Accessory dwelling units can be an exciting option for property owners looking for more space. A separate, freestanding building could add usable square footage onsite, host family or friends, or generate income as a short-term rental.
While owners may focus on the advantages, you should know that an ADU can present risks for sellers and buyers.
Laura Prouse is Director of REAP/REALAX Data Analytics at CRES, Gallagher Affinity Insurance Services, Inc., a Texas REALTORS® risk management partner. Claims involving ADUs are becoming more common, she says.
“ADUs can provide great benefits, but they can also create additional risk exposures,” she says. “Instead of one structure in the transaction, there are two—which can mean more opportunity for disclosure or misrepresentation issues.”
Misrepresenting permits
Permits are the most common issue associated with ADUs, Prouse says. Perhaps the seller states the property’s ADU is permitted when it only has partial permits, incomplete final permits, or no permits at all.
Prouse recalls a claim in which the property owner was granted a permit to build a second structure, but didn’t have a permit allowing people to live there. “That led to a claim for misrepresentation for loss of rental income,” she says.
Then the buyer has to pay to get the ADU permitted while losing expected income and not using the property as intended.
Misrepresenting income
Sellers and agents risk misrepresentation accusations when they advertise an ADU’s income-generating possibilities.
A buyer may purchase a property thinking it has an income-generating ADU, only to discover permitting and/or habitability issues due to poor construction, Prouse explains.
Then the buyer has to pay to make the ADU habitable or compliant. Even if the ADU generates income, it might not be as much as originally advertised. Prouse is aware of claims in which the buyer alleges the ADU doesn’t earn as much as the seller said it would.
Problems with short-term rentals
Are short-term rentals even allowed where the property is located? Some cities have STR restrictions. “We’ve seen claims where there are pending changes to STR ordinances,” she says. The buyer soon learns that she isn’t allowed to rent out the ADU because of new rental restrictions.
Failure to disclose problems
Sellers can face disclosure complaints if they fail to document issues such as substandard construction, health and safety issues, code compliance, no separate entrance for the tenant, or insufficient utilities. “For example, can the septic system handle an ADU?” Prouse asks.
If the property is not in the condition the buyers expect, the buyers can claim that they overpaid for the property. The buyers may demand compensation for repairs, bringing the property up to code, lost income, and loss of use.
Staying safe with ADU transactions
“As with any transaction, it is always best to have a written trail. That way if there is any question about what was said and when, it is in writing,” Prouse advises. “Save text messages and email threads. Conversations should be followed up in writing to confirm what was said.”
If you are representing the homesellers, advise in writing that the sellers should fully disclose everything they know that can materially affect the value or desirability of the property, she says. “The seller should not understate issues or be vague. The seller should provide permit information and invoices so the buyer has an accurate understanding of what work was done and by whom.”
Were the contractors and subcontractors licensed? Does the seller know about any current or potential ordinances that could affect if the ADU can be rented? The more information the buyer has about the property, the more the buyer can research and investigate the property to a satisfactory level.
If you represent the homebuyer, tell your client in writing to do due diligence. Your buyer should hire qualified professionals to conduct inspections, check permits, deed restrictions, zoning, and investigate any ordinances that could affect the ability to rent out the ADU, she says. “If the seller is representing the ADU as an income-producing property, then the buyer should retain a qualified expert to examine the financials,” Prouse adds.
Your errors & omissions coverage typically covers disclosure and misrepresentation claims, but every scenario is different, she cautions. Talk with your E&O provider before an issue arises to learn more about your coverage.