What is 'opportunity cost'? Investment terms explained
‘Opportunity cost’ is a buzz phrase when it comes to property and investing generally, and you’d be wise to understand the concept before even thinking about purchasing.
Every time you do or do not buy, you are potentially stopping yourself from buying something else. If that “something else” is a better investment, then you’ve missed that opportunity. That’s your ‘opportunity cost’. It’s the ‘cost’ of money you could have had by making a different choice.
Of course, hindsight is 20/20, and there will likely always be a better choice that could have been made. There will always be some degree of the unknown – and the fact is, you can never 100% accurately know what the cost of missing that opportunity was. However, it is something you should bear in mind particularly when funds are limited and the property you purchase has a lot riding on it. The point is, you want to be comparing the possibilities to try and make the best choice you can with the information available.
You can consider ‘opportunity cost’ alike to ‘missed opportunities’. Not all of them are particularly measurable. You also don’t be beating yourself up over missed opportunities, but do learn from past mistakes if, indeed, you should have known better.
RentCover’s Sharon Fox-Slater put ‘opportunity cost’ as the number one risk first time buyers need to overcome.
"Property investment can be financially rewarding but it’s usually negatively geared, at least to begin with, reducing your opportunity to invest in other asset classes or different properties," she said.
"Can you argue the merits of a property you are considering buying over others in the marketplace and over other types of investment?"
Opportunity cost is also worth thinking about when it comes to tying your money up for a period of time – such as in an off the plan property, or in a block of land that doesn’t provide you any rental return and has uncertain growth. While some people can afford to speculate on certain properties, or to put money into investments others consider unwise, not everyone has this luxury.
For each person opportunity cost looks different as not everyone is able to seize every opportunity. For instance, those with plenty in the bank and with high serviceability may not miss out on a rare purchase if some cash is tied up in a property that hasn’t seen any equity growth. However, someone else may need to step away from that dwelling due to having no funds left or hitting a serviceability wall.
It doesn’t just relate to property either. Any investment, of your money or your time or another resource, can be seen as opportunity cost. It’s a regularly used term in economics as well.
How can you be aware of opportunity cost?
There are, sadly, no hard and fast rules. However, there are several things you can do with every purchase you’re considering to determine what the outcome may be.
Take a step back and think unemotionally about the purchase
Ask yourself – why am I considering this property? What is the purpose of it? How does it fit into my portfolio?
Understand how it is likely to perform and why
If you’re looking for a growth asset, and this is a high yielding property in an area said to have slow growth, then you might want to re-think your purchase. Make sure you know what performance is expected (this is where research and expert advice can be useful).
Consider the implications for if the property underperforms
It’s always likely that a property will not perform to your best expectations. Know what the worst case scenario is and how this will affect you. If you can’t find a tenant, or it doesn’t grow in value, what will this do to your finances? Knowing this will help you plan and mitigate the risks as well as assess how likely these things are to occur.
How does it compare?
Comparing your property to others within your price range, as well as comparing it to what will happen if you do not purchase at all, is an important part of reasoning out the investment. If you are in a better financial situation in the long run, when considering potential growth and outgoings, then it may be worth asking yourself why you’re buying this particular property.
How do you assess opportunity cost when considering an investment?