Opportunity Cost and Renting

Opportunity Cost and Renting

This is a real estate blog, and for the most part, real estate decisions are about buying, but there are situations in which I’d much rather be a renter than a buyer because the renter is treated better. Chances are, it happens more often than you think. Knowing when, why, and how that happens will help you make better deals as both a landlord and as a tenant.

At the very core of rental real estate is the concept of opportunity cost and the management thereof. Most people, if they had unlimited funds, when faced with the decision of whether to rent or to buy would choose to buy because it allows them more liberties when deciding what to do with the property. Most people don’t have unlimited funds though, and for them, spending their money one place means they can’t spend it on something else. That something else that they don’t spend the money on is called the “opportunity cost” of the thing that they DO buy.

All cost is an opportunity cost, and opportunity cost is the reason for a rental real estate. Just like renting a book, a movie, a lawnmower, or a car, renters rent real estate so that they can avoid buying it because buying it comes at a high opportunity cost. For the sake of argument, let’s say that a hypothetical renter had the cash to purchase, if they should choose to do so, a house for $500,000 and not enough cash to purchase anything else. For simplicity, cash is the only way they can purchase real estate in this example. At the same time, the US Treasury is selling bonds for a 6% return. The renter is thinking about buying one of the two, and so first thinks about buying the house. Well, they’ll have taxes to deal with, insurance, maintenance, and all the trouble that must be gone too when the home is actually being bought (then again if they decide to sell!). They estimate that after going to all of this trouble to live in the house for a year they’ll spend about $1,000/mo. Buying the bond though is totally different, they’ll simply pay $500,000 and get a half percent payment each month, or $2,500/mo, but they’ll also have to rent so that they have a place to live. Let’s suppose they are able to negotiate a contract with the current owner of the house to rent it instead for $2,000/mo. Now let’s compare the two options.

Buy the house: -$1,000/mo

Buy the bond and rent the house: $2,500/mo – $2,000/mo = $500/mo

It seems clear that in that case, renting is better financially for the renter because of the opportunity cost of buying the house, which is passing up on the 6% bond which would make them such nice cash flow.

I know I made many assumptions through the course of that example, but there are many markets where the purchase prices, other opportunities (such as the bond), and rent rates are exactly like that and the best option is to rent. It occurs most frequently in cities where rents are apparently quite high, such as New York, San Francisco, Austin, Vancouver, Sydney. In these places, typically the real estate prices rise much faster than the rents and the opportunity cost of buying real estate becomes high enough to favor renters. A sharp investor could easily find contracts to rent a flat in downtown New York for much less than they could make on a monthly basis by investing the amount of money it would take to buy the space. They may live in New York and buy apartments in Memphis or trade the stock market, and the more skilled they are, the bigger the opportunity cost for them and the more likely they are to be well served by renting.

So don’t just assume that if you can buy that you should buy. Think about what your alternatives are, and which ones you might have to give up if you purchased a piece of real estate. Are they worth it?

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