What do you figure for 'Opportunity Cost' of you money?

Question

Hello,

I am not sure if this is the right forum for this, but it seemed like the most logical one.

As I run numbers to see if a property is a 'good investment', I often find myself wondering 'what could my money be doing otherwise'. Of course there are MANY different ways of thinking about this.

The properties we have bought within our SDIRAs and are looking for more of are: buy and hold rentals that are fairly low maintenance, bought at least 30% below assessed value (estates or foreclosures), generate at least a 1 1/2% per month income, and would be leveraged at a maximum of 50% (non-recourse loan inside of IRA), and should have less than 10% vacancy. I see this is a pretty safe investment from a stability and low chance of negative returns standpoint.

In my analysis, I think along the lines of say "what would a semi-conservative 
	 mutual fund that had a similar risk factor return on average"? Maybe 8%?

I am projecting the rental to make from about 9% - 18% depending on leverage, appreciation, repairs (figuring 15% of rent income). Lets say it might average 12-14%. I then think "Is the work worth the extra 4-6% return."?

Within a year hopefully I will be freeing up about 80K-100K in non IRA funds that I also plan to invest in real estate, and the returns look MUCH better with a higher leverage ratio!

Thoughts on 'analyzing investment options' and how you approach this issue?

Thanks, Dan Dietz

Ellis San Jose · Answer

If I can achieve 12%-15% note investment without the joys & pleasures of property management, plus the associated risk of  owning property, I usually opt for notes.

If owning a property has a superior return then I considered going that route.

I have a tough time using mutual fund returns as a comparison because they can be incredibly variable & I have no influence over the value or income. Plus, stock market crashes are no fun.

J Scott · Answer

If you can find a mutual fund that returns a compounded 8% long-term (independent of load/fees) and without much risk, I would take that over real estate investments at 12-14%.

That said, I'm skeptical about the 8% number...

Brian Adams · Answer

Keeping Bill Gulley well spoken caveats in mind, the annual average of the Dow Jones from its 1929 pre-Depression zenith to today (sort of a worst case scenario) is a 4.42% annual return.  That is a pretty good floor for a long hold that requires exactly zero personal effort.  The SPDR Dow Jones ETF (DIA), initiated January 1998, has had an average annual return of 6.58%.  Considering that 1998 was still in the era of irrational exuberance, and today is not, that seems like a conservative floor, still.

I don't think there is anything wrong with using 8% as an opportunity cost, nor is expecting that much from a long hold in an index ETF.

Dan Brewer · Answer

Interesting topic.  I have been in real estate investment property lending for over 10 years, and firmly believe the cap rates on investment properties are difficult to hit, particularly for the average rental property owner.  If your sharp and a detail-oriented person, they can be achieved.  But property ownership is not for everyone.

Will Barnard · Answer

Great question, but as others pointed out, comparing RE with mutual funds is apples to oranges. Very difficult to compare.

There are a number of benefits to RE that mutual funds do not offer for the most part. Leverage is a key factor as are tax benefits. Then the usual cash flow, plus appreciation, plus amortization paid by the tenants. That generates multiple income streams from one investment. In comparison, the mutual fund has only the appreciation. Of course some stock investments deliver both appreciation and dividends (which you could call cash flow), but that hardly compares to RE. I would take the RE at 12% cash flow return over the 8% mutual fund because of many reasons. The 4% increase is well worth the more active ness of the investment because the 4% is greatly increased by the added income of appreciation, tax benefits, amortization, and leverage abilities. For me, it is no contest and I believe the RE investment can be "controlled" opposed to the mutual fund which is entirely out of your control.

Brian Adams · Answer

@J  Scott - I'm afraid I don't know.  I got the 6.58% from:

https://www.spdrs.com/product/fund.seam?ticker=dia

My own calculations of the DJIA annual growth between January 1998 and today is 4.14%.  Between 01/20/98 and 08/27/12, I calculated 3.5% annual DJIA growth.  The SPDR fund pays dividends, 2.35%, which I guess roughly makes up the difference between 6.58% and 4.14%.

I don't pretend to be really knowledgeable about stocks - not at all.  But this is how I have evaluated my own investments and opportunity costs with the use of my excel file that annualizes returns.  Not sure how others would go about analyzing and evaluating opportunity costs, but wanted to jump in the conversation.

J Scott · Answer

Any idea what the 6.58% number would be if you had written this post 1 year ago?

Bill Gulley · Answer

Opportunity costs should be viewed as like investments, with similar risk, capital requirement, maturity and management requirements. RE compared to other RE, muni-bonds with muni-bonds, then selecting the best use of funds.

In RE, being in the business of RE will have other incentives simply by staying in and dealing in that specialty beyond what you might measure financially. Good will of the company, name recognition, another successful project for lenders or investors in seeing your track record, the intrinsic values of promoting yourself. Are you an "investor" that goes with anything at the time that make a buck or are you a RE operator/investor as a profession?

Nothing less than 12% hit at 15%, on bricks and mortar.

I would not compare RE to any mutual fund as it's not a like investment, I'd take 8/9% on a MF, where is a good one? :)

Therese V. · Answer

This is a great question~ I've often thought about this and would love to see what others think!

What do you figure for 'Opportunity Cost' of you money?

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