Always Calculate The Opportunity Cost When Making A Major Investment

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I love window shopping and never buying a gosh darn thing. Vendors hate me, but my bank account thinks otherwise.

This habit started when I was a teenager making minimum wage with shoes and clothes. Spending 30 hours slaving away behind a grill to be able to buy a pair of new basketball shoes felt like a bad trade. But at least working those laborious jobs made me appreciate the value of a dollar.

Then, when I had a regular day job, my window shopping habit morphed into visiting car dealerships and test driving the latest models. There were several dealerships on the drive home so I figured why not drop by, eat a free cookie and have a free beverage while inhaling that lovely new car smell! I must have averaged 20 visits a year for 10 years. It was impossible to buy a new car when I knew the money could be invested to make more money in order to finally escape work.

Now I’m addicted to putting in lowball offers on homes and going through rigorous negotiations. If I win, money will likely be made. If I lose, awesome, because maintaining a property and paying never-ending property taxes are no fun. Since 2H2017 I’ve submitted four lowball offers with likely more to come.

It feels amazing to walk to the edge, look down, and walk back to safety. Do you guys ever feel the rush of this type of excitement, that is, almost parting with your hard-earned money? 

A Slightly Better Counter Offer

In a previous post about big homes and egos, I mentioned that I had put in a $1.95M cash offer for a larger house asking $2.2M. They verbally came back and said they wanted $2.3M, which I found absurd so I didn’t bother to respond with anything in writing. Since then, a couple weeks have passed and they are now offering another counter, this time at their original asking price of $2.2M.

It was nice that they came down by $100,000, but the price was still not enticing enough given the amount of work that would be involved to update the home. I considered countering in writing with an offer of $1.98M, but then wrote them this letter instead. The letter’s original intent was to convince them to sell to me below $2M, but instead it ended up convincing me to not pursue the deal any further!

Dear Seller,

Thanks for the counteroffer, but we cannot afford this price. We went back a couple times to check out the foundation with a couple professionals, and there is foundation work that needs to be done to level the house and retrofit the house in case of an earthquake.

The city has already made it mandatory for wood frame multi-unit apartment buildings with garages to be retrofitted to the tune of $100,000 – $300,000. We believe it’s only a matter of time before the city identifies pre-1970 wooden frame multi-story houses over a garage which will also require retrofitting. With addition to the remodeling work planned, we simply do not have enough funds left to comfortably afford your home.

The real estate market is also at an all-time high, but it is slowing as interest rates are rising, rents are flatlining, and the stock market is stuck down 10% for the year. The stock market is foreshadowing a slowdown in corporate profits and job growth. With the institution of the mortgage interest deduction and state and local income tax cap this year, it’s an inevitability real estate prices will slow.

We need room in our budget to account for unforeseen expenses that come with remodeling an old house and dealing with new city retrofitting rules. At $2.2M, it would make much more sense to simply buy a completely brand new home on the market for $2.7M and save all the hassle and time.

Finally, the alternative to buying the house is to simply reinvest the money in risk-free 10-year treasury bonds yielding 3%. With a $2M investment, we would earn $60,000 a year, or $5,000 a month guaranteed without having to do any work or have any worry. A simpler life sounds pretty good to us as we take care of our baby boy.

If you would like to reconsider our offer sometime in the future, let us know. Our lines of communication are always open.

Regards,

Sam

The key paragraph that convinced me not to buy this house was the one on investing $2M in a 3% yielding treasury bond. Earning $5,000 a month, free of state income tax, is a lot of money for us. It’s enough to pay for all our existing housing costs and some weekly sushi dinners. Not only would spending $2M on this house have an opportunity cost of $60,000 a year, it would also have an ongoing carrying cost of $25,000 in property taxes.

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Therefore, the actual cost of owning this home without accounting for any of the remodeling and ongoing maintenance costs is $60,000 + $25,000 = $85,000 / year.

When I recognized the true cost of owning this home, it became very clear to me that even with its much lower price/sqft asking price, the house wasn’t a steal.

At a $2M purchase price, I estimated it would cost another $350,000 – $500,000 to fix the house up. Add on $85,000 in opportunity cost and now we’re talking an all-in cost of $2,435,000 – $2,585,000. Add on another $130,000 in taxes and commissions to sell the house, there simply isn’t enough profit for the risk.

Run Through Various Opportunity Cost Scenarios

Whether you are buying a vacation property or investing your entire bonus in Netflix stock, it’s always important to calculate the opportunity cost of not investing elsewhere. The baseline opportunity cost is always the risk-free rate of return, also known as a US treasury bond. I use the 10-year treasury bond yield as a barometer. The US government isn’t going to default on their debt obligation and you will get 100% of your principal back and the annual coupon if you hold until maturity. If you decide to sell before maturity, you are subject to principle appreciation or loss.

Here are a couple examples using a $2M investment.

1) S&P 500 index. The index is currently yielding roughly 2%, therefore, you would get $40,000 in dividends each year. You expect the S&P 500 to return +/- 10%. Therefore, your potential return is -8% (-10% + 2% yield) to +12% (+10% + 2% yield), or -$160,000 to + $240,000.

However, if you bake in the opportunity cost of losing a guaranteed 3% return on your $2M, the true expected return on your S&P 500 index is therefore -11% (-10% + 2% yield – 3%)  to +9% (+10% +2% yield – 3%) = -$220,000 to +$180,000.

2) Real estate crowdfunding. You can buy individual deals or you can invest in various types of funds. I invested in the RealtyShares equity fund that targets a 15% return. Given I never believe in any stated target returns, let’s cut that target investment to 10%. My expected return is $200,000 a year ($2M X 10%). But of course, the 13 investments in the fund might all end up losing money. Let’s say the potential loss is 5% or – $100,000. Therefore, the expected return range is -$100,000 to +$200,000.

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If you bake in the opportunity cost of losing a guaranteed 3% return on your $2M, the true expected return on my real estate crowdfunding investment is -8% (-5% + -3%) to +7% (+10% – 3%) = -$160,000 to +$140,000.

In other words, opportunity cost makes the downside loss even worse and the expected returns not as great.

Principal Appreciation Is Needed

The opportunity cost of not investing in a risk-free asset isn’t as impactful when asset prices are rising rapidly. However, as soon as interest rates start to rise and the pace of asset appreciation starts to slow, opportunity cost means everything.

When the 10-year bond yield was at 1.5%, the risk-free opportunity cost was insignificant. Investors preferred taking more risk for a potentially higher rate of return. But with the risk-free rate at ~3%, it’s finally starting to get more enticing to lower one’s risk profile.

10-year bond yield breaks 3% historical chart

The key is to amass enough capital to the point where taking excessive risk is no longer necessary. Think about a scenario where you have $10 million liquid to invest and could live happily on $250,000 a year in gross income. Why would you bother putting most of your $10 million in risky assets like stocks and real estate that could lose you millions, when you can earn $300,000 a year risk-free?

In such a scenario, I would invest 40% of the $10 million in risk-free treasury bonds, 30% in AAA municipal bonds, 20% in stocks, and 10% in alternative investments. Do this and you’ll lead a care-free happy life, which is what having money should provide.

In conclusion, opportunity cost is not just about lost guaranteed money, it’s also about lost time and happiness. The older and wealthier we are, the more we should care about the latter. After the age of 50, it no longer makes sense to hustle so hard because you already put in your dues.

Related:

The Average Net Worth For The Above Average Person

Why Real Estate Will Always Be More Attractive Than Stocks

Retire By A Certain Age, Not After Reaching A Certain Financial Amount

Investors, are you properly accounting for opportunity cost before making a large investment? Why don’t more people who splurge on items they don’t need realize the opportunity cost of not investing? Anybody who invested their money in the stock market or real estate market since 2010 have doubled or tripled their money.

Thanks to Wunder Capital for supporting the FS podcast.

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