Effective Cost of Ownership

One of the fundamental concepts in Finance is the notion of “Total” or “Effective” cost of ownership.  This is the total cost from purchase to sale of an asset.  The importance of this concept is that it shifts focus away from the acquisition cost of an asset such as machinery, computers, etc. and places it on the total cost over the useful lifetime of that asset.  This principal is especially helpful when evaluating income property investments.

The reason for this importance is because most reporting on property and real estate looks at the market value only.  Other important considerations are the interest rate, required down payment, management fees, taxes, and maintenance.  The combination of these factors create your effective cost of ownership and directly influence the return on investment that is generated over the months and years that you own the property.

It is tempting for many people to emphasize the market price of an investment property while ignoring many of the other prescient factors.  However, the interplay of these other factors in conjunction with the market price can make all the difference to the attractiveness of a deal.  For example, if we look at a hypothetical deal where the price is $200,000 and the interest rate is 4.5%, the monthly payment comes out to approximately $811.  However, if there is a 5% drop in the price combined with a 10% increase in the interest rate, the effective cost of ownership stays the same.  This is also true for a 10% drop in price and a 20% increase in the interest rate.

This insight is important because our current environment is one where interest rates are the lowest that they have ever been and values are highly depressed, but may not be at their absolute bottom.  The fundamental question for aspiring investors to ask is whether interest increases are deemed to be likely and how much more the values could potentially drop.  Many people have waited themselves out of phenomenal deals because they held out for a “bottom” in market values only to see interest rates climb back upward.  The advent of a 30-year mortgage gives investors a tremendous opportunity to lock-down major parts of their effective cost of ownership for three decades.  

It is certainly true that nobody knows for sure what the future will bring.  It is also true that failing to act on attractive deals can cost us millions in lost gains.  Understanding the effective cost of ownership for income properties is one of the ways that investors can evaluate whether the deal they see represents an attractive long-term opportunity.  Investors who seek out fundamental value are typically rewarded over the long term as their investments blossom into real assets while short-term profit seeking places investors at risk of large losses if the market winds turn against them.  Each person must make their own choice.  Our recommendation is to lock-in on fundamental value and take decisive action while the door of opportunity is open.

Action Item: Take advantage of the current historic lows in effective cost of ownership for income producing assets immediately.  Once you have acquired enough information to become educated and found enough capital to begin investing, make the decision, and begin building your financial future. (Top image: Flickr | bjornmeansbear)

The JasonHartman.com Team

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