What is Appreciation and Depreciation in Real Estate?

Becoming a homeowner comes with many perks, such as stability, tax benefits, and the ability to personalize your home however you want. But another great advantage, some would say the best, is that it allows you to grow your wealth over time through building equity and appreciation. We’ll focus on the latter today as we go through everything you need to know about the crucial concept of appreciation in real estate. We will also look at the other side of the coin, depreciation, a generally misunderstood measure that can work in your favor.

What is Appreciation?

Investing in or owning an appreciating asset is an individual’s fundamental way of increasing wealth. Assets can appreciate for various reasons, including increased demand, declining supply, or changes in inflation or interest rates. In the simplest terms, appreciation is when the value of an asset goes up over time. The most common assets that undergo appreciation are stocks, bonds, savings accounts, and real estate.

Real estate’s ability to appreciate is one thing that makes it such a valuable investment. The increasing value can net you a tidy profit when it comes time to sell or increase your monthly earnings on a rental property. You can also increase the appreciation rate through home improvements such as a kitchen or bathroom remodel. An increase in appreciation will also increase your equity if you have a mortgage.

How to Calculate Appreciation

To calculate your home’s current appreciation rate, subtract the initial value from the current value, divide that by the initial value and multiply by 100. For example, you bought a home for $395,000, and now its fair market value is $410,000.

410,000 – 395,000 = 15,000

(15,000/395,000) 100 = 3.8%

You’ll need to know how long the property will appreciate and how much it is initially worth. You can also calculate what an investment will be worth based on the annual appreciation rate. Start dividing the appreciation rate by 100 to convert it to a decimal. Add 1 to this and raise the result to the power of the number of years the property will appreciate. Like a mathematical formula, this would be:

Future growth = (1 + annual rate) ^years

Lastly, multiply this result by the initial cost of the property.

Future value = (Future growth) x (Current value)

Taking the same example above, let’s assume that 3.8% is the annual expected appreciation rate on the property for the next five years.

Future growth = (1 + 0.038) ⁵ = 1.20499922492

Future value = (1.20499922492) x (395,000) = $475,974

Calculations like this can be handy when determining if a home is a good investment. However, remember that no one has a crystal ball that can accurately predict home values over the coming years. Average historical appreciation rates tend to be pretty reliable, but they can include many ups and downs. Estimating a home’s future value can help determine your profit potential. But by no means should you expect the home to be worth exactly this much.

What is Depreciation?

Let’s look at depreciation when an asset’s value decreases over time. This can happen for various reasons that are outside the homeowner’s control. For instance, market fluctuations and declines can reduce home values. Neighborhoods seeing a lot of growth and development will see their home values increase, while those that stagnate or decline in growth will see their home values decrease. This is why choosing the right location for your home is essential when buying.

Regular maintenance and upkeep can prevent depreciation and keep your home looking fresh and up to date for the time to sell. Homes can also decrease in value over time due to poor maintenance. Homes with old-fashioned features tend to sell for less as the buyers must factor in the costs and hassle of renovating. Homeowners should consider long-term trends when deciding what parts of their homes to upgrade. Neutral is the best approach when upgrading.

Depreciation and Rental Properties

Now, worth noting that depreciation is not always a bad thing. When dealing with investment properties, it can be a positive. Real estate, meaning the building itself, is what depreciates. However, its built land is a fixed cost and does not depreciate.

Home depreciation divides the deduction across the property’s lifespan (27.5 years for residential properties) rather than subtracting a larger, single deduction at the time of purchase or improvement.

Be aware that the IRS has specific rules on how this works. Homeowners can write off a portion of the asset’s initial cost each year in “depreciation losses.” Enabling you to recoup a part of the initial investment cost each year for up to 27.5 years. These deductions allow you to reduce your tax base, reducing the amount of taxes paid on an asset that is appreciating simultaneously. The more you write off, the less you pay in taxes.

A crucial concept in real estate investing. You can create positive cash flow by purchasing real estate while simultaneously reducing your taxable income through depreciation losses, even though the investment also appreciates. There is no other type of investment that can do this.

Final Thoughts

There is no guarantee of how much a home will appreciate over time. But by buying in a desirable and upcoming neighborhood and maintaining your property in good condition, you can best position yourself to take advantage of any appreciation you gain. A home is likely to be the most significant investment a person ever makes. Therefore, you’ll want to make sure it’s an investment that pays dividends in the future.