Investments are great, and they are even better if they come with a massive helping of value appreciation, also known as property appreciation, or simply, appreciation. The returns achieved from any kind of investment are the primary reason to choose a particular type of asset, but the conscious decision to stick with the asset type is primarily due to the appreciation that is associated with the investment. Appreciation and depreciation are two major factors that dictate if your money works as an investment or as just an expenditure. Before we go into illustrating how that works, let us explore the official definition. As per Investopedia, appreciation is an increase in the value of an asset over time. Increased demand, slow down in supply, changes in interest rates or inflation can cause a change in appreciation rates from time to time. Depreciation, on the other hand, causes a reduction in the value of an asset over time.
Appreciation and Depreciation
Now that the definitions are over, let’s get down to brass tacks. It must be obvious to almost everyone reading this article, that anything new is valued more than something old, in terms of things that can be purchased. So, a new vehicle is worth more than one even a day old. Depreciation at work. So, how does appreciation come into play and when? The same vehicle, if an antique with a huge mass appeal will continue to appreciate in price, the older it gets, because of its rarity. When it comes to commercial real estate, one might argue that a new building can have more takers as tenants than an older one. Here though, if the region is saturated enough with buildings and there is no scope for any more new supply in the locality, based on how the region fares for different kinds of businesses, demand will always be there. That leads to appreciation. More on that in the reasons that affect appreciation.
What Impacts Appreciation in Commercial Real Estate
Appreciation in any asset is mostly caused due to similar factors with very less difference in specifics.
- Inflation - Increase in inflation leads to increased rents, which adds value to the commercial property
- Increased demand in a location - From among offices, warehouses, retail spaces, and multi-purpose properties, commercial spaces are only going to get shorter in supply, and more so if one considers Grade A assets
- Growth in Business and Economy - As the economy flourishes and more businesses seek out places to continue their trade from, it will lead to increased demand
- Newer Infrastructure - A future-ready property has better chances of appreciating than a space that has no accommodations whatsoever for any kind of improvement or adding more amenities
- Policy changes - Last but not the least, government policies related to trade and business can impact the value of commercial properties
Calculating Appreciation for Real Estate
Generally speaking, the compound annual growth rate or CAGR is the appreciation value. The calculation is simple and works for both residential and commercial properties alike. To calculate the appreciation rate, you will need to know the initial investment value and the current or future value of the property. The time involved in appreciation will also play a major role in calculation.
For example, let’s say you invested in a commercial office space in 2019 at INR 2000 per sq. ft. Let’s see how appreciation adds value to your investment. In 2022, the value of the property has now increased to INR 2300 within 3 years. Thus, the office building has appreciated by 15% (INR 2300 - INR 2000/INR 2000) during the past three years. The appreciation rate (or CAGR) is 4.7% [(INR 2300/INR 2000)^(⅓) -1].
Now, lease agreements typically feature an increase in rent by a stipulated percentage every year, but value appreciation provides a rather sizable increase to your investment, if a new tenant decides to step in or the lease agreement is renewed. Thus, it is not uncommon to see tenants going in for longer lease periods to keep their costs lower. As an investor, this also works out in your favor. Longer lease periods mean your investment and returns are stable.
Why Value Appreciation is Important
As indicated in the example above, value appreciation adds on to the stability and returns of your investment in commercial real estate. This kind of benefit is almost negligible or absent in other contemporary or traditional forms of investment with comparable low risk, like fixed deposits.
Understanding the importance of value appreciation is key to building a great investment portfolio, whether you are looking at commercial real estate or any other asset types. It helps protect your investment against the negative effects of inflation and ensures your investment always keeps growing year after year.