Last Updated on April 16, 2021 by Oddmund Groette
Charlie and I don’t know our cost of capital. It’s taught in business schools, but we’re skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I’ve never seen a cost of capital calculation that made sense to me. Have you Charlie?
– Warren Buffett
Is it more rational to rent than to buy your residence (economically)? We seldom hear about the opportunity cost of homeownership. In April 2021 the Dividend Growth Investor had an interesting thread on the subject:
The definition of opportunity cost is defined like this by Investopedia:
Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. The idea of opportunity costs is a major concept in economics…..Because by definition they are unseen, opportunity costs can be easily overlooked if one is not careful. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making.
An investor should always try to increase the opportunity cost. In economic terms, it means the difference between the best use of your capital compared to the second, third, fourth etc. The famous investor Charlie Munger regards Berkshire and Costco as his opportunity cost, obviously only when the price is right.
This makes sense: why would you invest in your capital in your tenth best idea?
Let’s calculate Warren Buffet’s opportunity cost:
Let’s assume Warren Buffett could have invested his capital (31 000 paid for the house) at 20% for 63 years. Compounded, without considering taxes, this is 3.02 billion today.
We have no idea what the house is worth today, but obviously a lot less, perhaps 500 000 USD. Considering Buffett has paid maintenance, real estate taxes, etc every year, the “investment” in his property is, of course, worth even much less. If the value is 500 000 today, the CAGR is a modest 4.5%.
However, most investors wouldn’t be close to a 20% return. The long-term passive CAGR has been around 10% over this period.
Warren Buffett is, of course, unique, and is a 100% rational investor. However, not everything can be valued or be put down to a nice exercise in compounding:
Realistically, real estate is a good investment for most people
The reason why real estate is a good investment for most people is that it’s a long-term investment: most own real estate for the majority of their lives. Would they do the same if they owned shares? Most likely not. They would be more prone to behavioural mistakes.
In an earlier article we discussed the pros and cons of real estate and stocks:
Realistically, the opportunity cost is not the return in the stock market. Most people don’t invest in stocks at all. We can argue they should, but in reality, they don’t.
A home is more an emotional decision – not financial. It feels better to live in a home that you own compared to renting – for most people. You can do what you want, and you feel safe in paying down a mortgage than paying to a landlord.
Buying and selling real estate is complicated and expensive
In Norway, you pay the broker at least 1% per transaction, depending on the value of the object. A lot needs to be added: photography, decoration, insurance, etc. The real cost is at least 2%, probably more. You can buy an index fund for free.
Additionally, we can safely assume it costs 1% a year to maintain a property. An index fund costs from 0.1 to 0.3% annually.
And not to mention the legal mess with real estate. Leaks, fire, plumbing, etc. The list is long. You are unlikely to have any legal disputes in the stock market.
Homeownership is overrated – economically speaking.