Verify Permitting Before Purchase

During due diligence:

• Request all ADU building permits
• Verify certificate of occupancy
• Confirm zoning allows rental ADUs
• Check for outstanding code violations
• Verify compliance with local ADU ordinances

Don't rely on seller representations—independently verify all permits with local building department.

2. Target Markets with Established ADU Acceptance

Focus on:

• Cities with streamlined ADU permitting
• Markets where ADUs are common (lender comfort)
• Areas with high rental demand and rates
• Jurisdictions with clear ADU regulations

Avoid being an early adopter in markets without ADU infrastructure.

3. Work with ADU-Experienced Lenders

Ask potential lenders directly:

• Have you financed properties with ADUs?
• How do you classify ADU properties in your underwriting?
• Do you count ADU income in DSCR calculations?
• What documentation do you require for ADUs?
• What occupancy/rental history requirements apply?

Don't waste time with lenders who are unfamiliar with or hostile to ADUs.

4. Maintain Higher DSCR Ratios

Given ADU financing uncertainty, target DSCR ratios of 1.2+ rather than minimums:

• Provides buffer if lender discounts ADU income
• Accounts for potential vacancy in either unit
• Accommodates higher insurance or property tax costs
• Creates margin for unexpected expenses

5. Document Rental History Thoroughly

If purchasing a property with rental history:

• Obtain leases for both main house and ADU
• Collect 12 months of rent payment records
• Verify separate rental agreements
• Document any included utilities or services

Strong rental history documentation convinces skeptical lenders.

6. Consider Conventional Multifamily Financing

For properties with substantial ADUs that clearly qualify as two-unit properties, conventional multifamily loans might offer:

• Lower interest rates than DSCR loans
• Better terms for owner-occupants (if you plan to live in one unit)
• More lender options
• Established underwriting guidelines

Compare DSCR loans against conventional multifamily options before committing.

Insurance Considerations for ADU Properties

Properties with ADUs require specific insurance coverage:

Landlord policy for entire property: Standard homeowners insurance won't cover ADU rental activity. You need:

• Dwelling coverage for both structures
• Liability coverage for rental activity
• Loss of rental income coverage
• Separate structure coverage (for detached ADUs)

Higher premiums: Expect insurance costs 30-50% higher than single-family rental insurance due to:

• Multiple dwelling units
• More tenant liability exposure
• Additional structures
• Higher replacement cost

Budget $150-$250/month for properties with ADUs vs. $100-$150 for standard single-family rentals.

Property Management Complexity

ADU properties require consideration of unique management issues:

Tenant Dynamics

Managing two households on one property:

• Noise and privacy concerns
• Parking arrangements (who gets driveway, who gets street)
• Trash and recycling coordination
• Yard maintenance responsibilities
• Shared laundry facilities (if applicable)

Maintenance Coordination

• Scheduling repairs that affect both units
• Managing contractors accessing the property
• Landscaping and exterior maintenance
• Roof repairs affecting both structures

Screening Considerations

With attached or close-proximity ADUs:

• More critical to screen for compatible tenants
• Consider renting both units to related parties (friends, relatives)
• Set clear expectations about shared spaces
• Establish ground rules for noise and guests

Professional property management companies experienced with ADU properties can navigate these challenges more effectively than many self-managing landlords.

Tax Benefits of ADU Investments

ADU properties offer excellent tax advantages:

Depreciation:

• Primary structure: 27.5 years
• ADU structure: 27.5 years (separately calculated)
• Land improvements: 15 years
• Appliances and fixtures: 5-7 years

Construction cost recovery: If you built the ADU, all construction costs become depreciable basis:

• Materials and labor
• Permits and fees
• Design and engineering costs
• Utility connections

Cost segregation potential: ADU properties are excellent candidates for cost segregation studies because:

• Clear construction costs for secondary structure
• Separate systems and components
• Can accelerate depreciation on specific ADU elements

Section 179 and Bonus Depreciation: Certain ADU improvements and equipment may qualify for immediate expensing.

The "House Hacking" Angle

While DSCR loans require non-owner-occupied properties, the ADU model supports a future house-hacking strategy:

Purchase → DSCR → Refinance → Live In

1. Buy property with ADU using DSCR loan (both units rented)
2. Build equity and cash flow for 1-2 years
3. Decide you want to live in the area
4. Refinance to conventional owner-occupied loan
5. Move into main house, continue renting ADU
6. Reduce housing costs while maintaining investment property benefits

This strategy provides flexibility to convert an investment property into a primary residence while maintaining rental income.

The Reality: ADU Financing Requires Specialized Knowledge

Properties with ADUs sit in a gray area between single-family and multifamily real estate:

What works in your favor:

• Strong rental demand for small, affordable units
• Higher total rental income than single-family homes
• Growing lender acceptance of ADU properties
• Clear economic benefits in high-cost markets

What works against you:

• Inconsistent lender policies on ADU income
• Permitting and regulatory complexity
• Higher down payment and DSCR requirements
• Limited lender experience in some markets

Success requires finding the intersection of:

• Properly permitted, conforming ADU
• ADU-friendly lender
• Market with established ADU rental demand
• Property that generates strong DSCR ratio counting both units

Final Recommendations

ADU properties can work well with DSCR financing when you:

• Verify ADU is legally permitted with certificate of occupancy
• Target markets with established ADU regulations and rental demand
• Partner with lenders experienced in ADU financing who count ADU income
• Aim for DSCR ratios of 1.2+ to provide buffer against income discounts
• Focus on detached ADUs 400+ square feet with full kitchens and bathrooms
• Maintain 6-12 months of reserves for both units
• Consider markets like California, Oregon, Washington, and Colorado where ADU lending is more established
• Purchase properties with existing, rented ADUs rather than building new

ADUs offer compelling investment economics—higher total rents, efficient use of expensive urban land, and strong tenant demand. However, the financing landscape remains fragmented. Investors who do their homework on permitting, find experienced lenders, and target appropriate markets can build successful portfolios around ADU properties using DSCR financing. Just don't expect it to be as straightforward as financing a traditional single-family rental.