Understanding the opportunity cost of investing in a property
While most investors have become involved in 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 do not fully understand opportunity cost.
Remember that anyone who enters a property generally does so to generate money or income; the amount of offers / properties you own 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 example, if a city decides to build a hospital on vacant lot it owns, the opportunity cost is something else that could have been done with the land and construction funds. Sports center on that lot, or a parking lot, or the ability to sell the land to reduce the city’s debt, etc. “
Therefore, in terms of real estate investment, if an investor decides to invest £ 50,000 in a property in, for example, Wales, the opportunity cost would be what he could have obtained 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 alternatively have invested this money in and the resulting value.
Now again, this will depend on your specific strategy, and many people are not too concerned about opportunity cost, they are just eager to buy 1-2 properties that they can keep for 15-25 years to use as a pension. That is fine if that is your strategy, but for me it is too broad a strategy, carries risks and does not maximize the opportunities available.
For me, I’ve always had the philosophy, right or wrong, that I should always work hard for my money. What does this mean? Well, as soon as I feel that my money has made a significant return and the returns are likely to decrease, compared to other possibilities, I will look to realize my profits and invest elsewhere, that is, when I feel that the opportunity elsewhere is greater than the current one. chance.
The good thing about property is that this does not 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 depending on the price you paid and the price you sold, although clearly with the property it is a good opportunity to make a regular income. Also, if you keep it for 15-25 years it should make money, but chances are there will be some 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 cheap and sell high!
I’ll give an example, while buying off the plan now has a bit of rigor in the UK, I’ve done it successfully in recent years, but having a clear strategy is the key.
For example, by doing all my due diligence, I have managed to buy a property at the right price in the right location, but then I sold it within a year of completion as I felt that was the period when I would see the maximum returns. in, and the opportunities would be greater elsewhere during the next 3 years.
So to review the numbers, I just sold one that I bought on top of the plan last year 12 months before its 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 allow for competition. This was secured with just a £ 5k deposit. Upon completion, I put another £ 28k on deposit, so I tied up £ 33k of my own money. There was no stamp duty in this area.
Then I put it on the market at the end, now even with things slowing down in the area I just sold it for a profit of £ 23k. So I tied up £ 5,000 for 1 year and another £ 28,000 for 6 months to get back £ 56,000.
Why did I sell it? Did I consider refinancing?
My first option would have been to refinance and let out, 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 without doing much for me. So since I am not forecasting great capital growth in the area over the next 3-5 years, and the return was not attractive enough for me, it was better for me to release this capital and find another investment, that is, I felt there was better opportunities for me to spend my £ 56,000 to make more money.
Now clearly when looking to the future it is an element of risk and speculation and there are no definitive answers so you have to forecast the best you can with the data currently available, that is, how you forecast interest rates, costs buy / sell, supply and demand, employment, general economy and market sentiment over the next time period in the markets / regions in which you are investing / looking to invest.
Although the 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 with Liverpool last summer, his home club and where he is captain, the opportunity cost was what it could have accomplished. if he had moved to Chelsea. It will be interesting to see what he decides this summer; now you may feel that the opportunity cost is too great to reject.
I hope this makes sense and remember to consider opportunity cost the next time you make an investment decision.