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opportunity-cost

I would like to start off by saying that the ProCalc Lease Analysis Software System allows you to compare Lease vs Buy and allows you to enter opportunity cost in the buy scenario. However, that does not mean that I agree with actually doing it. This post offers 3 good reasons why you should think about NOT including opportunity cost when comparing Lease vs. Buy. The final decision to include opportunity cost in your analysis is up to you but I am sure this post will make for interesting reading and debating about “Opportunity Cost”.

As with my other blogs, these are very technical topics that I write about in an extremely user-friendly way so that EVERYBODY can understand them. It takes me a little longer to explain the concepts but it is well worth the read. Think of this more as a white paper than a blog and feel free to go back and re-read sections if necessary. If you need to get a better understanding of these concepts, please feel free to call our tech support line at 516-484-8080.

Definition of Opportunity Cost

For purposes of this blog, opportunity cost is considered to be the lost earning potential on your down payment, or in the case of an all cash deal, your purchase price. For example, if you were buying a building and you were paying $1,000,000 all cash, you would no longer have the interest income from that $1,000,000. Many people believe that we should add that lost interest to the cost of buying this building. The sample 5 year cash flow below shows a $1,000,000 purchase price with an additional cost of 5% a year (The opportunity cost) to reflect the lost interest. This is an additional expense to the buyer. The opportunity cost is increasing the cost to purchase the building by almost 28% from $1,000,000 to $1,276,282.

cash-flow

IMPORTANT NOTE – Opportunity cost can either be calculated on a compounded basis or a non-compounded basis. Non-compounded would just be $50,000 Per Year. The example above assumes a compounded basis.

Here is the important thing to think about:

YOU ARE NEVER ACTUALLY GOING TO PAY THIS ADDITIONAL $276,282

It is in the analysis because you will no longer be earning the 5% interest on this money (lost opportunity) but it is definitely increasing the cost of buying the building by 28% or $276,282.

Why You Should Not Include Opportunity Cost in a Lease vs Buy Analysis

I am going to give you 3 reasons why you should think about not including opportunity cost when comparing Lease vs. Buy. Reason #1 is not more important than reason #3. They are all equally important reasons.

Reason #1) If you are comparing lease vs buy, you cannot opportunity cost affect one side of the deal (The Buy) and not the other (The Lease). If you are buying a building, the cost of the buy analysis goes up by the amount of interest you will no longer be earning. If you end up leasing space, you will still have the $1,000,000 in the bank and you will still be earning the 5% interest. Therefore, when you are doing your lease analysis you should put the same opportunity cost amount into the lease analysis but as a CREDIT rather than a debit.

If you put the opportunity cost into the lease analysis as a credit, the cost of your lease goes down by the same amount of interest your buy analysis went up.

In the example above, the opportunity cost increased the buy analysis by $276,282. If we decreased the cost of leasing the space by the same $276,282, that means the opportunity cost has created a spread of $552,564 ($276,282 x 2). It is $552,564 cheaper to lease the space than it is to buy it and that difference is because of the opportunity cost only. We have not yet entered a single actual cost that we will be paying in either scenario.

SUMMARY – You cannot add opportunity cost to the Buy analysis only. If you are going to make the buy analysis more expensive because of lost interest, you must make the lease analysis cheaper because you will still be earning interest.

REASON #2) If you are comparing Lease vs Buy, you MUST sell the building at the end of the term otherwise the analysis will never make any sense. When you enter a sale cost at end of term you will most likely assume some increase in value. This is where you will get all that lost interest back. You are investing $1,000,000 today and when you sell the building in 5 years you will get back X. Where X is some value above $1,000,000. The increase in property value makes up for the lost interest.

You are not really losing interest, you are deferring interest until you sell the building.

REASON #3) I assume that you will be comparing Lease vs Buy using a time value calculation (Present Value or Net Effective Rental Rate). Any time value calculation takes into account that in the buy analysis I am spending $1,000,000 up front to purchase the building and in the lease I am spending nothing up front.

Let’s assume you have 1 month of free rent in the lease scenario (Not an unreasonable assumption). This means that your cost in month 1 to Lease the space is $0. In the Buy analysis your cost in month 1 is $1,000,000 (The purchase price and you are paying all cash). If you did the lease & buy analysis and stopped both at the end of the first month, the Present Value of the lease would be $0 and the PV of the Buy would be $1,000,000.

SUMMARY – All time value calculations will take into account the fact that you are spending $1,000,000 up front in the buy scenario and you have virtually no up-front costs in the lease scenario.

I hope this post has made you think differently about what you have been taught in the past. If I was doing the analysis, I would leave opportunity cost out of the analysis and focus on the actual costs of leasing space or buying a building. Your analysis will be better off for it.

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