Opportunity cost is one of the most underappreciated concepts in economics, and yet it is fundamental to good decision-making. Whenever we choose to use our resources for one thing, we give up what we could have done with them instead. The opportunity cost of something is the cost of foregoing the opportunity of using the resources for something else. More specifically, the opportunity cost is measured as the value of the next best alternative that is foregone.
Despite its importance, it is surprisingly rare to see opportunity cost mentioned in the media, even in business or economics stories. So, it was a delight to see this recent article in the New Zealand Herald:
Financial adviser Niran Iswar says almost every rental property he’s ever owned has lost money – and he thinks more people are coming around to the idea that it’s not always a surefire way to make money.
Iswar, who is head of accounting, wealth and advisory at Float, said once he counted the rates, insurance, maintenance and the opportunity cost of money tied up in rental properties, every rental he had held had gone backwards, except one that worked because it was bought at the right time “which is luck dressed up as skill”.
When making a decision about how to invest their savings, an investor has many alternatives to choose from. Each alternative comes with an opportunity cost - the return they could have earned from the best of the other alternative investments. The economic cost of an alternative includes all of the explicit costs, as well as the opportunity cost. In the case of rental properties, Iswar notes the rates, insurance, and maintenance, as well as the opportunity cost of the savings tied up in the investment.
Iswar is essentially saying that, once you take the opportunity cost into account, the cost of investing in rental properties (including the opportunity cost) exceeds the benefits. That is what he means when he says that the rental properties "have gone backwards". The savings would have been better off invested in some other alternative. As an example, an investor might be attracted to a rental property investment that offers an annual net return of six percent, but fail to consider that an alternative investment of comparable risk offers eight percent. The opportunity cost of the rental property investment is eight percent return foregone from the other investment. So although the rental property earns a positive net return of six percent, relative to the next-best alternative it actually generates an economic loss of two percent. By investing in the rental property, the investor would give up an eight-percent return in order to earn six percent.
Now, there is one important caution to note. In the context of financial investments, a straight comparison of returns ignores the role of risk. Different investments come with different risks, and different investors will have different appetites for risk. So, where investments differ substantially in risk, it is their expected returns adjusted for risk that should be compared. Only where the alternatives have broadly similar risks is a more straightforward comparison of returns appropriate.
Finally, while opportunity cost is not often mentioned explicitly, I imagine that many investors are implicitly taking it into account. Anyone who weighs up alternative uses of their savings and chooses the alternative that offers the best risk-adjusted return is already thinking in terms of opportunity cost. But making the opportunity cost explicit is useful, because it reminds us that simply earning a positive net return doesn't necessarily mean that an investment is a good one. We need to consider what else could have been done with the savings instead. That is why it was refreshing to see opportunity cost brought to the fore in the New Zealand Herald story.
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