Understanding Opportunity Cost

Understanding the Opportunity Cost of any decision you make is critical – to ensure you make the best choices to maximise your profits, and ultimately your long term earnings.

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 and therefore do not maximise their profits.

Remember anyone that gets into property is usually in it to generate money or income – how many deals/properties you own is insignificant – but I meet some investors who feel it is all about buying as many properties as they can and never selling, irrespective of performance or other opportunities.

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 they 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.

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, after costs are taken into account.

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 there is a good opportunity to earn a regular income as well. If you hold onto a property for 15-25 years you will make money, but most likely there will be a few scares along the way, as the market passes through several cycles!

To be a successful investor, you 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 you an example. By doing all my due diligence I bought a property at the right price in the 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 more importantly, the opportunities would be greater elsewhere over the next 3 years.

So to go through the numbers, I have just sold a property 6 months after completion, that I bought off plan last year 12 months before completion. I bought at a price that was already £15k 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 the deposit – so tied up £33k of my own money. There was no stamp duty in this area.

I then put the property on the market on completion - now even with the market slowing down slightly in the area, I sold it for a £23k profit. So I tied up £5k for 18 months, and a further £28k for 6 months, to get back £56k 6 months later.

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 at the new valuation. So while the rental would have stacked up at the price I paid for the property, I felt that I would have had 56k in equity sat not doing very much for me for the next 3 years in this property investment. And I felt that there were better opportunities for my money both here in the UK, in different regions, and in several overseas markets, which would give stronger returns ie the opportunity cost was too great.

How can I tell this?

Clearly when we are looking into the future there is an element of risk and speculation and there 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.

I do not forecast huge capital growth in the area over the next 3-5 years, for a range of reasons – the main reason being that the prices are now pretty high compared to the average salary, and the rentals are not as attractive for an investor at the price I sold up at – around 5% gross yield.

As 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.

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 this summer, his home club and where he is captain, the opportunity cost was what he could have achieved if he had moved to Chelsea or Real Madrid. In the end he felt the rewards he could achieve at Liverpool would be greater than he could achieve at Chelsea – but clearly this is an individual decision depending on individual goals.

So, in conclusion, what does this mean for a property investor?

Well, I would say always be looking at your equity/investments and looking at how well they are performing. If you have money tied in a property that you think will go up in value over 15 years – but may not go up for the next 5 years, is this the best place for your money?

It is no different to the stock market, you must keep an eye on market movements and other opportunities.

By working your money hard, and maximizing potential leverage, you can maximize the opportunities out there.