Understanding the opportunity cost of investing in property
While most investors got into real estate investing because they understand the opportunities to make money through leverage and capital growth or high returns, I still see and hear from many who don’t fully understand opportunity cost.
Remember that anyone who enters a property is generally doing so to generate money or income; the amount of business/property he owns is negligible.
So what does opportunity cost mean?
Well, according to the encyclopedia, “Opportunity cost is a term used in economics to refer to the cost of something in terms of a lost opportunity (and the benefits that could be received from that opportunity), or the most valuable lost alternative. For For example, if a city decides to build a hospital on vacant land it owns, the opportunity cost is something else that could have been done with the land and construction funds instead. parking, or the ability to sell the land to reduce the city’s debt, etc.
So, in property investment terms, if an investor decides to invest £50,000 in a property, say, in Wales, the opportunity cost would be what they could have done by investing in Spain, Ireland or Dubai. Or similarly, if an investor decides to hold 50k equity in a property, the opportunity cost is what they could have alternatively invested this money in and the resulting value.
Now again this will depend on your specific strategy, and many people are not overly concerned with opportunity cost, they are only willing to buy 1-2 properties that can be held for 15-25 years to use as a pension. That’s fine if that’s your strategy, but to me it’s too broad a strategy, carries risks and doesn’t maximize the opportunities available.
For me, I’ve always had a philosophy, right or wrong, that I should always work hard with my money. What does this mean? Well, as soon as I feel like my money has had a significant return and the returns are likely to decline, compared to other possibilities, I’ll look to take my profits and invest elsewhere, that is, when I feel the opportunity elsewhere is greater than the current one. chance.
The great thing about property is that this doesn’t necessarily mean selling, as you can refinance and invest money elsewhere.
This is no different than any other type of investment like buying stocks and shares – you make/lose your money based on the price you paid and the price you sold for, although clearly with property it’s a good chance to earn a regular income. Also: If it sticks around for 15-25 years, you should make money, but there will most likely be a few scares along the way!
To be a successful investor, you must know when to enter the market and when to exit the market. And the people who do it best buy low and sell high!
I’ll give an example: while off-plan buying now has some entrenchment in the UK, I’ve done it successfully in recent years, but the key is to have a clear strategy.
For example, by doing all my due diligence, I was able to buy a property at the right price in the right location, but then sold it within a year of completion, as I felt that was the period I would see the maximum returns. , and opportunities would arise. be older elsewhere for the next 3 years.
So to go over the numbers, I 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 buying competition to leave. This was secured with just a £5k deposit. On completion I put another £28k on deposit so I tied up £33k of my own money. There was no stamp duty in this area.
I then put it on the market on completion, now even with things slowing down in the area I have just sold it for a £23k profit. So I bought £5k for 1 year, and a further £28k for 6 months, to get £56k back.
Why did I sell? Did I consider refinancing?
My first choice would have been to refinance and rent, but the rent would not have accumulated. So while the rent would have accrued to the price I paid for the property, I would have had 56k in equity which wouldn’t have done me much. So, as I don’t forecast a lot of capital growth in the area over the next 3-5 years, and the return wasn’t attractive enough for me, it was better for me to free up this capital and find another investment, i.e. I felt there was Better opportunities. to spend my £56,000, to make more money.
Now clearly looking into the future is an element of risk and speculation and there are no definitive answers so you have to forecast to the best of your ability with currently available data ie how do you forecast interest rates, purchase costs /selling, supply and demand, employment, the general economy and market sentiment over the next period of time in the markets/regions in which you are investing/looking to invest.
Although opportunity cost can be difficult to quantify, its effect is universal and very real at 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 at Liverpool last summer, his home club and captain, the cost of opportunity was what he could have achieved. if he had moved to Chelsea. It will be interesting to see what he decides this summer – now he may feel the opportunity cost is too high to turn him down.
I hope this makes sense and remember to consider opportunity cost the next time you make an investment decision.