Note: In this post, I am focusing solely on rental properties—not REITs or crowdfunding platforms.
The Pros of Real Estate Investing
Recently, I’ve been coming across parents that swear by only investing in real estate to pay for their children’s college education. Typically, they believe only in real estate because it’s a brick and mortar asset that is not tied to the stock market.
These parents are not wrong to embrace real estate investment as a college-funding vehicle. There are many benefits involved in real estate investment. Here are several:
- Tax deductions
- Direct control over your investment
- Lower volatility than the stock market
- Equity building
Furthermore, with regard to college funding, if parents have good credit, they may even qualify for a cash-out refinance or a HELOC where interest rates may be less than traditional student loans.
Real estate investment can offer some much-needed breathing room when it comes to college funding, but it’s not for everyone. I would not suggest attempting to use ONLY real estate investment to pay for your children’s college.
Things You Need to Be Aware Of
Excited by the many benefits of real estate, many people ignore the amount of time and money that they will spend to oversee a property. Essentially, prospective real estate investors tend to focus on the ‘passive’ income and not on the active maintenance.
First off, if you are personally renting out a property, you will be dealing with tenants—tenants that are not always going to be the respectable, low-maintenance renters that you envisioned. They may cause a serious amount of damage, both physical….and psychological.
Second, repairs and maintenance are going to add up to the point where you may wonder why you did this in the first place. Either you are handy and will spend valuable time doing these repairs yourself, or you will pay a sizeable fee to a property management company to handle it for you.
Third and finally, real estate is not a liquid asset. if you need to sell your property, you may be cash-strapped for however long it takes to sell, and there are no guarantees you are going to sell it at the right time for the amount you need to cover your kids’ college expenses.
I’m not saying all these things to steer you away from owning property. On the contrary, I think it can be a great strategy; average-20 year returns in real estate have performed a little better than the S&P 500. But, you need to be aware of what you are getting into, especially if you are planning to use it to pay for your kids’ college education.
What bothers me most is that many people are determined to follow this strategy because it’s the only strategy they may know or be familiar with. Many families we come across say, “that’s how my dad/uncle/family member built his wealth so that’s what I’m going to do.”
A Cautionary Tale
I would like to share the story of a parent that had this same thought process in the late ’90s. Let’s call her Sarah.
Sarah’s father often repeated to her, “invest in real estate today, and when your kids go to college, you can use the property to pay for college; it should quadruple in value by then.” She listened to her dad and put $40,000 on a $200,000 investment property in 2001. Based on her dad’s projections, it would be worth $800,000 by the time her youngest graduated high school in 2019.
From 2001 to 2018 Sarah had good tenants that paid their rent on time. The rent covered the mortgage, property taxes, and provided some extra income at the end of the month. Mortgage interest rates in 2001 were hovering around 7%, so it was only feasible for her to refinance a few times since 2001.
Unfortunately, Sarah didn’t fully comprehend the weight of all the repairs she would need to take care of. New roof? New stove? Fix the hot water heater? More windows to repair? You catch my drift—all the costs to maintain and repair a two-family rental property are typically not considered when purchasing a new home.
Then, the anvil came down: the mortgage crisis occurred in 2008, and property values took a hit. The national average for a $200,000 home purchased in January 2001 was $377,800 in January 2018—a 3.54% annual rate of return, and way off from the $800,000 Sarah’s dad had predicted.
So now it’s 2019 and Sarah’s house is worth about $370K. What should she do? Sell the property and pay capital gains taxes and closing costs? Since Sarah refinanced a few times, she’s still carrying a mortgage of $150,000. She will be lucky to clear $100,000. Should she take a HELOC? Do a cash-out refinance? These are all options, but Sarah was expecting $800K to pay for all three of her kids to go to college. Although she didn’t dig herself into a hole, she could have done a lot more to prepare to pay for her kids’ college education.
Balancing Real Estate with Other Investments for College Funding
A sound financial plan would’ve put Sarah and her family in a better position to pay for college. A few non-assessable assets would’ve been a good choice, and perhaps a 529 college savings plan above and beyond the real estate property. It also probably would’ve been a prudent idea to take the discretionary rental income and invest systematically into one of these accounts aforementioned.
It should also be noted that rental property value and rental income are assessable assets when applying for FAFSA. If your family is hoping to qualify for any need-based aid, real estate equity and rental income will be assessed. Consequently, strategies such as paying down non-deductible debt to free up cash flow or utilizing financial instruments like a Roth IRA, annuity, or even cash value life insurance, which are both non-assessable, should be considered.
In conclusion, real estate can be an incredible asset as part of a balanced portfolio, but it has some downsides— especially if you’re hoping to use it for college funding. What I’m trying to say is this: it’s not about finding the magic financial product, it’s about having the right combination of financial products with the best strategy for each parent for the right school