Thursday, July 13, 2006
The Hidden Cost of Real Estate Investing
Any real estate transaction involves a hidden cost that only shrewd investors factor into their offers. If they didn’t, they wouldn’t be shrewd investors.
Investment is a term that refers to the money used to buy capital assets, including real capital assets such as land, houses and buildings. Real capital assets are a special type of consumer goods, in that they are not consumed instantaneously but, rather, they are used for accumulating future wealth. In fact, since this type of assets are non-productive by nature, their sole purpose to exist serves the accumulation of capital.
Clearly, without investment the accumulation of capital would be at a standstill, since one’s personal capital stock would gradually wear out. This is, in fact, one of the axioms of economics, since for economic growth to occur, new investment must be sufficient not only to add to the capital stock, but also to replace what amount of capital stock is wearing out. Hence, for investment to generate growth, the rate of capital accumulation must be always over and above the current rate of inflation, to make economic sense. Furthermore, the more money that is saved, i.e. that is not spent on consumption, the more money is available for investment.
Investment operates as a function – and as a direct and proximate cause and effect - of the equilibrium between income and interest rates. An increase in income will encourage higher investment, whereas a higher interest rate will discourage investment as it becomes costlier to borrow money. Even if an investor does not need financing and chooses to use his own funds, the interest rate represents one measure of the opportunity cost associated with the choice of investing those funds rather than putting them out to different uses.
Cost of opportunity is best described as the benefit or benefits forgone by investing capital stock in a certain way as opposed to the best alternative way. Given the innate scarcity of resources of investors, that is the limitation of capital available to them, investors will invariably try to maximize growth by, among other things, reducing costs. Suppose that an investor is willing to increase his investment so as to increase the accumulation of wealth. The investor will have to divert resources away from other purposes, to acquire a real or other capital asset. Therefore, the opportunity cost that the investor must bear is the loss of the gain(s) he would have received by investing the money elsewhere in the most valuable alternative.
Opportunity cost need not be assessed in monetary terms but, rather, it can be assessed in terms of anything that is of value to the person or persons doing the investing. The consideration of opportunity cost is one of the key differences between the concepts of economic cost and those of accounting cost. Assessing opportunity cost over a scale of values to investors 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 cost may produce the illusion that the benefits derived out of a certain course of action cost nothing at all. The unseen opportunity cost then becomes the hidden cost of that course of action.
It is important to note that opportunity cost is not the sum of all available alternatives, but it is instead the benefit that could have been derived by opting only for the best alternative. Thus, the opportunity cost to a real estate investor might be the benefit he forwent by not investing his capital into stocks, or in a different property, or not at all (as in the case of an investment resulting in a capital loss, for example). Although opportunity cost needs not to be expressed in monetary terms, the following practical example perhaps best describes the cost of opportunity to be borne by a typical real estate market participant.
Let’s assume that an investor is given the choice to buy one of three rental properties offered for sale. Property A costs $600,000 and yields a net annual rate of return of 7 percent. Property B is priced at $700,000 and has a net yield of 7.5 percent per annum. Property C is offered at $650,000 with a yearly capitalization rate of 7.75 percent. Our investor has $200,000 of his own for the down-payment, and qualifies to purchase any one of the foregoing three properties. Whatever he buys, his best option is to finance the deal with a 3-year term closed mortgage. The $200,000 are invested in a term deposit bearing interest paid semi-annually at the rate of 4 percent per year and accruing to the benefit of the investor . The investor decides to put in an offer to purchase Property C.
The factor in the determination of the hidden cost of opportunity in the foregoing example is that had the investor opted not to purchase any rental property and, in fact, had he decided not to do anything at all with his money, the term deposit would have yielded 12 percent in three years – the length of the term of the mortgage he is about to take on. By electing to go ahead with the purchase, he is now going to invest his $200,000 at the new net rate of return of 7.75 percent per year, equivalent to 23.25 percent in three years. Since $200,000 amounts to 30.77 percent approximately of the purchase price, the net yield attributable to the down-payment is going to be (23.25 x 30.77%) = 7.15 percent, so that his cost of opportunity spread out over three years will be 12 – 7.15 = 4.85 percent.
Hence, our clever investor will target a purchase price of a maximum of $618,475, say $618,000, to recover $31,525 over and above the standard negotiating discount, which is equivalent to the 4.85 percent opportunity cost on the purchase price of the acquisition (in this example assumed to be $650,000 - the asking price, for the sake of simplicity) spread out over three years.
Real Estate Chronicle