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Return on investment

Hi,

For a real estate case, purchase with mortgage, basic P=R-C structure;

Revenues: Rent revenue & increase in the estate value

Costs: Downpayment & cost of the invested capital.

Here, don't we need to calculate the opportunity cost too in the cost bucket? Since if you didn't invest this money but instead land it to a bank you'd have received an interest which you can't get when you buy the house. So should the opportunity cost be added to the costs?

Hi,

For a real estate case, purchase with mortgage, basic P=R-C structure;

Revenues: Rent revenue & increase in the estate value

Costs: Downpayment & cost of the invested capital.

Here, don't we need to calculate the opportunity cost too in the cost bucket? Since if you didn't invest this money but instead land it to a bank you'd have received an interest which you can't get when you buy the house. So should the opportunity cost be added to the costs?

3 answers

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Best Answer

Opportunity cost is an Economic Cost (used in an economic perspective to arrive at decisions)
Economic costs differ from Accounting Costs (which are reported on PnL and Balance Sheet statements)

Thus, for a real estate project, you calculate the accounting costs and accounting revenues and calculate NPV(or IRR) for the project. The risk and time value of the project is captured in the discount rates and the income from the the project is converted to cash flow for the project.

Thereafter, you look at alternate projects (where you could have allocated your capital) and calculate their NPVs and IRRs. Its best to choose projects with the highest NPV unless there some very strategic considerations or constraints (issues not captured by your numerical analysis) that preventing you from doing so.

Opportunity cost is an Economic Cost (used in an economic perspective to arrive at decisions)
Economic costs differ from Accounting Costs (which are reported on PnL and Balance Sheet statements)

Thus, for a real estate project, you calculate the accounting costs and accounting revenues and calculate NPV(or IRR) for the project. The risk and time value of the project is captured in the discount rates and the income from the the project is converted to cash flow for the project.

Thereafter, you look at alternate projects (where you could have allocated your capital) and calculate their NPVs and IRRs. Its best to choose projects with the highest NPV unless there some very strategic considerations or constraints (issues not captured by your numerical analysis) that preventing you from doing so.

It would say it depends on your problem statement:

Scenario 1: given your financial position and mortgage agreement, is buying a house a financially viable solution? --> calculate ROI. Positive ROI is good, negative ROI is bad. Forget about opportunity cost.

Scenario 2: you consider whether to buy or rent a house and have 200k in your bank account at 3% p.a. you will need additional 300k to buy a house or you can rent it for 1.5k a month. --> calculate financials for both alternatives and compare ROI. Here: when buying a house you need to clear your bank account and basically lose 6k p.a. (=3%)which constitutes your opportunity cost from buying a house.

It would say it depends on your problem statement:

Scenario 1: given your financial position and mortgage agreement, is buying a house a financially viable solution? --> calculate ROI. Positive ROI is good, negative ROI is bad. Forget about opportunity cost.

Scenario 2: you consider whether to buy or rent a house and have 200k in your bank account at 3% p.a. you will need additional 300k to buy a house or you can rent it for 1.5k a month. --> calculate financials for both alternatives and compare ROI. Here: when buying a house you need to clear your bank account and basically lose 6k p.a. (=3%)which constitutes your opportunity cost from buying a house.

(edited)

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Yes, you can also subtract the opportunity cost and check whether you are still positive. But a more natural way would be to take the above profit and the resulting RoI, and then compare it to the RoI of the best alternative (e.g., lending the money to the bank).

Cheers, Sidi

Yes, you can also subtract the opportunity cost and check whether you are still positive. But a more natural way would be to take the above profit and the resulting RoI, and then compare it to the RoI of the best alternative (e.g., lending the money to the bank).

Cheers, Sidi

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