Opportunity cost is one of the most critical concepts for real estate investors to understand. And while it can be difficult to grasp, it can be easy to calculate with a bit of math. In this blog article, we’ll discuss what opportunity cost is, why it’s essential for real estate investors, and a few simplified formulas for calculating it. We’ll also provide a few examples to see how it works in practice.
What is Opportunity Cost?
Opportunity cost is the value of the next best alternative use of your money or time. In other words, it’s what you’re giving up by making one decision instead of another.
For example, let’s say you have $100,000 to invest in a rental property. You could either purchase a duplex for $200,000 or a single-family home for $150,000. The opportunity cost of purchasing the duplex is the $50,000 you would’ve had left over if you bought the single-family home.
It’s important to note that opportunity cost is not always monetary. It can also be time-related. For example, let’s say you have two investment properties that need repairs. You can either do the repairs yourself or hire a contractor. The opportunity cost of doing the repairs yourself is the time you would’ve spent on other activities if you hired a contractor.
YReal estate investors need to understand opportunity cost because it affects nearly every decision they make. For example, when considering whether to fix and flip a property or hold it as a rental, investors need to weigh the opportunity cost of each option.
If an investor decides to fix and flip a property, they’ll incur the opportunity cost of the time and money spent on repairs. They’ll also forgo the potential profits from holding the property as a rental. On the other hand, if an investor decides to hold a property as a rental, they’ll miss out on the potential profits from flipping it.
Real estate investors need to understand opportunity cost and how it applies to their business to make informed decisions. By considering all of the costs associated with each decision, investors can make the best choices for their business.
Now that we’ve discussed what opportunity cost is and why it’s important let’s look at how to calculate it.
There are numerous different ways to calculate opportunity costs. But, here’s one of the most simplified formulas:
This formula can be applied to any opportunity cost calculation. However, it’s important to note that there are different ways to measure returns. For real estate investors, common measures of return include cash flow, capital gains, and ROI.
Let’s look at some examples to see how calculating opportunity cost works in practice.
Let’s say you’re considering investing in a fix and flip property. The estimated return on investment (ROI) is 15%. After doing some research, you’ve determined that the average ROI for buy-and-hold properties in your area is 12%.
To calculate the opportunity cost, we would use the formula from earlier:
Opportunity Cost = Return On Forgone Option (15%) – Return On Chosen Option (12%)
The result is that the Opportunity Cost is 3%.
By investing in the fix and flip property, this means you’ll earn 3% more income than you would have made with a buy-and-hold property.
Now let’s say you’re considering investing in a fix and flip property. The estimated ROI is 15%. After doing some research, you’ve determined that the average ROI for stocks over the past year has been 16%.
To calculate the opportunity cost, we would use the formula from earlier:
Opportunity Cost = Return On Forgone Option (15%) – Return On Chosen Option (16%)
The result is that the Opportunity Cost is -1%.
This means that you’re earning one percent more than you would have made investing in stocks. Remember that this doesn’t account for the risk that stocks might have over real estate.
Let’s say you’re considering purchasing a single-family home to rent out. The estimated ROI is 8%. After researching, you’ve determined that the average ROI for multi-family properties in your area is 12%.
To calculate the opportunity cost, we would use the formula from earlier:
Opportunity Cost = Return On Forgone Option (12%) – Return On Chosen Option (8%)
The result is that the Opportunity Cost is -4%.
This means that if you invest in this single-family home, you’re giving up 4% of what you could have earned by investing in a multi-family property.
Obviously, there are numerous other factors that could go into these equations, but these examples are overly simplified for the sake of time.
In ClosingOpportunity cost is an important concept for real estate investors to understand because it can help them make better decisions about how to use their time, money, and resources. By understanding opportunity cost, investors can avoid making sub-optimal decisions that could cost them dearly in the long run.
We hope this article has helped you to better understand opportunity cost and how it can be applied in your real estate investing business. If you enjoyed this article, we encourage you to read Part 2 of this two-part series: