Opportunity Cost - Is the Property Worth an Investment
Opportunity Cost is perhaps the most neglected metric when evaluating a real estate project. Not only is it a great to measure risk/return, but it also can be a good bogey to determine if your time and effort is being compensated by the project.
Opportunity Cost = "the loss of potential gain from other alternatives when one alternative is chosen". Put another way, when you invest in real estate that is capital you no longer have to invest in something else - another piece of real estate, stocks, a business, etc.
The bogey I like to use is the greatest wealth creation machine of all-time - the stock market. Historically, stocks have generated between 8-10% per year or about 6.5% to 7% after inflation. This doesn't happen without volatility, but if you can ride out the drawdowns and hold for a long period of time investors you have been rewarded handsomely. Additionally, one of the best features is investing in the market is totally passive and requires basically 0 work.
Real estate investing is riskier, takes more time, has higher uncertainty, is less liquid, increases concentration, and requires a larger capital outlay. My general thought - if I can't beat the market by a wide margin what's the point?
To that end, I assume a stock market return of 8% and as such I want to target a minimum return of about 20% (2.5x vs the market) and a value multiple (total net value of project/divided by opportunity cost investment value) of around 2x, which accounts for the real return difference over 5 and 10 years. I am usually shooting for more than this, but it's a good baseline. I also like to see how much more value in absolute terms the property will generate.
The REIF Model lays out your project vs a simple alternative over various time periods to determine the Opportunity Cost. To enhance the decision making, the model users target inputs that create color changing cells (conditional formatting) based on the value of those outputs are good or bad (e.g. Total Property Value / Opportunity Value > 3 % = highlighted green).
