When trying to make decisions between two equally appealing investment opportunities, investors need to take a step back and evaluate their options in an objective light. When it comes to investing in real estate, many understand how rental yield, capital growth, and leverage are factors that create opportunities to make money from properties. After all, this is why they’ve decided to get into real estate investing in the first place. However, some beginner investors still don’t fully understand the importance of opportunity cost for real estate investing. If you’re not familiar with this concept, keep reading this blog post to learn what opportunity cost means and how to calculate opportunity cost so you can always make the best real estate investment decisions.
What Is Opportunity Cost?
Let’s start off by explaining what opportunity cost means exactly by definition. According to Investopedia, “opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another”. It comes from the view that no matter what we choose, there is the next best choice that we give up or an opportunity forgone. Investors can benefit greatly from understanding the potential missed opportunities forgone by choosing a particular investment over another as it allows for better decision-making.
Because they are unseen by definition, opportunity costs can be easily overlooked by investors when not careful. However, considering that almost every decision we make has a potentially beneficial alternative, it’s impossible to entirely eliminate opportunity costs from the decision-making process. Instead, when faced with multiple options, investors should minimize their opportunity costs by choosing the option that benefits them the most.
Calculating Opportunity Cost
There is no specifically defined or agreed upon mathematical formula to calculate opportunity cost, but there are ways to think about opportunity costs in a mathematical way. As mentioned, the opportunity cost is the benefit of the next best alternative or option. You can measure this benefit in money. As such, one formula for calculating opportunity cost is the ratio of the returns from the alternative you’re sacrificing to the returns you’re gaining from the chosen investment opportunity. When you think about it this way, then the opportunity cost formula becomes very straightforward:
Opportunity Costs = Sacrificed Returns / Gained Returns
A real estate investor can use this very simple formula to make educated decisions in different situations. We should note, however, that you should take certain variables into account before making an investment decision and calculating opportunity costs. These include your investment goals, risks associated with each alternative, as well as your ability to afford investment losses (i.e. the level of your risk tolerance). Take a look at the following examples to better understand how to calculate the opportunity cost of investing in real estate.
Examples of Opportunity Cost for Real Estate
#1. Investing vs Not Investing in Real Estate
As you start your journey to become a real estate investor, you’ll realize there are many critical decisions that need to be made. Some beginner investors feel overwhelmed by the number of choices and information and can’t decide, so they just stay put. This, however, can have terrible consequences – we all know how valuable time is when it comes to investing! It’s easy to miss out on great opportunities if you’re afraid to make an investment, especially in the real estate world.
When you think about it, not doing anything has an opportunity cost. For example, say you’ve saved $50K for investments but then changed your mind and decided to keep the money in your savings account. In this case, you sacrifice the benefits of buying an investment property and the ROI you could have earned, but you avoid the risks of investing in real estate.
#2. Investing in One Location vs Another
Say you decided to invest that $50K in real estate – let’s see how to find opportunity cost to make different decisions. One of the first choices a real estate investor is presented with is regarding where to invest or buy a property. As you know, the location of a rental property plays a major role in what returns you can expect it to generate. Different factors (like appreciation rate, rental demand, rental rate, job growth, etc.) differ across locations. This explains why some cities are considered better than others for real estate investing.
For example, say you live in Orlando, FL and want to buy an investment property here because it’s more convenient. However, you know that Dallas, TX is considered the #1 housing market to watch in 2019 so you could be making more money if you invest there. In this case, the opportunity cost is the ROI you could’ve earned in the top market over the ROI you’d make in your local market.
#3. Buying One Investment Property vs Another
Similarly, if you decide to invest your money in one property type, the opportunity cost is the returns you could have alternatively made if you’d invested in another type. For example, you’re torn between buying a single-family home or a condo for real estate investment. The condo will generate a $1,000 positive cash flow while the single-family home will generate $700 positive cash flow. However, you’re not the type of investor who wants to deal with HOAs and would rather own your investment and manage it yourself, so you decide to go for the single-family home rental.
Here’s how to calculate opportunity cost in this case: $1,000/$700 = $1.4 opportunity cost. This means that for every dollar you earn from investing in the single-family home, you sacrifice $1.4 from investing in the condo.
If you’re looking for a positive cash flow investment property for sale, use Mashvisor to find and analyze the best opportunities of any property type in your city and neighborhood of choice.
#4. Investing in Traditional vs Airbnb Rentals
Smart real estate investors also use the opportunity cost formula to see whether renting out a property as a traditional investment or an Airbnb investment is the better rental strategy. Let’s say now you’re an owner of a rental property. Using Mashvisor’s Investment Property Calculator (more on this tool below), you find out that it’ll generate $1,700 in monthly rental income if leased out traditionally and $2,000 in monthly rental income if rented out on Airbnb.
Even though you’ll make more income with the Airbnb investment strategy, you decided to go with the traditional way of renting because it’s a safer investment and you can’t afford the higher risk that comes with short-term rentals. What is the opportunity cost for this real estate investment? Simply divide the returns you’re sacrificing ($2,000) by the returns you’ll make from your chosen investment ($1,700). The opportunity cost of the less lucrative investment is $1.17. Again, this means that for every dollar you’d make from the investment property as a long-term rental, you could have been earning $1.17 from it as a short-term rental.
Never Lose Out on an Investment Opportunity
How can you ensure that you’re choosing the right real estate investment option that will both fit your criteria and reward you with maximum profits? Some might tell you that you can’t have a definite answer and that it’s all about forecasting as best as you can. However, we’ve got the tools you need to stop guessing and start making informed decisions based on predictive analytics and reliable real estate data!
The first tool Mashvisor provides is the Heatmap Analysis Tool. This tool gives you an overview of different markets in your selected city along with how strong they’re performing based on your investment criteria. For example, say you want to buy an Airbnb rental property in Orlando but you’re unsure of which areas have the highest occupancy rate. Simply set the Airbnb occupancy rate as your criteria and the Heatmap will show you the best neighborhoods in the city in no time. As you can see, this tool allows you to choose the investment opportunity in the best locations for real estate investing.
The second tool we’ve got for you is the Real Estate Investment Calculator. Backed by predictive analytics and timely data, this tool shows investors projections of the returns they can expect from rental properties (both traditional and Airbnb). After finding real estate deals, you can use this tool to run the numbers and get a comprehensive analysis of the property’s rental income, cash flow, cap rate, cash on cash return, and more! With this calculator, not only will you be able to do an investment property analysis on different properties to pick the most profitable one, but you’ll also be able to see which rental strategy is optimal to earn maximum profits!
Finally, if you’re looking for off-market properties, Mashvisor’s got a place where you can find them before anyone else. Mashvisor’s Property Marketplace allows you to search for and find non-MLS properties including short sales, bank-owned homes, auctioned homes, and foreclosures. You can also get access to data and use the aforementioned tools to analyze the properties and their locations to pinpoint the best real estate investment opportunities.
To start looking for and analyzing the best investment opportunities in your city and neighborhood of choice, click here.
The Bottom Line
Opportunities are always there and opportunity costs occur with every decision made, big or small. Knowing how to calculate opportunity cost and looking at the ratio between available alternatives is important to make the correct investment decision. While simple, the opportunity cost formula should always be used in your decision-making process to weigh the pros and cons in simple, mathematical terms. If still uncertain, real estate investors should go on to conduct more detailed analyses using Mashvisor’s valuable tools.
To get a taste of how Mashvisor helps investors make smart investment decisions in no time, start out your 14-day free trial now.