The “No Brainer” Investment
So your child has grown and you’re getting ready for her/him to head off to college. Certainly a bittersweet time in your life as a proud parent. Your “baby” is starting to be an adult, moving out of the house and learning to make decisions in the “real world.” And you are gaining (regaining) some of your personal space. This is definitely an anxious time in your life. And then you think, “How am I going to pay for all of this?”
It is estimated that the average cost to a parent (not the total average cost) to send a child to college in Florida is roughly $20,000 per year. Many kids are working and earning money and I suspect that is why this average cost to the parents is not higher. So whether the parent is sending $20,000 ÷ 12 = $1,667 per month for tuition and rent, or for food and transportation, or for entertainment or whatever, the average parent is spending $1,667 per month to send their child to a Florida college. The worst part is (according to an accountant friend of mine), this expense is not even tax deductible!
So what is a parent to do? Is there any investment strategy that might help the average parent in this situation? I guess you might suspect that I have a real estate solution (since this is the Tallahassee Florida Real Estate Blog ).
First the disclaimer. I am not an accountant (nor do I play one on TV). I suggest that you forward this blog on Tallahassee real estate investment to your trusted CPA and get her/his opinion on whether or not I’m crazy. If deemed sane, then consider my professional opinion on the real estate and let the CPA give you the professional opinion on the taxation.
Going back to the scenario with the average parent spending $1,667 per month to send their child to a Florida college, let’s consider how to reduce that effective monthly cost….. Now hang in there with me, because I’m going to be throwing a few numbers around here….
Let’s say that the parent decides to buy a home for their child to occupy during the child’s five years in a Florida college (I know, it used to be four years….). Here is the scenario:
- Purchase a four bedroom home for $140,000.
- Pay the child to manage it ($100 per month)
- Lease out three of the four rooms (at $300 per room)
- Have the child maintain the house (in return for 10% of the profit in five years after the sale)
So the scenario is set, how do the numbers work out?
Initial investment of 15% down ($21,000).
Cash Flow Before Taxes
- Annual Rents Received: $10,800
- Management Fee to Child: -$1,200
- Mortgage Payment (PITI): -$11,873
- Cash Flow Before Taxes: -$2,272
OK, at this point you’re thinking, I invest $21,000 and then lose another $2,272 in the first year in order to save money? How can this be… [This is where we ask our accountant to help us out]
Now remember, we were not comparing this investment to investing in the stock market or another investment. Rather, we were comparing this investment with sending $20,000 per year to our child for the cost of attending a Florida college. So before we can continue with the analysis, we need to estimate our “after tax” cash flow and position with this investment. [Accountants, please roam around this blog and assist anyone who raises their hands]
Taxable Actions
- Gross Income: $10,800
- Taxes & Insurance: -$3,080
- Management Fee: -$1,200
- Interest Expense: -$7,398
- Depreciation: -$4,225
- Total Taxable Income: -5,103
- Tax Rate Example: 30%
- Total Tax Savings: $1,531
Cash Flow After Taxes
Cash Flow Before Taxes: -$2,272
Total Tax Savings: $1,531
Cash Flow After Taxes: -$741
OK, we’ve now determined (to be verified by your qualified CPA) that with this investment, the cash flow on this property should be about negative $741 per year (meaning every year the parent(s) are sending $741 out towards this investment). At the end of five years, the total cost of this investment should be the initial investment plus the five years’ worth of negative cash flows which would be roughly $21,000 + $741×5 = $24,705.
Now we must figure out the investor’s position after five years. Historically in the Tallahassee real estate market and most of the US, this property would appreciate about 4% per year. Since we are in a two-year slide, I will assume the next five years should average below 4%, so I will use 3% for appreciation. You should have your accountant run this example with multiple levels to consider all realistic scenarios.
Total Investment: -$24,705
Cash From Sale: $39,900
Child’s 10% Share: -$3,990
Net Return: $35,910
OK, so the investor invested $24,705 and five years later received $35,910. That is a return on investment (ROI) of 7.77% (will be a little less after capital gains tax and depreciation recapture). Not too bad. But the real question is, where are the parents of this child financially versus just sending them $1,667 per month over five years?
We have to look back at that $20,000 per year average cost of college. We have to assume this child needs the same $20,000 as the other “average” children, less whatever benefits the child is receiving through the above scenario. We know the child received free rent plus a management fee each year, so that can be subtracted from the $20,000.
- Average Annual Cost: -$20,000
- Free Rent: $3,600
- Management Fee: $1,200
- Net Cash Needed From Parents: -$15,200
Conclusion:
Plan A - No Real Estate
Total Parents Cost: -$100,000
Benefits: 1 college degree
Plan B - With Real Estate
Cost: -$76,000
Parents Profit: $35,910
Total Parents Cost: -$40,090
Benefits: 1 college degree
Child’s Profit: $3,990
Using a real estate investment to take advantage of taxation and sound investing strategies, parents can save a significant amount of money in the efforts to get their child through a Florida college. If you find that you are in this situation, or are rapidly approaching this point in your life, I strongly recommend that you speak with a qualified Realtor and a qualified CPA.
Florida Prepaid College Plan
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Joe Manausa is the Broker and Co-Owner of Century 21 First Realty. He can be reached by clicking on the comments button below, via e-mail through his company website at www.manausa.com, or by calling (850) 386-2001.
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May 2nd, 2008 at 10:11 am
Ok . . . I’m going to read this again carefully but it seems to make sense. I just invested in a house in Latrobe, PA near St. Vincent College . . . it would actually make sense there for a parent to purchase a home and rent it out . . . you’d easily get break even cash flow or positive cash flow.
May 2nd, 2008 at 11:13 am
This is just a spin-off of the traditional rent versus buy analysis. The reason why the buyer wins out in your numbers is because the buyer took on significantly more risk than the renter: real estate market risk, risk of major repairs, risk of not finding acceptable tenants. You assume a 3% annual return which may be reasonable over a long period of time, but is certainly not anywhere close to a guarantee over a short term such as five years.
Also, did you take into account closing costs on the sale of the home after 5 years? And where is the child to get the money to pay for maintenance expenses?
There’s no such thing as a “free lunch” or a “no brainer”.
To the extent that such a market inefficiency exists, it will be quickly resolved by people bidding up the price of homes near the college until the inefficiency is gone.
May 4th, 2008 at 11:34 am
Thanks Greg, you have some good questions, but I already factored them in.
1. 3% (you say annual return): This is not an annual return, it is the assumed annual appreciation rate. While nothing is guaranteed, we have seen greater than 4$ over the past 50 years. If we hit a bad spell (such as we have over the past two years) then you own it longer, renting it out, until the buying market stabilizes. It is not just parents that own rental property.
2. Closing costs. I assumed the cost of sale was 8% in my scenario, so short answer is yes.
3. Maintenance cost for the child is the same as he would pay renting under a net lease elsewhere. That is why I used the cost of rent $50 less than a gross rent lease elsewhere (simple answer, there is already a $50 per month ,per tenant budget for maintenance).
4. There is no such thing as a “no brainer.” Here, I agree with you. That is why picking the right property is so important. I purchased a 6 bedroom home when my youngest brother started at FSU (pre med). He lived there four years and I still own it. I purchased it for $90K and it is now worth $180K less than ten years later. I have tenants in it and now rather than paying my brother to manage it, I pay a property manager to manage it.
The reason that I call this a “No Brainer” is that the parents are going to be paying money anyway to send their kid to school, they might as well structure it in a manner that gives them benefits. And that Greg, is the no brainer.
May 5th, 2008 at 10:00 am
You assume $16,800 of annual rent (on a gross rent basis) on a $140,000 property. That’s a 12% rent-price ratio; I’ve seen studies which suggest that historically the rent-price ratio is about 40% of that, meaning that realistically, the rent should be less than $700 per month. More recently, the rent-price ratio is about 3.5% meaning the monthly rent would be about $400 per month.
May 5th, 2008 at 4:35 pm
Greg, I’m quoting real market rent. We manage over 1,000 rental units at our companies. I’d be curious about your sources “studies which suggest…” That is the problem with the internet, if it is posted, it must be so.
My numbers come from the Tallahassee Board of Realtors MLS plus information from Metro Market Trends, a company which you can pay for market information that has been recorded in the county(s) that you are tracking.
May 6th, 2008 at 8:22 am
Below is a link to a December 2007 paper by a trio of economists that concludes that: (i) rent-price ratios in the US have historically ranged between 5 and 5.5 percent, (ii) rent-price ratios by end of 2006 had dropped to 3.5 percent, a historic low, and (iii) for rent-price ratios to return to historic levels, home prices would have to fall considerably.
The bottom line is that if you really can net over $14,000 per year on a $140,000 property (i.e., a 10% annual return) that appreciates 3% or more annually without incurring risk, you should do it regardless of whether your kid is going to college because it’s a great investment. In fact, you should put all your cash in it (and also borrow as much as you can), considering the best risk-free returns you can get nowadays are less than 3%. I’m highly skeptical of the facts you present, however. And, of course, there’s real risk here that you are significantly downplaying.
http://morris.marginalq.com/DLM_ fullpaper.pdf
May 7th, 2008 at 2:41 pm
That’s an interesting spin on a college savings plan. Now I have heard of parents purchasing houses near the town where their child plans on attending school, I have just not heard of them using it to offset the overall cost of tuition. Anything to offset that cost is worth investigation.