Updated: May 21, 2019
I first got introduced to the concept of opportunity cost in my economics class at university. It is "the loss of potential gain from other alternatives when one alternative is chosen" (New Oxford American Dictionary).
Back then, this was too conceptual for me. I couldn't imagine why this was a cost.
So I chose a Cornetto Drumstick over a Snickers bar. So what? Why would I be interested in the cost of either alternative?
Later on, I discovered the importance of being aware of this. It first started when I was a fresh employee working my first job. I had 2 options to get to work. One was a tolled route and the other was a non-tolled route.
I despised having to pay RM3.00 on a return journey via this tolled-route everyday. But I made a very interesting discovery.
If I used the non-tolled route I would save RM3.00 but would lose an hour everyday. It was then a question of this - is an hour worth RM3.00 to me? I was paid RM1,500 per month then, which worked out to RM8.50 per hour. This is a simplistic approach, but nevertheless, 1 hour was worth far more to me than RM3.00 and I decided to to use the tolled route.
I had found a useful application for opportunity cost!
Since then, I often look at different alternatives with opportunity cost in mind. In fact, I now believe that this is one of the most important metrics when evaluating property investment. Especially when you're disposing your property.
This post will be filled with examples to give you clarity.
Opportunity Cost Overview
Let's say you have RM100,000 in fixed-deposit giving you a return of 3.8% per annum. What is your opportunity cost?
Your opportunity cost is other alternative investments that can give you a higher return. The returns from mutual funds can be 7%. Amanah Saham Bumiputra gives a return of 7.5%. There are also "sexy" instruments like structured notes and venture capital that give higher returns.
Of course, you must not forget the old saying; "high returns, high risk".
Evaluating risk and balancing it with your ability to absorb such risk is not very complex. It requires common sense and an ability to prevent greed from overriding that common sense.
Let's look at the RM100,000 in a 3.8% fixed-deposit. If you do not touch your interest and the bank allows your interest to be compounded, in 10 years you will have RM145,202. A net gain of RM45,202.
What if you put the same RM100,000 in a mutual fund that has a historical average return of 6%? If it is allowed to compound, in 10 years you would have RM179,085. This is a net gain of RM79,085.
In comparing the fixed-deposit option and the mutual fund option, you potentially lose RM33,883 by keeping the money in a fixed-deposit instead of the mutual fund. This is your opportunity cost.
If you find that the risk of losing your capital in the mutual fund very low, then it makes more sense to have your RM100,000 in a mutual fund.
This is a pretty straightforward example and not very difficult to evaluate. Let's go a little deeper.
Opportunity Cost In Property Investment
Between 1997 to 2018, house prices rose 4.07% every year on average. But does that mean it is a better investment than a fixed-deposit paying you 3.8% per annum?
The answer to this question depends on a number of factors and you can play out every scenario using my property investment calculator.
If the value of the property you purchased is RM100,000, you bought it to occupy, and you paid for it in cash without any borrowing, despite the 4.07% increase every year, you would have just broken even if you sold it after 10 years.
The reasons for this are:
You are living in the property and therefore it is not generating revenue
There is a cost to owning the property (taxes, maintenance, annual improvements, transfer duty, etc)
The costs outweigh the gain from the appreciation
In this scenario, you are better off keeping your money in a fixed deposit as the opportunity cost for buying to own is high.
However, if you leveraged using a bank loan and bought to rent, it becomes a whole different scenario.
If you put in RM100,000 to purchase a 1,500sf, RM665,000 property (10% downpayment and additional costs like legal fees, transfer duties etc comes up to nearly RM100,000) and rent it out for RM2,500 per month, when you sell the property in 10 years, you would make a net gain.
The projected gain would be RM130,035 or an annual return of 11%.
The reasons for this difference are:
You are renting the property so there is revenue to offset costs
You leveraged using a mortgage
As you can see, there is a huge opportunity cost with buying to own over buying to rent. The latter scenario beats returns from a fixed-deposit or mutual fund.
But before you jump into buying an investment property, you must evaluate your risk. Some questions to ask:
Can you afford to pay the instalments and maintain the property?
Are you paying market rate or inflated rate for the property?
Will there be demand for your property in the future?
Should You Keep Your Existing Property or Sell It and Buy A New One?
I found something interesting when playing out different scenarios using my property investment calculator to play out different scenarios.
First I discovered that whether you are buying to own or buying to rent, the more you can borrow from the bank the better your returns.
This is primarily because the capital required to purchase the property is less when you get a mortgage and the appreciation is over the entire value of the property, not just your cash outlay.
Second, I discovered that over time the effect of the mortgage wears out and your return will go down to the actual appreciation. This may be a little hard to comprehend but allow me to explain with an example.
Let's use the example above where you purchased a RM665,000 property. Your return is 11% per annum if you sell the property after 10 years and the property appreciates by 4.07% every year. You are making a higher return than the actual appreciation of 4.07% because you have leveraged with a mortgage.
However, if rent does not appreciate, then in 30 years the return drops to 9.38% and it will keep dropping until eventually it comes down to 4.07%. It will take so long for this to happen that you could neglect it but there could be an opportunity cost to not buying a new property with a fresh mortgage.
Let us assume that after 8 years, you come across another property deal in the primary market. A developer is offering discounts and offsetting all incidental costs like stamp duties, and legal fees. All you have to come up with is RM5,000.
The property is 1,200sf and is priced at RM1,200,000. You expect to be able to get a rental of RM4,200. You know you can afford the monthly instalments if you sell your existing property which, upon sale, would give you a return equal to 11% per annum for the 10 years. What should you do?
Using my property investment calculator, the new property can give an annual return of 37.15% if appreciation continues to average 4.07% and sold after 8 years.
Therefore, your opportunity cost of keeping your existing property is high in light of this new property deal.
There is an opportunity cost to every decision you make in investment. You should be aware of this.
I have made it easy for you to calculate your opportunity cost by projecting different scenarios for properties you have and properties you are contemplating to purchase with the property investment calculator.
Use it and prosper :-)