I have had many discussions with people about how to evaluate the potential purchase of a home and it never fails that the discussion comes around to something like this:
Person: "I'd like to buy a rental property."
Mohican: "Make sure you are buying something that costs less than the rent you will generate."
Person: "I have done the math and if I put 20% down ($100,000) I can buy a house with a basement suite and the rent ($2200/mo) will carry the mortgage ($2200/mo)."
Mohican: "Really, that sounds interesting. Have you factored in taxes, insurance, maintenance, and any unexpected loss of income ($500 / month+)? Additionally, have you factored in the loss of income from your downpayment ($400 / month+)?"
Person: "Hmmmm . . . . I guess I'd have to pay the property taxes and stuff but the house will always go up in value so if I get stuck and can't make those payments I can just sell it."
Mohican: "What about the downpayment? How much could you earn on that every month if you invested it?"
Person: "The money is in a savings account right now and I don't know how much it earns, I think it is 4%."
Mohican: "My suggestion is that you have a look at your math again and assume that you don't have a downpayment. Would this potential purchase look as attractive with 100% financing? Additionally, I suggest that you find a property where the rent will cover ALL of the expenses, including taxes, insurance, maintenance and a buffer for lost income."
Person: "But that is impossible. No property is that cheap."
Mohican: "No property in Vancouver currently has those characteristics but that hasn't always been true nor will it always be true and Vancouver isn't the only place to invest. You are considering purchasing a $500,000 property which yields approximately 4%. This is the same yield as your savings account but with much more risk than a savings account. If I were looking at the same property I would only be willing to pay $330,000 for it, which would give it a yield of about 6%. This increased yield would compensate me for the risks I am taking on by owning the property and for an adequate return on my downpayment."
Person: "But real estate is so powerful because of the leverage component. You are ignoring that."
Mohican: "Yes, I am ignoring it because I can use leverage with all sorts of investments including dividend paying stocks and income trusts where the cash flow would cover my borrowing costs. So to be fair we should evaluate all investments without leverage first so we have a fair comparison and so the investments stand on their own merit."
Person: "I don't understand."
Mohican: "Let's assume we can find a property that yields 4%, which you have done. The price to earnings ratio of that property is 25. We can find a stock with a lower price to earnings ratio that also pays a large enough dividend to pay for our borrowing costs. An initial screen produces dozens of companies that meet these characteristics so based on that we should not purchase the property but the stocks instead."
Person: "But my brother lost his shirt in the stock market and he's made tons of money flipping houses. He owns 5 properties right now and he is buying more all the time."
Mohican: "It sounds like your brother is a speculator/gambler and he'll probably lose his shirt in real estate too. He may have made some money recently but that is no garauntee that the profits will continue. If you are buying for cash flow you should consider the metrics I have put forward but if you are buying for capital gains I can't help you evaluate the investment merits because there are none."
Person: "But real estate always goes up."
Mohican: "No it doesn't. If you are naive enough to believe that you deserve to lose money. Go do some more homework and investigation if you want to be a professional investor. Ameteurs jump in without doing their homework, professionals know all of the knowable facts before jumping in."
Person: "That sounds like work, I think I'll just buy the property."
Mohican: "See you later."
Opportunity cost is the loss of potential gain from the best alternative to any choice. Thus, opportunity cost is the cost of pursuing one choice instead of another. Every action has an opportunity cost. For example, someone who invests $10,000 in a stock denies oneself the interest that one can easily earn by leaving the $10,000 dollars in a bank account instead. Opportunity cost is not restricted to monetary or financial costs: lost time, pleasure or any other benefit that provides utility should also be considered.
Opportunity cost is a key concept in economics because it implies the choice between desirable, yet mutually-exclusive results.
If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of some other thing which might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it were not taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty (and are sometimes called "hidden costs" or "hidden losses", what has been prevented from being produced cannot be seen or known). Even the possibility of inaction is a lost opportunity (in this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns).
It can also apply to time; one might use a limited vacation time to travel to a place of cultural enrichment or to do household improvements. Thus the two-week road trip might preclude repairing or painting one's house that year. To the vast majority of people, time has value.
Evaluating opportunity cost
Opportunity cost needs not be assessed in monetary terms, but rather can be assessed in terms of anything which is of value to the person or persons doing the assessing (or those affected by the outcome). For example, a person who chooses to watch, or to record, a television program cannot watch (or record) any other at the same time. (The rule still applies if the recording device can simultaneously record multiple programs; there is going to be a limit, and if the number of desired programs exceeds the capacity of the recorder, some of them will not be saved, and thus cannot be seen.) In any case, at the time the person chooses to watch a program, either live or on a recording, they cannot watch something else, and if they are not able to record another program showing at the same time, the opportunity to view it is lost (presuming the particular program is not repeated). Or as another example, someone having a video game can choose to watch a program or play the video game on the TV; they can't do both simultaneously. Whichever one they choose is a lost opportunity to experience the other. Or for that matter, a lost opportunity to engage in some other activity entirely (exercising outdoors, or visiting with family or friends, as merely two examples).
The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.
Note that opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land, or the loss of any of the various other possible uses—but not all of these in aggregate, because the land cannot be used for more than one of these purposes.
However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money.
In some cases it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier. In microeconomic models this is unusual, because individuals are assumed to maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.