Implicit Cost

Definition of "Implicit cost"

Written by

Team Platinum of Naples and Southwest Florida

Berkshire Hathaway HomeServices Florida Realty

People say, in real estate, there's a lot more than meets the eye. If you're connected to the housing market in any way, you've probably heard the term "implicit cost." It sounds fancy, but don't let it scare you off! Today, we're diving into the implicit cost definition, how to calculate it, and why it could matter the next time you make a property-related decision.

What is implicit cost?

Implicit cost is sneaky because it's not something you see on paper. It's the cost of sacrificed opportunities (thus, it’s also known as opportunity cost). This means it's the value of something you give up to choose something else. Think about it like this. Suppose you decide to spend your Saturday updating your kitchen instead of working a side gig where you could earn $200. In that case, your implicit cost is the $200 you renounced. It's money you didn't make because you chose to do something else.

What is an implicit cost in the real estate world? 

The implicit cost can be the rental income you give up on when you decide to live in your property instead of renting it out. Or it could be the alternative ways you could have used an investment property instead of sticking to what you're doing now. It's all about weighing your options and understanding the trade-offs.

How to calculate implicit costs?

Calculating implicit costs may be tricky. Ultimately, however, it boils down to understanding your choices. Here's a simple way to break it down:

• Identify your options: What are your choices? For instance, you have a property, the most inflation-proof investment. How will you use it? You can either live in it, sell it, rent it, or use it for business.
• Estimate potential earnings: Determine how much money you could make for each option. If renting out your property could earn you $1,500 a month, that's a substantial number.
• Compare costs and benefits: Look at each option side by side. Which one gives you the highest financial return on investment (ROI)? The difference in earnings is your implicit cost.

Let's say you own a home and are deciding whether to live in it or rent it out. If you rent it out, you could earn $18,000 a year. That $18,000 is your implicit cost by choosing to live in it.

How to find implicit cost?

Finding implicit cost is closely tied to figuring out your alternatives. Here’s a step-by-step example:

1. List alternative uses: Consider what else you could do with your property. Could it be rented out? Used for a real estate business?
2. Evaluate each option: Calculate what you’d earn or save for each alternative.
3. Analyze opportunity costs: Compare these potential earnings to your current situation. The big difference is your implicit cost!

Say you're an agent or realtor and a renowned real estate agents directory member. You use your own office. If you could rent out that office to another business for $2,000 a month but choose to use it yourself, your implicit cost is $24,000 a year ($2,000 multiplied by 12 months).

More implicit cost examples

Let’s take two examples from everyday life to make things crystal clear!

Land use: You own a piece of land. You could either build a house to live in or create a parking lot and charge $50 per spot per month. If the lot could fit 10 cars, your monthly implicit cost of living on that land rather than earning from parking is $500.

Business property: You own a property that could be a storefront, bringing in $5,000 monthly. Suppose you use it as a lucrative warehouse for your inventory instead. In that case, your implicit cost is that $5,000 a month you're not earning.

What is the implicit cost of production?

Let's shift gears a little and talk about production. The implicit cost of production is what you give up when producing something with your own resources. Imagine you're a builder. If you decide to use your machinery to build houses instead of leasing them out, the lease income you give up is your implicit cost. The strategy is as follows!

• Resource use: Think about the resources you use in production. These include land, buildings, equipment, and time.
• Alternative income: Calculate how much you could earn if you used these resources differently.
• Compare earnings: The earnings you miss out on by not choosing the alternative is the implicit cost of your current production choice.

For instance, you own a plot of land used for farming. However, it could be sold for a significant profit or rented out for events. Then, your implicit cost is the money you'd make from those alternatives.

Final thoughts

Implicit costs play an essential role in real estate decisions and money management. Whether you're deciding how to use a property, what to invest in, or where to allocate your time, always consider the hidden costs and potential earnings.

Remember, in real estate, every decision comes with an opportunity cost. So next time you're faced with a perplexing real estate decision, think about those implicit costs hiding behind the curtains. They could be the difference between a good decision and a great one!