The Real Estate Investor’s Guide to Opportunity Cost

Choosing between investment opportunities can be difficult. Whichever investment you pursue, you’re missing out on the benefits the other investment would offer. This is called opportunity cost, and it rightly impacts the decisions of real estate investors.

What does opportunity cost mean?

Opportunity cost is the benefit forfeited by choosing one option over another. 

If you choose to spend your lunch hour working rather than taking a break, you forfeit the relaxation that could come from unwinding during that time. 

When you handle administrative work in the office rather than attending a networking event, you’re forfeiting the chance to build mutually beneficial relationships. Choosing one career path costs you the pursuit of another career path and all the benefits that path would offer.

Opportunity Cost Formula

In some cases, it’s very difficult to quantify opportunity costs. Let’s imagine for a moment that you’re choosing between two potential partners. It is impossible to know exactly what you’ll be missing out on by partnering with one person over another. One candidate may offer adventure while the other would offer stability. Can you assign a value to such an intangible?

Luckily, opportunity cost is clearer when it comes to financial decisions. If, for example, you are deciding between two investments, your only opportunity cost consideration may be the return on investment (ROI) potential. And the opportunity cost of ROI potential can be calculated with a simple formula:

Opportunity cost = ROI for the bypassed option - ROI on investment for the chosen option

Examples of Opportunity Costs in Real Estate Investing

#1: Holding Cash Instead of Investing in Real Estate

Some people refuse to invest because they know that all investments carry some risk. But let’s look at the opportunity cost of not investing. 

You have $20,000 on hand. 

Option 1: Save the $20,000 in your no-interest checking account for the next three years.

Option 2: Invest the $20,000 in a real estate project with a projected annualized return of 15% over the next three years.  

With option 1, you’ll end the three-year period with the same $20,000 you started with. 

With option 2, you’d end the first year with $23,000 ($20,000 + 15% interest). If you reinvest your proceeds for the second year, you will end the year with $26,450 ($23,000 from year 1 + 15% interest). And if you reinvest the proceeds for the third year, you’d end up with $30,418 ($26,450 from year 2 + 15% interest).

So, if we subtract the $20,000 you would have with option 1 from the $30,418 you would earn with option 2, we find that the opportunity cost of holding cash instead of investing in real estate is $10,418.  

This is the cost of saving vs. investing.

#2: Investing in Single-Family Flip Instead of Investing in a New Multi-Family Development

For this example, let’s say you have $100,000 to invest in real estate.

Option 1: Invest the $100,000 in a single-family fix-and-flip, which is projected to take 12 months and return 18%.

Option 2:  Invest the $100,000 in a ground-up multi-family development, which is projected to take 21 months and return 29%.

At first glance, this looks like a simple decision. With a projected return of 29%, the multi-family deal would earn 11% more than the single-family flip (29% minus 18%). So, you could say the opportunity cost of choosing the single-family project is 11%.

However, the timeframes are different. Comparing the total ROIs doesn’t account for this time element. To compare apples to apples, we would want to look at the annualized ROI, which is the return achieved over a 12-month period. 

Since the flip takes 12 months, its 18% ROI is already an annual figure. For the multi-family development, we would divide the total 29% return by the total 21 months needed. This tells us that the average monthly return is 1.38%. If we multiply this by 12 months, we find that the average annualized return for this project is 16.57%. 

So now, the annualized ROI for the single-family flip is 18% and the annualized return for the multi-family development is 16.57%. This means the annualized opportunity cost of choosing the multi-family development is 1.43%(18% minus 16.57%). 

#3: Direct Ownership Instead of Real Estate Syndication

let’s compare purchasing a rental property on your own vs. investing in real estate syndication. If you’re not familiar with syndication, it’s similar to real estate crowdfunding. Multiple investors pool funds to finance a specific real estate project, which is professionally managed by a real estate sponsor. This structure allows investors to own equity in unique real estate deals without shouldering the financial burden alone. 

For this example, let’s say you have $75,000 to invest in real estate.

Option 1: Invest the $75,000 in the down payment for a single-family investment property that you plan to rent out for the next five years. The projected annualized ROI, factoring in both cash flows and appreciation, is 11%.

Option 2:  Invest the $75,000 in a syndicated multi-family development, which will take two years to complete. The projected annualized ROI is 18%.

Major Opportunity Cost Factors

While returns rank as the most important metric for many investors when choosing between investments, there are additional factors to consider.

Risk

Your personal risk tolerance should factor into your investment decisions. For example, you could have a commercial development opportunity with high return potential, but a higher risk of falling well short of projections. 

The intangible opportunity cost of choosing a higher-risk commercial development over a lower-risk residential development is the peace of mind you would lose by stressing over the commercial project.

Liquidity

Having access to your funds could make one investment more appealing than another. In Example #3 above, direct ownership would require a five-year investment period to produce an annualized return of 11%, while the syndication project would take only two years to produce an annualized ROI of 18% per year. After just two years, your investment in syndication could be liquidated and funneled to new opportunities. 

The liquidity opportunity cost of investing in direct ownership would be the three extra years in which your funds would be tied up in the rental and inaccessible for other investments. 

Control

How much input do you need to have in the management of your real estate investments? Again, looking back to Example #3 above, direct ownership provides complete control. You decide if you’ll renovate, how much you’ll charge for rent, and how the property will be maintained. Control is limited in syndication. You can choose the project(s) you wish to invest in, based on the sponsor’s proposed plan for the property, but the sponsor will make decisions regarding design and day-to-day management. 

The opportunity cost of choosing the syndication project over direct ownership is the control that would be given up. 

On the plus side, giving control to a real estate sponsor, particularly one who is experienced and well-connected can result in higher returns. More experience, localized knowledge, and industry contacts typically lead to better decision-making and fewer real estate investing mistakes. 

Time and Energy

Finally, consider how much of your time and energy your investment options require. Using Example #3 above once more, syndication is entirely passive. Once you place your investment, you simply track its progress until the project is complete and you receive your returns. Direct ownership, on the other hand, requires hands-on management (or extra funds to pay a property management company, which would eat into your returns). 

The opportunity cost of choosing direct ownership over syndication is all the time and energy you would expend acquiring, renovating, leasing, managing, maintaining, and eventually selling the property.     

Next time we shall see how Today’s Real Estate Investors Minimize Opportunity Costs.

Douglas Mukwaya

Real Estate Consultant.

douglasmukwaya213@gmail.com

douglas@rentalynk.com.

+256 752 596 808.