Opportunity Cost
The definition of an Opportunity Cost is the loss of potential gain from other alternatives when one alternative is chosen. I try to think of this economic principle daily. If something is “working” and is on autopilot making a profit, then I blot it out of my mind. But what am I missing out on if I chose a different alternative? Maybe what was a great opportunity at one point in my life doesn’t fit my current goals or isn’t generating it’s full income potential.
For example, I purchased a long term rental house six years ago. I put roughly $25k down and it consistently generates $8k a year. This is a 32% cash on cash return. This is a great return for a property that is professionally managed and I barely have to think about. I might as well just let it stay on autopilot and collect my $8k yearly, only having to answer a random email from my manager about a larger maintenance issue or tenant turnover, right?
Well, let’s look at the opportunity cost. I purchased at a low price for the date of purchase and the market has appreciated significantly over the past six years. I now have $100k in equity in the property after I sell it and pay closing costs and commissions. With $100k in equity just sitting there not working for me, I’m essentially getting $8k yearly on $100k of equity. Now my 32% return is looking like an 8% return. Eight percent is still good, and beats the stock market/money market/etc, but if I could get a 32% return on the $100k of equity, that would be $32k yearly instead of $8k yearly!
My current goals are to be as passive as possible, so I won’t take this $100k and invest in another long term rental that needs work, instead, I’ll end up placing some of it with a local investor at a 12% annual return or lend some of it out personally to a local flipper for a quick return.
What investment vehicles in your life need to be analyzed again to find a better alternative that will generate more income or better align with your goals?
Deeper Detail:
I purchased this property six years ago. The market in that area was on the rise, but you could still find good deals if you were willing to get creative. The house was owned by an elderly lady who was going into a nursing home. The house, though dated, was in great shape. A local non-profit had come in and redid a lot of electrical wiring, installed a new roof, installed replacement windows, and replaced old water lines with new. People were turned off by the house because there was an old distressed single wide trailer at the rear of the property. I was able to negotiate a price below asking. For the house, there was a finished room on the lower level that had no access to the rest of the house and the access to the house was awkward. We put an entryway into the lower level, added a staircase, and moved some things around to add the finished room to the rest of the house. This turned the house from a two bedroom to a three, making it have more value and commanding more rent. As for the trailer that no one wanted, I spent around $5k and used my own manual labor to remodel. It had great bones, it just needed some minor repairs and refreshing. I paid around $125k for the entire property. The house rented for $1,200 and the trailer for $750.
After a few years of ownership, I refinanced the mortgage and pulled out around $40k of cash. I took this cash and purchased a short term rental in Boone, NC. Currently, this asset makes around $8k yearly. So once I sell the original property, I’ll be left with a short term rental plus $100k in cash for “free”.