Understanding Opportunity Cost When Investing In Property
While most investors have got involved in property investing because they understand the opportunities to make money through leverage and capital growth or high yields, I still see and hear of many who do not fully understand opportunity cost.
Remember anyone that gets into property is usually in it to generate money or income – how many deals/properties you own is insignificant.
So what does opportunity cost mean?
Well according to the encyclopedia, “Opportunity cost is a term used in economics, to mean the cost of something in terms of an opportunity foregone (and the benefits that could be received from that opportunity), or the most valuable foregone alternative. For example, if a city decides to build a hospital on vacant land that it owns, the opportunity cost is some other thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sporting center on that land, or a parking lot, or the ability to sell the land to reduce the city’s debt, and so on.”
So in property investing terms, if an investor decides to invest £50k in a property in for example Wales, the opportunity cost would be what he could have made by investing in Spain, Ireland or Dubai. Or similarly if an investor decides to keep equity of 50k in a property, the opportunity cost is what he/she could alternatively have invested this money in and the resultant value.
Now again this will depend on your specific strategy – and many people are not too concerned about opportunity cost, they are just keen to buy 1-2 properties that can hold onto for 15-25 years to use as a pension. That is fine if that is your strategy – but for me that is too broad a strategy, carries risks and is not maximising the opportunities available.
For me I have always had a philosophy, rightly or wrongly, that I should always be working my money hard. What does this mean? Well as soon as I feel my money has made a significant return and the returns are likely to drop off, compared to other possibilities, then I will look at realising my profits and investing elsewhere ie when I feel the opportunity elsewhere is greater than the current opportunity.
The great thing with property is this does not necessarily mean selling, as you can refinance, and invest money elsewhere.
This is no different to any other type of investing, such as buying stocks and shares – you make/lose your money depending on what price you paid, and what price you sold at – although clearly with property is good opportunity to earn a regular income as well – if hold onto for 15-25 years you should make money, but most likely will be a few scares along the way!
To be a successful investor, must know when to enter the market, and leave the market. And the people that do best buy low, and sell high!
I’ll give an example – while buying off plan has now got a bit of stick in the UK – I have done it successfully over the last few years – but the key is having a clear strategy.
For example, by doing all my due diligence I have managed to buy property at the right price in right location, but then sold on within a year of completion as I felt that was the period I would see the maximum returns in – and opportunities would be greater elsewhere over the next 3 years.
So to go through the numbers, I have just sold one that I bought off plan last year 12 months before completion. I bought at a price that was already £10k below market value based on my research in an area that had little buy to let competition. This was secured with only a £5k deposit. On completion, I put another £28k into deposit – so tied up £33k of my own money. There was no stamp duty in this area.
I then put on market on completion, now even with things slowing down in the area, I have just sold it for a £23k profit. So I tied up £5k for 1 year, and a further £28k for 6 months, to get back £56k.
Why did I sell? Did I consider refinancing?
My first choice would have been to refinance and let out, but the rental would not have stacked up. So while the rental would have stacked up at the price I paid for the property, I would have had 56k in equity sat not doing very much for me. So as I do not forecast huge capital growth in the area over the next 3-5 years, and the yield was not attractive enough for me it was best for me to release this equity and find another investment – ie I felt there were better opportunities for me to spend my £56,000 on, to generate more money.
Now clearly when are looking into the future is element of risk and speculation and are no definite answers – so you are having to forecast as well as you can with the data currently available ie how you forecast interest rates, buying/selling costs, supply and demand, employment, the overall economy and market sentiment over the next time period in the markets/regions you are investing/looking to invest in.
Although opportunity cost can be hard to quantify, its effect is universal and very real on the individual level. The principle behind the economic concept of opportunity cost applies to all decisions, not just economic ones, for example when Steven Gerrard decided to stay with Liverpool last summer, his home club and where he is captain, the opportunity cost was what he could have achieved if he had moved to Chelsea. It will be interesting to see what he decides this summer- he may now feel the opportunity cost is too great to turn down.
Hope this makes sense, and remember to consider opportunity cost when next making an investment decision.