If there’s one part of a home that owners and investors often overlook, it’s the backyard. This can be an ideal location for a secondary living space, which allows you to generate income and improve resale value without buying extra land.

Commonly referred to as accessory dwelling units, these additional living spaces are gaining in popularity as housing demand continues to rise. Here’s how to make the most of these rentals.

What Is an Accessory Dwelling Unit?

An accessory dwelling unit (ADU) is a smaller housing option built on the same lot as a single-family home. You may hear many different names describing them, such as granny flats, backyard cottages, secondary suites, and accessory apartments. They typically have their own entrance, living space, sleeping area, bathroom, and kitchen.

Although ADUs are often associated with the backyard, they don’t always have to be located there. The different types of ADUs include:

• Detached ADUs: A totally separate, stand-alone structure, such as a detached backyard unit
• Internal ADUs: Part of an existing home, like a basement or garage, that you convert into a separate living space
• Attached ADUs: A new addition to the main home, such as a side extension with its own entrance

There are at least 1.6 million ADUs in the U.S. right now. Their popularity is likely driven by the benefits they give to homeowners. They can house a family member for multigenerational living, offer an extra space, serve as a guest suite, or provide a source of passive income. For many homeowners facing higher taxes and mortgage rates, having these secondary spaces they can rent out is a big financial help.

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How Can You Generate Passive Income With an ADU?

You can use ADUs for a wide range of things. If you’re a remote worker, you can use it as a separate home office. Alternatively, a family member can move in. It’s an excellent way for older parents who want to live close to their children while still maintaining their independence.

ADUs also provide a way for people to generate passive income by renting them out. Similar to other property investments, the financial potential depends on your location, the unit's design, and the type of rental you choose.

Long-term rentals provide stable occupancy and predictable monthly payments. Due to the shortage of property for sale, there’s a rising demand for small one-bedroom or studio-style homes. Therefore, ADUs are appealing to students, young professionals, and downsizers.

Short-term rentals can offer higher monthly income, especially if your property is located in areas with tourism or seasonal demand. The challenge is extra management. You may need cleaning support, guest communication, and a way to handle bookings. It’s also important to double-check local rules in this case, since some cities limit this option.

The type of ADU you’re planning to build can influence your income as well. Detached ADUs, such as a cottage in the back of your house, tend to offer the most value since they offer more privacy.

Thanks to the rental income it offers, a legally permitted ADU can also increase your property’s value. Even if you plan to sell later, the presence of a rental-ready unit attracts buyers who look for steady returns from day one.

How Should You Plan Your ADU Project?

The difference between a unit that performs well for years and one that struggles to stay occupied is good planning. Here’s how you can plan your ADU project.

Know the Rules and Regulations

Begin by familiarizing yourself with the rules and regulations. Many states in the U.S. support ADUs because, unlike apartment blocks, they add housing options to a neighborhood without changing its characteristics. Some states, like Vermont and California, have passed laws allowing their cities and towns to be more lenient with these additional units. While you generally don’t need to get special permission, you may still need to follow local regulations. Some common ones are:

• As the property owner, you may have to live in either the main house or the secondary space.
• There may be requirements for the unit’s size, height, and design to make sure it fits in with the rest of the neighborhood.
• There should be a dedicated parking space for the ADU.
• There might be rules about how big your lot needs to be, how many bedrooms the secondary space can have, and how many people live in it.
• There’s a limit to how many ADUs you can have on one lot. Some states, like Washington, allow you to build up to two ADUs per residential lot.

Regulations vary widely by municipality and state. Some are stricter than others, but the effort is typically worthwhile, as a well-planned unit offers a dependable way to grow both income and property value.

Build Your ADU Carefully

Once you know the rules, it’s time to build your ADU. For many renters, these units are notorious for being unlivable because they’re not built or renovated well. A good unit should offer privacy and be easy to live in. Ensure you research the rental preferences that tenants value. In general, it may include the following:

• A functional kitchen with good storage
• A comfortable bathroom
• Sound insulation
• Natural light

If you already have a structure, such as a garage, a renovation can be a faster and more affordable option. Converting a space you already have can be just as good as a new build if you plan it well. One of the most important things to consider is the layout. It should be functional and livable, so leave enough space for a kitchen, a sleeping area, and a bathroom.

The design is just as important. Painting both the exterior and interior of your ADU can improve its marketability and result in 107% ROI, which means it’s a simple refresh that pays for itself. A good rule of thumb is to opt for a neutral palette that's both timeless and modern. If you want to play with optics to change how you perceive the interior dimensions of the granny flat, check out our guide on using wall paint to change the size of the room.

Tenants also prefer flooring that feels clean and modern. Therefore, select materials that offer durability and style, such as vinyl plank and laminate wood.

It’s also a good idea to improve long-term insulation and add energy-saving features, as lower utility costs can make the space more attractive to renters.

How Can You Finance the Project?

Renovating or building an ADU is not cheap. The cost can depend on the type of unit, the size and the amenities you want to include. The good news is that there are various options available.

Some of the most common financing options include:

• Home equity lines of credit (HELOCs)
• Cash-out refinancing
• Savings
• Second mortgage
• Renovation loans or construction loans
• ADU-specific programs

In addition to these options, you can explore local grants or seek fee reductions. Several states have statewide grant programs, such as California, Vermont and New York. In Vermont, grants of up to $50,000 per unit are available, while New York offers up to $125,000 for qualified homeowners. Other cities in the U.S. with ADU incentive programs include Portland, Boston, Santa Cruz, Austin, Montpelier, among others.

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Tips for a Successful ADU

Follow these steps to ensure you build an ADU that meets your needs and all local requirements.

Estimate the Budget

When building your budget, remember to include permits, utility upgrades, site preparation, landscaping, and furnishings for rental use. Property insurance is essential, too. Notify your insurer before you build one. In some cases, your ADU may be covered under your existing policy, or you will need to add a new one.

Set the Right Price

It’s essential to set a competitive price to attract potential tenants. Pricing your ADU requires research and understanding of the local market. Find out the average rental price for similar properties in your area, and consider factors like size and amenities.

Use Quality Materials and Keep It Simple

Always use quality materials to reduce your long-term maintenance costs. Durable flooring, moisture-resistant surfaces, and strong insulation handle daily wear and tear far better than cheaper alternatives. Additionally, keep your ADU simple. Most tenants prefer a well-functioning space over a highly stylized one that’s difficult to maintain.

Add Value for Tenants

You can offer benefits that make your ADU more appealing to potential tenants. A fully furnished unit often attracts more interest, and providing a pet-friendly policy can do the same. Both features can justify a higher rent because they add clear value.

Build Your ADU and Generate Income

A well-built ADU is a fantastic investment option. With careful planning and financing, it can help you generate passive income, increase the value of your property, and provide a flexible space that supports your changing needs.

Peter Chambers is an associate editor at Renovated, where he offers practical advice to new homebuyers to help them make the most of their investment. His expertise helps them navigate market complexities and build long-term wealth.