On Let’s Make a Deal, the host offers you a prize behind a door.
You know how it works.
Sometimes the door opens to a donkey. You’ve lost.
Sometimes it opens to a set of steak knives.
Technically you’ve won — but everyone watching knows you’ve lost. Because behind one of those doors is a brand-new car, and anything less means you blew it.
Opportunity cost is winning the steak knives
I learned about opportunity cost in economics class in college, and it sounded dry. It’s anything but. Opportunity cost is savage. Opportunity cost is winning the steak knives.
The merciful thing about Let’s Make a Deal is that the opportunity cost of winning the steak knives and not the car is immediate and visible and visceral. The door opens. The audience groans. You walk off stage knowing exactly what you gave up.
But real life never pulls back the curtain.
A real world example:
Should we keep our house as a rental property?
We own a house in a suburb of San Francisco with around $750,000 of equity in it, and a sub-3% mortgage — a below-market rate I suspect none of us will ever see again.
When my daughter graduates from high school in two years, we’re planning to move.
The obvious question: keep the house and rent it out, or sell?
The case for keeping it writes itself. A below-market mortgage in a higher-inflation world is basically free money. A tenant pays down the principal. The house appreciates. Very little downside. Very clear upside. Keep the house.
But here’s a component many miss: a decision to keep an investment is economically identical to a decision to buy it today. If we wouldn’t write a $750,000 check out of savings tomorrow to buy this house as a rental property — same equity in, same mortgage, same time horizon — we shouldn’t keep it. Same decision. Same capital. Same time horizon.
What my financial model told us
So I built a financial model in Excel to flesh out all the details. I treated the $750,000 of equity the way it should be treated — as capital we could deploy somewhere else. Rental income, insurance costs, property taxes, maintenance expense, appreciation expectations, all in the model.
Two things jumped out.
First, the property would be cash-flow negative. That’s not unusual in the Bay Area, where home values have risen far faster than rents. But negative cash flow alone wouldn’t make this a bad investment, as the principal balance shrinks each month, and the house slowly appreciates. The net of those forces still produces a positive return.
Second, the ultimate modeled investment return was mid-single digits on an internal-rate-of-return basis over a twenty-year horizon. Something between 4% and 5%.
Slightly negative cash flowing, but with a modest positive return. Very little visible downside. A home in the Bay Area owned outright within 20 years.
A good investment.
For us, we decided that keeping the house is winning the steak knives.
(For details on my financial model, see Disclosures below)
What’s behind door number 3?
The honest comparison isn’t “keep the house vs. do nothing.” It’s “keep the house vs. the best alternative use of that $750,000.” For most people, the alternative that sits there waiting, at the click of a button, in any amount, is the public stock market.
Over the long term, US public equities have compounded at roughly 10% a year. That’s not a forecast. That’s a historical fact across many decades.(1) Whether the next twenty years deliver that exact number or something a few points lower, the math is hard to overcome: compound a mid-single-digit return (what we expect to earn on keeping the house) against a higher-single-digit return (what we’d hope to earn in public equities) over twenty years on the same starting capital, and the wealth gap can be very large. With less concentration risk. And no 2 a.m. calls about the water heater.
We’re going for the car.
Some objections
I’m ignoring transaction costs, capital gains taxes, depreciation on the rental house that can shelter rental income, the potential for a 1031 exchange down the road. True. Yet in my model, none of these factors materially changed the results of the analysis.
Future stock returns might not match the past. True. But the same uncertainty applies to every input in the real estate model: appreciation, rents, vacancy, costs. All of it is a forecast. The honest comparison is one set of forward-looking assumptions against another. For our money, we’re more comfortable with public market investing.
Beyond the financial points, the objections I hear from those who like their real estate are mostly psychological. I can see the house. It’s tangible. I can touch it. I control it. You also field 2 a.m. calls about the water heater, eat vacancies, and write checks for the new roof. What feels like control is mostly labor you’ve assigned yourself. And concentrating seven figures of net worth in one zip code, one house, one set of tenants feels safer than owning a market-cap-weighted slice of global productive capacity. It isn’t. It’s just more visible.
Real life won’t show you what’s behind Door #3
The purpose of this blog post is not to argue that real estate investing is a bad idea. Or that keeping your home and renting it out isn’t the best decision for you. There are plenty of scenarios in which keeping and renting it out could make a lot of sense. The numbers we ran to come to the conclusion we did are specific to our situation, not yours.
The point is that you should look at all investment decisions as incurring a hidden opportunity cost that you should be as well informed about as possible.
On Let’s Make a Deal, the tragedy is unmistakable. The door opens. The car gleams. The audience groans. You see exactly what you gave up.
Real life is crueler. It never opens Door Number 3. You keep the house, you collect the rent, you sleep fine — and the car stays behind a door you’ll never open. You’ll never see the portfolio you didn’t build. You’ll never feel the loss, because the loss is invisible.
That’s what makes opportunity cost savage. It doesn’t punish you with regret. It punishes you with a comfortable, confident, well-reasoned decision that quietly costs you everything you could have had.
And remember: a decision to keep is a decision to buy. If you wouldn’t write the check today, you shouldn’t be holding it tomorrow.
Steak knives are great. But everyone knows you should go for the car.
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(1) Since 1926, the S&P 500 Index, including reinvested dividends, has generated annualized total returns of approximately 10%. Different start and end dates can produce materially different results.
Disclaimer: This piece describes my own decisions about my own house and how best to invest, for me. It’s not investment advice for you. The math is specific to my situation, and your circumstances will differ. The point isn’t the specific number or numbers I have calculated. The point is that you should do the calculation.
Model disclosures: When we purchased this home in 2018, we had an idea that we’d sell it within a decade, around the time our youngest daughter goes off to college. For that reason, we selected a mortgage product well designed for these facts: a 30-year fixed rate mortgage that only starts to amortize in year 11, with the first 10 years requiring an interest-only payment. The numbers are staggeringly low. The monthly interest payment is just $1,664.90 for a house worth well over $1 million. Factor in property taxes and insurance, which we pay into an escrow account monthly, and the monthly cost has been a little more than double that — around $3,368.98. In year 11, that interest-only payment will jump to $3,938.84. Add in property tax and insurance, and the monthly cost will likely be around $5,600. While that’s a big jump, it’s still a lot less than what we’d pay monthly on a 30-year mortgage at 6%, which would be closer to $7,000 a month. The fact that we have to start amortizing the principal in year 11 will make the mortgage more expensive — but the 2.75% rate is still so much lower than today’s rates (around 6%) that we’re net better off. To understand the economics of keeping the home, we modeled:
- Rental income – In our area, our house would probably generate gross rents of around $5,500 a month. I assume rental income grows at 3% a year, basically the background inflation rate.
- Appreciation – Home prices are soft where we are, largely because of the increase in mortgage rates over the last few years. I’m not planning for rates to come down. So my assumption is that our house value basically keeps pace with inflation, at around 3% a year. Note that appreciation has historically been the primary driver of strong real estate returns.
- Property management – I know I don’t want a 2 a.m. call to fix a toilet, so I’m assuming we’d have a property manager who charges around 15% of gross rents. Expensive, but worth it.
- Property tax – Even though we’re protected from jumps in assessed value because of Prop 13 here in California, our property taxes are close to $18,000 a year right now. I project they’ll go up by the 2% a year that’s permitted under law.
- HOA dues – $4,200 a year, growing at around 2% a year.
- Maintenance – As any homeowner knows, sh*t happens. Roofs leak. Pipes burst. Hot water heaters need replacing. A good rule of thumb is that maintenance expenses average around 1% of the value of the home per year. At $1.35 million, that’s $13,500 a year — a bit more than $1,000 a month.
- Insurance – $2,000 a year, which is great. A cost we assume grows around 2% per year.
The resulting IRR – The primary output we look to is the Internal Rate of Return (IRR) calculation. An IRR is the discount rate that makes the net present value of a series of cash flows equal to zero. Conceptually: it’s the annualized return your money earned, given the timing of money in and money out. With the range of assumptions we utilized, the resulting IRR was between 4% and 5%.
Disclosures: Tim Corriero, an investment adviser representative (IAR) of Gemmer Asset Management LLC (“GAM”), conducts advisory services under the tradename Juris Wealth pursuant to GAM’s investment adviser registration with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Juris Wealth offers comprehensive financial planning services to GAM’s clients at no additional cost. The JD Investor is a website/blog dedicated to educating and informing investors. Neither Juris Wealth, nor The JD Investor provides investment advisory services. For additional information, please refer to GAM’s Form CRS or visit adviserinfo.sec.gov for more information. The views expressed herein are those of Tim Corriero and do not necessarily reflect those of GAM. Investing in stock markets involves the risk of loss. Past performance is not a guarantee of future results. Information presented (including all charts, graphs, and statistics) is believed to be factual and up to date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Information in these materials may change at any time and without notice. This material is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. GAM does not make any representations as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party incorporated herein, and takes no responsibility, therefore. All such information is provided for convenience purposes only and all users thereof should be guided accordingly. Any mention of a specific law firm herein does not constitute an endorsement, recommendation, or favoring by such firm.
