William M. Bennett
Smoke or fire? What is the effect of university tuition increases on student housing investment?
Student housing has become an increasingly accepted investment within the real estate sector, and investors are beginning to consider how many of the macroeconomic risks impact it. For example, on December 9, 2010, Britain’s parliament passed a bill to TRIPLE university tuition, which was quickly followed by students rioting in the streets, setting fires, and shaking up a royal evening. These events caused sophisticated investors to begin asking questions about U.S. student housing:
“Are U.S. universities at risk of having similar riots? If so, which ones?”
“What is the present and future of government’s role in funding higher education?”
“How does increasing tuition and fees impact student housing investment?”
The answer to the first question is yes — students rioted at the University of California-Berkeley campus in March 2010 over a 32% tuition increase.
Government’s role in funding education is a complex question. In a democracy, a minimum level of education is necessary for the creation of productive citizens. However, education’s benefit not only accrues to the individual, but to society as a whole, so the public financing of university education allows high achievers to become business, social, and political leaders that benefit all of us through their individual accomplishments. It is not possible to predict the benefit to society of an individual’s education ex-ante or quantify benefit ex-post, so there is a "neighborhood effect” giving reason for government to fund (through our collective desire as taxpayers) and regulate public education. There is a wide body of research that shows the rate of return on investment in education is significantly higher than the rate of return on financial assets. Stated simply: investing in college education in the U.S. produces a durable competitive advantage and high return for both individuals and society, but as a country, we are under investing in our most precious resource — our talented young citizens.
So, what is the impact of rising tuition rates on student housing investment? One has to look deeper at the problem to get to the underlying cause of tuition increases, and then to analyze its impact on student housing investment. To confront the problem directly, there is no doubt that the major cause of tuition hikes in excess of CPI is state fiscal mismanagement. According the Center on Budget and Policy Priorities, the states with the five largest budget shortfalls in 2010 spent, on average, 50% more than available in their general fund revenues, for a staggering total deficit of $77 billion. These states also recorded average tuition and fee increases exceeding 15.3% in the 2010-2011 academic year. While not the primary cause of tuition hikes, it is worth noting that the bloating of University administration acts like sludge in the education engine that is increasingly fueled by student tuition. These fiscally mismanaged states include what I refer to as the structurally broken states of California, Illinois, and New Jersey, and the housing melt-down states of Arizona, California, and Nevada. Yes, I listed California twice — it is hard to fathom the depths of its problems.
The 2010-2011 in-state tuition increase of 32% in the California public University system resulted in tuition and fees of $12,462 at flagship UC Berkeley, 64% higher than the national average of $7,605 for four-year public universities, which only grew at 7.9% in 2010. Not to be outdone, New Jersey came in at $12,363 for Rutgers, and University of Illinois-Urbana tipped the scales at $13,568. These are before including room, board, and books, which can easily tack on between $10,000-$20,000 per year in high cost of living states. While Arizona and Nevada delivered a high tuition and fee percentage increase, Arizona’s tuition and fees of $8,132 are reasonable and the University of Nevada, Reno’s totals are a bargain at $5,588, especially after considering that many UNR students have approximately 75% of their tuition covered through the state’s millennium scholarship. On the other side of the ledger, the five states with the best 2010 budget management with less than a $1.1 billion combined general fund gap saw an average tuition & fees increase of less than 3.5%. We truly are a country of divided political opinion, fiscal management, and demographics at the state level.
State’s also contain large problems that are less often discussed, such as underfunded university pensions and credit ratings that are likely to impact the student tuition and housing landscape. The general obligation bonds of Illinois recently were downgraded to an “A” rating with a negative outlook by Fitch, its fifth downgrade of Illinois in the last 18 months, costing the state as much as $551.3 million extra on bonds issued between September 2009 and July 2010 and setting a new record for the amount of premium required to insure that Illinois bonds don’t default. Additionally, the Illinois State University pension plan is underfunded by $12 billion, which will undoubtedly be a point of conflict as employees and taxpayers come to realize the size of the problem and personal implications. California holds an “A-“ rating from Fitch on its general obligation bonds, only marginally above junk status. The University of California retirement plan was 71.4% funded (if one counts unrecognized investment losses!) , and allows employees to retire at a minimum age of 50! New Jersey has been able to maintain a stable “AA” rating from Fitch, but has done so in part by not funding pension obligations — kicking the $19.7 billion liability down the road in hopes that investment performance will exceed the lofty 8.25% return assumption used to calculate the liability.
To gain an understanding of what the investment impact is for student housing we must synthesize the tuition increase on a “state by state” analysis along with conventional supply and demand economics. To be sure, it is likely that states with large financial problems will seek to raise revenue wherever possible, leading to increased tuition and fees in their public university systems. Budget deficits not only translate to higher tuition in fiscally mismanaged states, but also to a probability that the local municipality will look to the “rich, faceless, and non-voting” apartment owners to finance their spending with increased property taxes that reduce NOI, cash flow, and asset value. Additionally, an increase in tuition and fees acts as a senior claim on the limited funds available for education and student housing owners are residual claimants on more of the higher risk mezzanine position. Finally, universities with excess dorm supply (or the capacity to create additional supply) often move to require additional students to live on campus, shrinking the pie of available renters.
Believe it or not, there are benefits of cash strapped states for student housing owners. Top tier universities, especially in growing states, often have application demand far above supply and can choose to make up the funding gap by accepting more students. Another plus is that, dorm development quickly falls off the bottom of university priority list when states cut back on funding.
While each investment needs to be underwritten based upon its own merits, investors wanting to avoid high risks that are not directly manageable will seek to invest in states with high credit ratings (AA+ or better), moderate tuition levels relative to primary market area family income, and superior demographics. The table to the right shows the state credit ratings, population growth of 5-17 year old residents (used as a proxy for the future growth of in state public university enrollment), and the affordability on a tuition and fee basis ranking the States 1-50. States with strong fiscal management, growing college age populous, and affordability include Texas, Utah, Virginia and Idaho.
I will attempt to step out of my academic role and into my investor’s hat and put forward my opinions and predictions for the states discussed, as an example. Wise investors will steer clear of California, Illinois, and New Jersey student apartment purchases due to the negative demographics, horrendous state fiscal management, high and growing tuition burden, potential big property tax increases, and relatively overpriced assets. Nevada and Arizona will be rescued by great demographics and relatively affordable tuition, with state finances that bounce back with a bottoming of the housing market and rebound of the economy. However, if Nevada or Arizona legislatures enact draconian cuts to the university education funding that is the lifeblood of their future, then all bets are off for most long term investment in those states, including student housing.
Additionally, student housing investors are advised to refocus on fundaments, which include:
Demographics. There is no substitute for state, metro, and university primary market area population growth, which drives demand and rents higher. Another great advantage is that demographers are right more than anybody else I know, so student market selection is more predictable as one just moves the data in each column to the right January 1 of each year!
University market dynamics. Major state universities with a “vibrant college environment” have deep student housing demand, consistent enrollment, and master plans and budgeting that reveal any new dorm supply far in advance. Major “brand” universities = lower risk.
Student housing specific knowledge. Student housing is a contrarian investment, as apartments in small university towns like Blacksburg, Virginia, (home of “Virginia Tech”) feature supply constraints, high occupancy, and stable demand similar to large apartment markets like Seattle. Student housing offerings in major metros compete with a myriad of renter options, commuting dynamics, and non-traditional college living experiences that make understanding the landscape more difficult — and probably is a reason why many of the student housing investments are underwater in places like Chicago.
Proximity. Proximity to campus acts both as a major amenity to students enabling walking and biking, but also as a supply constraint as most land within close proximity of a major university was developed decades ago.
Size, quality, and location of units. Too many developers play proforma maximizing games that reduce unit finishes and shrink bedroom sizes in order to “pencil” higher return on equity. Too often, the output of this work is an excel “model” that shows a high returns, right up until the point that the units cannot be rented because smart college students don’t like living in small and boring boxes. The elegantly simple, but dirty little secret too often ignored, is that students prefer bigger units, with modern features, and close to campus.
Valuation, financial structuring, and business plans. The last real estate cycle featured investors betting the farm on residual value through high leverage, low cap rates, and stretched growth assumptions to underwrite transactions. Real estate fundamentally is an asset that is meant to produce consistent cash flow, and should be reviewed in that role. People, who have skills that increase NOI through leasing, managing, and developing, are capable of creating value. Business plans reliant on leverage and flawed assumptions are speculative, and remembering that leverage NEVER increases risk-adjusted returns, only the amount of risk for a given return is a good thing to repeat before investing.
In conclusion, proper underwriting of student housing investments need to include an emphasis on state finances because asset performance will increasingly be impacted by the state and university selected, and less by the operator, than historical precedent. Investors who understand which states and universities to invest in and who also know how to find or develop fundamentally sound business plans will outperform the lemmings who allocate capital to student housing with unsophisticated analysis and overly broad brush strokes.
— William M. Bennett is principal of Iconic Development and a lecturer of real estate at the J.L. Kellogg Graduate School of Management at Northwestern University.
 Ideas on government funding of public education are largely borrowed from one of history’s greatest thinkers - Milton Friedman
 Instructors calculations
 Administrative Bloat at American Universities: The Real Reason for High Costs in Higher Education
 Author’s personal bias noted – William M. Bennett is a resident of Evanston, Illinois
 National Center for Education Statistics
 National Center for Education Statistics
 California 32% tuition and fee hike in 2009-2010 likely moves it into the bottom half of states in affordability