Opportunity cost is the loss of potential gain from other alternatives when one alternative is chosen. Think about it before investing.
Not long ago I had lunch with a friend, Joe. He shared an idea he had about purchasing retirement property now for use in roughly 10 years. Joe feels confident about the location and is concerned about being able to afford a house there later when he is ready to move because the area has experienced a lot of appreciation recently. He doesn’t want to rent out the house prior to moving in as it would make him feel uncomfortable. Meanwhile, he can enjoy using the house for a weekend a month. Joe asked my opinion of his plan.
I generally disagree with such an action on several fronts, many of which I will discuss in future posts. Today, I want to discuss the idea of opportunity cost. Perhaps what spurred me to write about this now was that I had more or less the same discussion the following few days with other people. So, this idea is coming up a lot.
What is Opportunity Cost?
Basically, choosing to invest in the vacation home would mean he could not invest the same money in some other way, like stocks, bonds or T-bills. Let’s try some examples to see what this might look like:
Example 1 – Joe pays cash for the house today and moves in 10 years
Assume Joe pays $270K for his house today and his house appreciates at the rate of 3%/year, which is close to the historical national average. In 10 years, his house would be worth $360K, for a gain of $90k. However, he would have carrying costs to maintain the house and pay property tax and insurance for 10 years. We will figure on a carrying cost of $4300/year or $43K for 10 years, reducing his effective gain to $47k, or $4700/year.
So, after 10 years, Joe owns a house worth $360K and paid $43K, for a net value of $317K.
Above is a chart showing historical values for the location of Joe’s home. Since 2014, nominal home prices have grown to $270K. We can see the 2006 bubble and that home prices have been reverting to the mean since the crash. So, the inflation-adjusted pricing seems consistent and therefore the 3% growth rate sounds reasonable.
Example 2 – Joe invests the money and buys a house in 10 years
Assume Joe invests the money in the stock market, which has an average annual return of 5.7% (with dividend reinvestment) over the last 20 years. If those returns continue (big IF), his $270K today would grow to $470K in 10 years, for a gain of $200K. He would then sell his shares and pay tax on the gain, let’s say 20% of 200K or $40K. That would leave him with $430K. Joe could then purchase a similar house for $360K (the future value of the house from Example 1).
Meanwhile, he would have spent $100/nt for a hotel on his monthly weekend vacay and adjusting that for inflation to $120/nt average over the 10 years he would have 24 nights/year at $120/nt = $2880. For 10 years, that would be roughly $29K. So, we take that $29K out of the $70K profit for $41K profit when this path is pursued.
After 10 years in this example, Joe owns a house worth $360K and has $41K in his pocket, for a net value of $401K.
Joe’s Opportunity Cost
The difference between Example 1 and Example 2 is $401K – $317K, or $84K. Joe could buy his house now, but he would incur a potential opportunity cost of $84K (by being unable to invest his funds). Of course, actual inflation and returns will vary, but a difference of $84K on an initial $270K investment is substantial. Ultimately, Joe will need to decide whether his peace of mind for securing his retirement home today is worth the potential opportunity cost of $84K.
How has opportunity cost impacted your decisions?