Real estate depreciation is important from an investment perspective (apart from tax policy), especially as commercial property depreciation is ubiquitous and significantly known to affect the nature of property performance.
From the investor perspective, commercial property depreciation compels how much capital growth the investor can expect (in the long run), and it’s measured concerning total property value – cash flow and current market value.
In this paper, we explore how depreciation can vary among several factors, including location, building type and age, and ultimately – market conditions.
Bear in mind that this article is “just” an introduction. For a more thorough approach, feel free to contact me.
What is Real Estate Depreciation?
When someone spends their money for business purposes, the cost can usually be “written off” or decreased from the business’ final profits for tax purposes. Two main ways to reduce business expenses are:
- Money spent for an item that is immediately consumed
- Day-to-day costs of doing business, and
- Small-dollar purchases
By the term real estate depreciation we are referring to the long-term or temporal drop in property value, and it’s usually caused by several reasons, such as:
- Netting out after inflation periods
- Due to the aging and obsolescence of the building structure
- Temporary cyclical downturns in market values
- After routine capital maintenance
In the U.S., real estate depreciation in income-producing structures has been made from the perspective of income tax policy, given that asset value in accrual income accounting is based on historical cost and allows for depreciation to be deducted from taxable income.
How Are Commercial Properties Depreciated?
First of all, there’s no way to predict (or know) when an asset will be “used up,” and how different asset classes in the same category can have different lifespans.
To create a universally applicable process, depreciation periods for real estate have been set. For residential properties, depreciation period is 27.5 years, and for commercial real estate – it’s 39 years.
Land can not be depreciated – only the buildings can. The two most acceptable ways to determine the value of the land are:
- Property appraisal
- Tax assessment
Let’s say you’ve purchased an office building worth $1 million, and that the appraised value of the land now is $200,000. This means that the building value is $800,000. Divide this amount by 39, and you will be left with a $20,513 depreciation expense you owe for the property.
Here’s another example of why depreciation is such a major tax benefit for real estate investors:
If you buy a self-storage property for $1,500,000 (acquisition costs included), the assessment indicates that the land value is $500,000.
Now you have a depreciable cost basis of $1,000,000, and let’s say that the property brings you in $150,000 in rental income – over your first full year of ownership. You will have the following deductible expenses:
- Rental revenue – $150,000
- Property taxes – $15,000
- Management expenses – $50,000
- Insurance – $5,000
- Marketing costs – $5,000
- Other expenses – $10,000
- Income after expenses – $65,000
Investment Perspective on Depreciation
Although tax policy is clearly important, it may have complicated or omitted considerations that are more important from a tax investment perspective.
What we are referring to as the investment perspective on commercial real estate depreciation is the perspective that reflects the fundamental economic performance of investments.
This perspective is the basis of capital allocation decisions that derive their financial value and opportunity cost. In the investment industry, profit or performance is measured by financial return metrics, most prominently – the internal and the total rate of return.
At the most fundamental level, real estate depreciation directly and importantly affect investment returns, apart from taxes.
Source of Depreciation: Income or Capitalization?
It is considered of great interest for investors to investigate the depreciation phenomenon and explore how much real estate depreciation is expected to change in the current net cash flow.
One property can generate cash flow as it ages, but it is also interesting to investigate how much of that income is due to the asset market’s reduction in the present value, and how much the investor is willing to pay as the building ages.
This phenomenon is referred to as “cap rate”. Understanding it can improve the accuracy of investment return, forecast and possibly improve the management and operation of commercial property depreciation.
IPG has been monitoring real estate depreciation because it could have substantial implications for our investors. While we can only speculate for now, what we do know is that billions of dollars in additional funding could be allocated towards projects aimed at establishing affordable housing.