When acquired in the context of a thoughtful strategy, real estate investments can be a great vehicle to help you achieve all your financial goals. A well-constructed real estate portfolio can provide passive income to fund and outlast your retirement. That same portfolio can help you grow your net worth to maximize your investments and allow you to leave a legacy for your loved ones. Also, it can help you reduce risk across all your investments by diversifying your holdings with assets that serve as inflation and interest rate risk hedges. Finally, real estate investments can provide an alternative way to fund college tuition for your kids or grandkids.
The first thing you’ll want to do before you dive into the strategy is to define the problem you are trying to solve. Some focusing questions you may want to ask yourself:
- How many years of college education are you funding? Are we talking about a 4-year bachelor’s eegree or do you want to also fund graduate studies?
- Are you looking to fund college education in a state university or a private college? The tuition cost can vary dramatically depending on which option.
- Do you want to fund 100 percent of the tuition cost or some other percentage? Some parents feel that their children will appreciate and make the most out of their degree when they have to cover a portion of the expenses themselves.
- Are you looking to fund just tuition and books or room and board as well? Again, some parents don’t want their children to need to work when attending college, while others feel that working while going to school can keep college “distractions” at bay.
Based on the answers to those questions, you can start to quantify both the total cost of college tuition you’re trying to fund and the timing of when each payment is due.
Before we go deep into the details of each strategy, let’s agree on a set of facts. Let’s say you’re in your late 30s and you’re trying to fund four years of tuition, books, room, and board at University of Texas (public, in-state college) for your two-year-old daughter using real estate investments. Using a free online tool like Vanguard College Cost Projector, we can estimate the future cost to be $198,800. One thing to keep in mind here is that the rate of inflation for college tuition is much higher than normal inflation. I used the 10-year historical rate of 5% for the purposes of this calculation.
Now, I want to show you two real estate investment strategies you can use to fund college tuition without exposing yourself further to stock market risk and fluctuations: The “Earmarked Asset” and the “Cash Flow as You Go” strategies.
The Earmarked Asset Strategy
In this strategy, you acquire a property that you earmark for the purpose of funding college tuition. This property is part of your real estate portfolio, but it doesn’t contribute to any other financial goals except funding college tuition. The next step is to use its positive cash flow and other savings from your disposable income to pay off the mortgage on the property by the time your daughter is ready to start college. Last but not least, you liquidate the property during the year your daughter starts attending college, and you fund all four years of college at that time.
Let’s walk through the numbers. Your daughter will attend college in 16 years at which point you will need $198,800 to cover four years of tuition, books, room, and board. If we’re going to purchase, pay off, and liquidate an asset to cover those costs, we need to make sure that you net $198,800 after-tax from the sale of the property. Let’s assume that you will owe 20% to capital gains and depreciation recapture taxes and 7% to sales and closing costs. In order to net $198,800 after-tax, the sales price of the property 16 years from now should be $252,500. If we assume a conservative average property appreciation rate of 2% (less than the rate of inflation), that would mean that we need to acquire a property today for about $184,000.
Now that you know our target purchase price, you can acquire the property with 25% down a 30-year mortgage for the rest at 5% fixed. (Note: You could get a 15-year mortgage here instead, but it would force you into a higher payment and would not provide enough flexibility in the event any detours that we will discuss later happen along the way.) So your initial investment into this “earmarked asset tuition plan” is about $48,000.
Next, in order to get this property free and clear in 16 years, you will need to make $407 in extra principal-only payments in addition to your regular mortgage of $987. Let’s assume that the property conservatively produces $170 per month in positive cash flow. That means you would need to contribute $237 per month from your income savings to get this property free and clear by the time your daughter is ready to attend college. So essentially, a latte and a half a day to fund four years of college for your child—not a bad bargain!
Now let’s look at the 10,000 ft view. When you acquired the property, you invested $48,000 into the deal, and then you contributed $237 per month for 16 years for another $45,500. So, without going into complicated time-value-of-money calculations, you invested $93,504 and managed to fund $198,000 worth of tuition cost in 16 years without exposing yourself to the bipolar whims and sequence of return risk of the stock market. Also, let’s not forget that our assumptions on property appreciation rates were very conservative. If the property you acquired was located in Houston, where the historical appreciation rate is 3.23%, the value of your property 16 years later would be closer to $300,000, which means you could fund a tuition and a half!
The Cash Flow as You Go Strategy
If you don’t want to earmark a property for the purposes of funding college education and you plan on building a substantial real estate portfolio, you could use the alternative Cash Flow as You Go strategy. With the Earmarked Asset Strategy, you fund college tuition from your balance sheet. With this strategy, you look at tuition cost as an annual expense in the year it’s due, and you fund it from your income statement.
For instance, the cost of tuition for Year 1 is $46,124, Year 2 is $48,430, Year 3 is $50,851, and Year 4 is $53,394. So, instead of purchasing an asset that when liquidated will produce enough proceeds to cover the entire cost of tuition, we would build a portfolio that would produce the required income to cover the tuition expense in each of the four college years. The principal difference is that after you fund college, you still own the assets and can use them to fund other important financial goals.
Related: Parents: Stop Contributing to 529 Plans for College. Use This Superior Method Instead.
The average cost per year of $49,500 is the starting point to determine the value and makeup of your portfolio. We need to build a portfolio that in 16 years’ time could produce $49,500 in income to cover the college tuition expense. Assuming a free and clear yield of 6% and a conservative property appreciation rate of 2%, we would need to first acquire a portfolio worth $600k now and get it free and clear in 16 years so that on the first year of college is worth approximately $825,000. Again, assuming a 25% down payment on those purchases, we’re looking at around $150k in capital required to build this portfolio and deploy this strategy.
Obviously, in this scenario, we’re not just solving college tuition but the whole financial picture puzzle. If we can build a real estate portfolio that can fund $50k a year for tuition for four years, we are also creating $50k in passive real estate income toward your retirement income goals.
Thoughtful real estate investments can be an excellent vehicle to fund college tuition for your children without the sequence of returns risk and volatility of the stock market. First, you quantify the tuition funding goal and get very specific about what it will take to accomplish it. Once you’ve done that, you can earmark a specific property to fund tuition, pay it off in the time available until college starts, and liquidate it that year. Or you can look at tuition as an annual expense and build a portfolio that will create sufficient income to cover it as it arises.
Will you be using either of these strategies to fund your kids’ schooling?