How To Calculate Opportunity Cost

Key Takeaways


There will always be deals you have to pass up as an investor, even in a perfect world. After all, there are only so many hours in the day. But have you ever wondered exactly how to tell which deals will have the most significant impact on your portfolio? The answer to this dilemma lies in learning how to calculate opportunity cost.

No matter where you are in your investing career, opportunity cost can help you develop your deal analyzing skills even further. That way, you know exactly how to choose a good deal — and how to walk away in favor of an even better one. Keep reading to learn more about opportunity cost and how it can help your real estate investing business.

What Is Opportunity Cost?

Opportunity cost is the benefit an individual loses when choosing one option over another. The term is most frequently used in economic contexts, though it is also applied to finance and investments. The purpose of opportunity cost is to learn how to decide between two alternatives by looking at potential outcomes.

Opportunity cost requires looking at each of the benefits an option could provide before comparing the two. For investors, calculating opportunity cost typically involves looking at the profit potential of one investment over another. However, it is not always that straightforward. When it comes to some investment decisions, opportunity cost could push you to consider any positive components of a deal (time, involvement, cost, proximity, etc.) — and ultimately decide if they are worth missing out on when compared to another deal.


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what is opportunity cost

How Does Opportunity Cost Work?

Opportunity cost works by allowing investors to estimate the potential outcome of two different decisions and select the one with the most promising outcome. When it comes to real estate, this typically means analyzing the potential of a given property. For example, you could look at the projected cash flow of an investment and compare it to another.

There are some limitations associated with opportunity cost to be aware of. This calculation relies heavily on your ability to estimate the future performance of different investments. As you might have guessed, this can be easier said than done. I recommend familiarizing yourself with a good real estate investment calculator so you can make your estimates as accurate as possible.

Opportunity Cost Formula

Learning how to calculate opportunity cost is simple enough, it’s predicting the outcomes of each option that will be more challenging for investors. Here is the formula for opportunity cost:

Opportunity Cost = Return on Option 1- Return on Option 2

The above formula would tell you the opportunity cost for not choosing option 1. It could easily be reversed to show the opportunity cost of option 2. Reading through an example below will help illustrate this.

Opportunity Cost Example

There are examples of opportunity cost everywhere you look, but most people aren’t thinking in terms of missed opportunities in their day to day lives. Anytime you make a decision, there is some opportunity cost involved.

Let’s say Alex has been running her own business for about a year. She is starting to gain momentum but has been considering going back to school to improve her skills. One option is for Alex to pursue a Masters of Business and Finance. The other option is to spend the next two years continuing to build her business.

In this scenario, the benefit of going back to school is the level of education it could provide, plus the value of any extra business she could generate with her new credentials. However, going back to school would mean putting her business on hold for two years. The opportunity cost of getting her Masters would be the value of any income her business might have gained during that time, minus her degree’s potential value.

Opportunity Cost Vs. Sunk Cost

Both opportunity cost and sunk cost are used to evaluate certain investment decisions, though they look at completely different things. A sunk cost refers to any money that has been spent and cannot be returned. Opportunity cost instead looks at an entire missed opportunity — and relies more on predictions than actual numbers.

If you spent $2,000 on a new computer for your real estate business, that money would be a sunk cost. The opportunity cost of that $2,000 would require you to look at where else that money could have been spent. For example, if you gave up renting office space to buy the computer, you would lose that office’s benefits in favor of the new tech.

Opportunity Cost Vs. Risk

Risk is another factor used to evaluate investment opportunities, though, in practice, it is also quite different from opportunity cost. In most cases, risk refers to the potential losses associated with an investment decision. For example, if you were to spend $10,000 buying stocks, you would risk losing some if not all of those funds if the company were to perform worse than expected. When evaluating risk, consider how much money you could potentially lose by making that investment decision. On the other hand, opportunity cost will ask what you missed out on by making that investment.

opportunity cost definition

How To Find Opportunity Cost In Real Estate

Real estate investors are constantly using opportunity cost to build their portfolios, whether they call it that or not. Think about any time when you toured more than one property before buying it, met with more than one lender before financing, or even debated using a property manager or not. In each of these situations, you likely evaluated all possible outcomes before choosing the one that made the most sense for your real estate business. All of these are times you likely thought about opportunity cost.

That being said, the ability to fully integrate the opportunity cost formula into your real estate calculations will depend on a few factors. First, you need to have a reliable deal analyzer before you start comparing investments. Depending on your investment strategy, you need to calculate ARV, rental income, cash flow, and more. These will help you to accurately estimate the opportunity of each investment.

As you begin comparing opportunities, it is also important to consider other factors. Learning how to calculate opportunity cost not only involves numbers but also takes social or even economic factors into consideration. When using opportunity cost, you will need to consider certain effects that might not be represented in numbers or formulas. An example could be if you are presented with two properties with similar returns, but one allows you to expand your reach in a particular market. That property could represent a better opportunity because of its location — something that you may not be able to immediately put a price on.

Real Estate Opportunity Cost Examples

There are examples of opportunity cost all over the real estate industry. Here are a few common scenarios you may encounter:

  • Real Estate Vs. Other Investments: Many people get stuck when deciding what type of investment they should make. A common example of this is choosing whether to invest in real estate vs. stocks. By looking at the opportunity cost associated with each investment, you can get a better idea of which type is right for you.

  • Short Term Vs. Long Term Rentals: If you want to own a passive income property, you will need to decide if you want to operate as a short or long term rental. If you live in a popular tourist destination, short term rentals can be highly lucrative. However, they will require more time and work to manage. A long term rental would most likely be easier, though you risk losing some of the profit potential.

  • One Market Vs. Another Market: Location is everything in real estate, but sometimes it can be hard to predict how areas will perform. Always research market factors before investing and look for signals that real estate might appreciate. There will always be an opportunity cost associated with choosing one area over another; however, you can use data to your advantage and work in a growing market.

Summary

There are so many ways to evaluate a real estate investment deal — but perhaps none is more helpful than learning how to calculate opportunity cost. This process gets at the baseline of what makes a good investment, and when used correctly can guide your entire real estate portfolio. By incorporating this formula into your day-to-day, you can learn to trust your gut and have confidence in each investment you make.

Did this guide help you understand how to find opportunity cost? Leave any additional questions in the comments below!


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