Tuesday, February 19, 2008

Economics 101: Opportunity Cost

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."

From Wikipedia:

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.

Example

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.

23 comments:

Mark said...

HA! Are you going to send the link to Chipman???

I doubt he'll get it even with the 101 course laid out. :-)

Warren said...

Good post. I'd also add in some consideration of taxes, especially if you are looking at rental income (full marginal rate) vs. capital gains, dividends, etc.

mohican said...

warren - in this example there are no tax implications because there is no income - it is a purely breakeven scenario. The interest paid and other costs eat up all of the rental income. There would be taxes payable on the downpayment funds but that can be mitigated to some degree. It would also largely depend on a person's marginal tax rate.

jesse said...

" '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.' "


Ah yes. But the argument goes even further. With real estate you can borrow against the value of the property itself so the payments are lower compared to something unsecured like margin accounts. And land has intrinsic value so prices cannot go to zero, unlike stocks. What would I say to this?

The other argument is that investing in RE gives you much more control compared to throwing money over the fence to some board of directors, aka the "driving without a steering wheel" argument made (im)famous by Rich Dad.

Warren said...

mohican,

Interest paid on a rental mortgage is tax deductible as well, like any business it "benefits" by not making as much income.

I understand there are many things to consider.

freako said...
This comment has been removed by the author.
freako said...

the payments are lower compared to something unsecured like margin accounts.

A margin account is secured against equities. The cost of borrowing using margin is quite low.

And land has intrinsic value so prices cannot go to zero, unlike stocks.

1. Who cares if it goes to zero? The change of a well diversified portfolio going to zero is nil.

2. If you are going to utilize the "magic" of leverate you can go FAR BELOW ZERO.

The other argument is that investing in RE gives you much more control compared to throwing money over the fence to some board of directors, aka the "driving without a steering wheel" argument made (im)famous by Rich Dad.

1. Such a factor would already by priced in. It can't keep on giving and giving and giving.

2. You really don't control your tenants, and given the difficulty of diversifying RE, I'd be far more worried about lack of control regarding a renter than a waywards CEO.

Siobhan said...

Land does NOT have an intrinsic value. The value of land can go down to zero and even negative. Two examples come to mind "leaky condos" and contaminated sites.

The improvements have an intrinsic value as they can provide rental income.

Vacant residential land does not have a rental income and therefore has no intrinsic value.

condohype said...

Excellent post Mohican. What I find so astounding is that so many people think like the person in your story. They think a 4.5% return is crap and make fun of people like me for putting my cash into GICs. Meanwhile, their "investment" condos yield 2% at best and involve huge risk.

Tim said...

I don't disagree with much of your post, but I can't agree with you either.

A margin account is secured against equities. The cost of borrowing using margin is quite low.

Ouch! Low compared to what? a loan shark? Margins is far from ideal, which is why most investors won't touch it unless if they are absolutely certain. In fact, most investors - in order to ekke out 10% gain, will only use roughly 50% of their cash and make 20% for the year. They use cash as a diversifying mechanism. Not only is margins borrowing not 'low', it also involves far more risk. 'secured against equities'... I trust you mean besides a margin call? If you leverage 2:1, your stocks have to fall 50% for you to lose everything. (Over the last 2 months, Goog and AAPL recently fell by 30% to put things in perspective). If you are able to find a brokerage to leverage even higher, such as 4:1, you only need to lose 25% to get the call. Everything.

When borrowing against RE, you're effectively leveraging up to 10:1. Imagine if your house gets devalued by 10% and the bank gives you a margin call. That just doesn't happen. RE is far less risk.

Once you bring leverage back into the picture, it completely throws off half of your post.

As for a diversified portfolio, ... what you say is correct, but diversifying is a way to reduce risk, not make fast money. Diversifying *reduces* your earnings!

freako said...

Ouch! Low compared to what? a loan shark?

TD Waterhouse (for example)charges 6.75% on margin loans. Not bad at all.

Not only is margins borrowing not 'low', it also involves far more risk.

Yes, that would be the infamous flip side of leverage, which is totally beside the point.

In fact, most investors - in order to ekke out 10% gain, will only use roughly 50% of their cash and make 20% for the year.

No idea what you mean by this.


I trust you mean besides a margin call? If you leverage 2:1, your stocks have to fall 50% for you to lose everything.

Again, what is your point? As in your own example, 10% down home buyers loses all his equity if prices go down 10%. An investor can buy Google on full margin, or he can drink himself to death. Another investor may use the margin borrowing to DIVERSIFY his portfolio and actualy LOWER his risk. The choice is there, that is the point. Don't automatically assume the worst.

Imagine if your house gets devalued by 10% and the bank gives you a margin

Do you have a fixation on margin calls? Why do you automatically assume that the investor is a risk seeking moron who puts all his eggs in one basket? Leverage of any kind can be used to amplify risk to dangerous levels. And you don't think people lose their homes?

The fact is that over the long haul, unlevered RE has lower risk/return than equities. Reasonable levered RE has similar risk-return to unlevered equities. Similar Sharpe ratios, as market efficiency would predict.

As for a diversified portfolio, ... what you say is correct, but diversifying is a way to reduce risk, not make fast money. Diversifying *reduces* your earnings!

WTF are you talking about? Diversifying does in no way or form reduce your earnings. It is a FREE improvement in risk adjusted returns. You completely misunderstand the relationship between risk and return. Diversification will allow me to earn a higher return for the same risk, or less risk for the same return. Leverage is the tool used to choose between these two alternatives.

Leverage and diversification are tools. Tools are great, but if misused they can hurt you. The underlying asset class is really irrelevant.

patriotz said...

you really don't control your tenants

You also don't control:

1. The neighbours.
2. The condo association (if applicable).
3. Local zoning.
4. Traffic
5. Crime

Etcetera.

If you have stocks and aren't happy with the way a company is being run, you can move your money to another company for grand sum of $20 (plus capital gains taxes if you're ahead), just by sitting at your keyboard. Compare with unloading RE , especially if it's tenanted.

patriotz said...

I will also add in defense of RE that it's safer to leverage than stocks because the earnings are much more predictable. I.E. rents are much less volatile than corporate earnings and usually hold up in nominal terms even in a recession.

This means BTW that RE prices ought to be a lot less volatile than stock prices, in aggregate. That they aren't is testimony to the amount of dumb money chasing RE.

But that's only an argument in favour of leveraging if the fundamentals make sense, i.e. the yield exceeds the cost of borrowing.

Clarke said...

Another great post Mohican. I remember years back in my first econ class at university. Half the class did not even comprehend opportunity cost. As that was the first thing that was covered, this was not a good sign......

Do you really get a lot of potential clients that are that dense? In your little scenario, you pretty much move through the numbers painstakingly. One would assume a light bulb would click with most people.

Radley77 said...

I find it interesting that tim would point out that AAPL and GOOG fell by 30% over the past two months without pointing to the reasons why it fell. With P/E multiples into the 30's or more, earnings would need to double or triple for these companies to be a good buy. It's no big surpise, to a savvy investor, that these companies corrected, especially with the uncertainty that a US recession will bring to earnings.

As for real estate, earnings or rent would have to grow significantly to be a competitive investment with safe investments like bonds or GIC's. I would argue that real estate returns should be close to the cost of money (roughly 6% as a fair valuation) for it to be worthwhile to invest in.

It's safe to say that real estate in Vancouver is in speculative territory, not unlike GOOG or AAPL. Year over year sales are down by 40% for February in Calgary, and inventory is approaching triple last February.

For Calgary, the supply/demand balance has shifted dramatically, and furthermore price/rent ratios do not make it a worthwhile investment. e.g. Buyer's have no economic incentive to buy, irregardless of supply/demand.

Vancouver should be taking note.

Fencesitter said...

Tim: "Imagine if your house gets devalued by 10% and the bank gives you a margin call"

This essentially does happen, just at longer intervals.

If you have negative equity in your house when your mortgage comes due for renewal, good luck having your lender renew without question.

People seems to forget this, especially with the shorter 2yr-3yr mortgage terms. It doesn't take much of a downturn to wipe out the 5%-10% down crowd.

Radley77 said...

Also, I agree that real estate has the "potential" to be a good investment. That said, I won't be looking to buy anytime soon, until there is valuations that are closer to the long term trend (Better rates of return, and less risk).

I think the only thing that has changed dramatically in the past couple years is people's propensity to get into debt. Household income and rent has certainly not increased to the same degree.

mohican said...

Clarke said: "Do you really get a lot of potential clients that are that dense? In your little scenario, you pretty much move through the numbers painstakingly. One would assume a light bulb would click with most people."

In short, yes I have had nearly this same conversation with more people than I care to remember and it tends to go the same direction every time. In the end we agree to disagree and many times, fortunately for them, they are unable to follow through on their desire to purchase the property for whatever reason. Personal anecdotes of brother / fathers / wive's co-workers / etc making bucket loads of 'imagined equity' just proves to be too much for most people to overcome with logic. The rational argument is sound but the emotions involved with a personal story outweigh the reason for most people. I have tried telling stories of people in other places or times losing their shirts but it always comes back to the cliche "it's different here" argument. I subsequently lose any hope for the person I'm talking to and give up. I'm not here to convince everyone, just the ones who are smart enough to listen and think it through.

jesse said...

"If you have negative equity in your house when your mortgage comes due for renewal, good luck having your lender renew without question."

The so-called walking dead. Good callout -- that's one thing not talked a lot about in the US because loans down south are typically made with longer terms. In Canada the renewal times are frequent (<= 5 years) and this changes the game.

It means in Canada banks will spend significant resources re-working terms of many many borrowers (if rates rise or property values decline), not just delinquent buyers like in the US.

What do banks do when mortgages need to be renewed but property values have decreased to force many into negative equity? Keep the millstone attached I would presume.

Jordan said...

Mohican this is a fantastic post. I honestly think you should take this "typical story", cut it down a bit in length, and submit it to the local newspapers (Province, Sun, Georgia Straight maybe?) as an editorial. I think it's that good, and that important that more people could get a little dose of reality. In fact you should try and do the same with your Uberpost.

patriotz said...

What do banks do when mortgages need to be renewed but property values have decreased to force many into negative equity?

Such mortgages would have been insured at the outset, except for low-ratio mortgages which are an endangered species anyway. And if values fall enough to make low-ratio mortgages underwater we're looking at something truly ugly no matter what.

SO the real question here is does the mortgage insurance stay in place unconditionally across term renewals, or does it have to be renewed too.

If the latter, it's really CMHC's call as whether to continue holding the bag.

Don't know the answer because I've never taken out an insured mortgage. :-)

M- said...

Patriotz: my last mortgage was a low-ratio mortgage.

For high-ratio mortgages:
(1) you pay the insurance fee when you sign up for the mortgage.
(2) presumably, you can get your ratio low enough during your first 5 years so that you don't have to pay insurance again.
(3) if your LTV ratio is still high, you need to pay the insurance fee again when you renew.

Now, if the home is underwater-- mortgage owing greater than the value, it's questionable/doubtful that CMHC will be willing to sell insurance.

I think most move-up buyers these days have low-ratio, uninsured mortgages. Most new entrants (without major family support) will be on high-ratio insured mortgages.

It'll be interesting to see how ugly it gets.

patriotz said...

(2) presumably, you can get your ratio low enough during your first 5 years so that you don't have to pay insurance again.

Because RE always goes up, right? :-)

(3) if your LTV ratio is still high, you need to pay the insurance fee again when you renew.

Ouch. We're really looking at something unprecedented here, since we've never seen the combination of inflated valuations over a period of years, low/no down payments, and 40 year amortizations that we have today.