Paying for Kids College the Easy Way (The Magic of Rental Properties)
While not the normal passive investments we usually talk about, Kriss and I have purchased several rental properties over the years. In fact, I picked up my first rental when I was in high school.
Yes, rentals can be more work than our passive investments. And, let’s be clear rentals are not always the “passive” investments some people claim, nor do they have to be active investments either. You get to choose! (Even when they are ‘active investments’, they aren’t that much work. And, they can become passive if you simply hire a property manager (more on this below.))
I hear some people, who take the active approach, complain about their rentals and how much work they are. Once you dig deeper, though, you find out that after cashing tenants checks for 10 months straight (paying off the ‘complainer’s’ property), the poor person I’m listening to had to hire a furnace repair guy to get the heat back on for the tenant. Poor guy. Had to make 3 phone calls and use up some of the profit that he was setting aside for repairs anyways. Now, there are rental horror stories, don’t get me wrong and don’t get me started. (Hard not to digress into stories I’ve been told.) But, if you break it down, rentals are a fantastic way to build up wealth with minimal effort. They’re also a great way to pay for kids college.
The Break Through
For me, the break through of the value of rentals occurred in 2012. An investor buddy of mine, Ed, was buying as many rentals as he could find and afford. But, instead of putting these rentals on 30-year mortgages, he was putting them on 15-year mortgages. That’s counter to what many of the “rental gurus” teach. The gurus say, “It’s all about cash flow.” Sorry, for me, making an extra $300-$500/month just isn’t that exciting (though I realize it is for some investors). But, when my buddy Ed explained his method, something clicked.
We all know how fast time flies. As my wife and I were discussing paying for kids college for our two boys (at the time, Kindergarten and 2nd grade), the numbers were pretty big (and for the cost and true value of college is yet another discussion). But, with Ed’s plan, there was an easy solution. Buy a rental for each kid, put the properties on 15-yr mortgages, and by the time the boys are ready for college (10 and 12 years), the two houses will be nearly paid off. And, if I put in a little extra along the way, they very likely would be paid off. I could either sell the property to pay for their school (and this still works even paying brokers and taxes), or if the mortgage is paid off, take the expected $3k/month/property to apply to their school expenses. Now, that is exciting.
So, that’s what we did. We bought two rentals, one for each boy. We’re a few years into the loans and the renters are paying for my boys’ educations.
So, to make this a little more real. Here’s how the numbers look:
- Using an online “college cost calculator,” I averaged the age of my boys (they’re two years apart in age), and the rough cost to put each boy through a 4 year college will be $151,101 when they graduate from high school. Obviously, there are many variables such as an in-state “state” school or a prestigious school. We’ll call it $150k each, or $300 grand that I need. This sounds about right to me.
- My two mortgages started out at an average of $110k, and I put an average of $30k into each property as a down payment and for fixing them up.
- I make about $300/month in profit per property (though I’ll be raising rents soon which are skyrocketing in Denver, and that number will soon become an astonishing ~$900/month). I don’t think much about this money. I leave it in the accounts to pay for repairs and every 5 years or so will use a good portion of it to pay down my mortgages faster. (Of course, Uncle Sam will have his grubby little hands all over part of that as well.) Let’s just set this money aside to reinvest back into the properties. I probably will only need to use half of it, but what the heck. Let’s be conservative here to make the point.
- On top of that, my renters are paying down another $500 of my mortgage per property per month.
- Now, the cool thing is that right now after just a few years with these houses, I could sell them and pull out $240k in gross profit and, in addition, get my original $60k back. I’d have to pay long-term capital gains on that profit as I’ve held the homes for over a year (15-20% depending on which tax bracket, I’d be in,) and I’d have buying brokers fees (2.8% of sales price). (I have a way to list the properties on the MLS for cheap to save the listing broker fee..or at least to get it to the $500-$750/house range instead of $8k/house (3.2%x$250k)!) So, after these expenses/taxes, I’d be left with ~$181,000 profit (plus my $60k back) – not bad for a little hassle a few years ago and a few hours of time every year. I should, through other passive investments, be able to turn that raw cash/profit/equity into $300k in 8 years, but it’s actually much easier just to keep the rentals and let the renters pay down the mortgages and let things keep appreciating (though as we all know, property values can go down too…)
- Mix this all together, and in 8 years when my oldest heads off, I should be able to sell the first of the properties for $300k (right now, their averaged value is $260k.) The mortgage will be paid down an additional $48,000. That anticipated increase in equity, coupled with the lower mortgage amount is an additional $88,000 in profit, on one of the houses. The other house will have 2 more years of appreciation (hopefully), and at least another $12k paid down. So, there should be at least another $100k in that house. When I factor in brokers fees and taxes, that nets an additional $146k on both houses, meaning I should have $372k in cash after taxes (this does include $60k of our own funds, though, so $312k in profit) from these two deals to pay for the anticipated $300k expense.
- Note that I’m factoring all of this pretty conservatively. I’m not factoring in the fact that each month more and more of each payment goes to principle pay down, so my loans should be paid off faster than in this example. I’m also not using any of the monthly profit in these numbers either. Hopefully, I don’t have to use all of that money for repairs and improvements. But, should I need it, it’s there. I am taking a stab at what the appreciation will be. Just at 3% appreciation over 5 years, I’d get where I need to be. I have 8 years, so I should be safe on this front too.
…and Voila. Two rentals. Two boys college paid for. Lots of work along the way, but the work is much easier than managing the stress of how I was going to pay for college in other ways.
Buying Rental Property: Why It’s Such a Great Idea
Buying rental property is one the best long term investment strategy that I see in the marketplace. What other asset class (compared to others such as stocks, commodities, bonds, other types of real estate like fix-and-flips) give you the following?
- Something YOU control: In one of my master-mind groups we were recently exploring various investment opportunities, and while we all had different view points, there was one common element we all agreed on – invest in something you control. If you invest in stocks, you may luck out and hit it big; you may lose it all. You’ll probably muddle along, but you cannot really control your investment. Same with wheat futures, oil contracts, and low-yield municipal bonds. With a rental property, however, you can accurately assess the value. You can go see it whenever you want. You can improve the property if you’d like. You write the lease and can hold out for a great lease, or take the first person that comes by…and most importantly, if you buy right, you can sell it for a profit if you ever need to get out.
- Tax advantages: There are too many tax benefits of rental properties to list, but if you plan to hold for the long-term and use your IRA to purchase with leverage, you can hit it big (and transfer the property to your heirs tax-free, if structured correctly.) You’ve got depreciation, you’ve got 1031 exchanges, the list goes on.
- “Passive” income: I was with a group of fellow real estate investors and someone said, “And rentals are great because they are passive income!” Those of us with rentals rolled our eyes and said, “Look, buddy, it’s not completely passive. You have to lease it, fix plugged toilets, and deal with tenant phone calls…or property manager phone calls at the least.” While we were making the point that rental properties are not completely “passive” where the checks just roll in with no work, they are not usually “active” investments either. Many people fear owning rental properties for fear that they’ll have to do what I just mentioned – fix a plugged toilet in the middle of the night. It’s not fun. I’ve done similar things (fixed a frozen pipe that was shooting water 20’ in the air outside of a house at midnight in the dead of winter), but, if you stop and think about it, it’s worth it…usually. So, you had to fix a plugged toilet. How does that compare to the five previous months of collecting a rent check and making $400/month. Does the $1600 you made since the last repair offset the 2 hours and $200 you spent solving that issue? I think so. And, if you want to be completely passive, hire a good property manager and you make $300/month instead of $400/month and don’t have to deal with any issues, isn’t that worth it? Unless, you’re starting the next Facebook, I don’t see many better uses of time and dollars.
- Someone else is paying off your investment for you: Where else do you buy something that someone else pays off for you? If you place a mortgage on the property, every month your tenants – not you – are paying off the property. Given time, it will be yours free and clear. I know some investors (like myself described above) that put 15-year mortgages on their properties. They make less each month than they would with a 30 year mortgage, and they may just break even. But, in 15 years, they will have a property free and clear. Some use this strategy to pay for their kids’ college. One house per kid. When the kid graduates from high school the house will be paid for. Sell it off, and even paying taxes on it, should pay for college – in this scenario 15 years of tenants paid for your kids college.
The ways you benefit from rental properties are nearly endless. Of course, however, you must buy and manage the property correctly.
How to Buy Rental Property
Buying rental property should be done carefully and with at least some training. It is a big investment, and if not done with a little bit of know-how can be a rough go.
Find the property
Take a look at our other blog posts and products for more details on how to buy investment properties. But, as a primer there are a number of ways to find great deals on properties:
- Find a great investor-focused broker…or 2 or 3 of them.
- Find local “wholesaler” – the guys that have those signs on street corners that say “We Buy Houses” (they sell them too)
- Buy at foreclosure auctions.
- Buy at private auctions like Hudson and Marshall.
- Give offers to current landlords, especially those who have recently evicted tenants.
- Drive neighborhoods and look for properties that are in distress, look up who owns them on your county assessor website, and give them an offer.
- Attend local real estate investor meetings.
Analyze the property
I cannot stress enough how important it is to thoroughly analyze a property before buying it. Do not rely 100% on your broker. Rarely do I see a broker that gets everything right. They are incentivized to have you buy a property they find and may, consciously or not, push the limits on the value of the property, the rents, and may have an unrealistically low fix-up costs. Pay a buddy to double-check their work. Get other opinions…or even better, learn how to accurately assess values yourself.
Make sure that when you are comparing similar properties (comparables), that you are truly comparing like properties. You really have to work hard at this. Comparing a brick tri-level to a brick ranch with a basement doesn’t work, unless you make adjustments. Make sure your comps are the same finished square footage (+/- 150 sf), and the same unfinished sf (+/- 150 sf again.) Compare the years the properties are built, compare their locations (one on a busy street and one on a quiet street are not equal comps,) compare all of their amenities (garages, swimming pools, etc.)
Have a contractor bid out what it will cost to repair the property. Research comps and rents on the internet with sites such as www.finestexpert.com, www.zillow.com, www.craigslist.com and your county assessors’ website. Then drive the neighborhood and carefully make your decision.
Managing Rental Property
Once you buy a property, don’t over repair it. Fix it up to the minimal level of finish necessary to rent for the price you are hoping to obtain. Renters will not treat the property as nicely as if they owned it.
Hire a tried-and-true property manager, who usually charges 8-10% of each months rent, and sometimes will charge ½ a months rent to lease the property for you. If you manage it yourself, run credit checks and call references before placing a tenant. Then, treat them well so that they stay in the property for the long-term. Lots of tenant turnover can really reduce your profits.
There is a lot to learn to have a great rental property – or a portfolio of them – but with some basic research and some tenacity, you can put together what I believe is one of the best investment vehicles available in the market (and this can be an active or a passive investment.)
What are your experiences and thoughts on rental properties?