What is Appreciation?

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Definition:

Appreciation is when an asset’s value increases over time because of market factors – not because you’ve improved or added to the asset.

🤔Understanding appreciation

In economics, finance, and accounting, appreciation refers to a positive change in the value of an asset thanks to market factors. In accounting, appreciation is when an asset experiences an upward adjustment from the initial value on a company’s books. In finance, appreciation is the goal for most investors – Their investment goes up in value, which means more profit if they choose to sell. In economics, appreciation generally refers to the rise in a currency’s value relative to another currency. Tangible assets (such as real estate), financial assets (like stocks or bonds), and intangible assets (such as trademarks) can all appreciate over time. Appreciation is the opposite of depreciation, which is when an asset decreases in value over time.

Example

In 1934, President Franklin D. Roosevelt signed the Gold Reserve Act, which gave the government the ability to fix the price of gold. At the time, gold was worth about $35 per ounce. The US government created a two-tier market in 1968: While central banks continued to use the old model, the price of gold could otherwise fluctuate according to the market’s supply and demand. The gold standard ended completely in 1971. In June 2019, gold was worth about $1,340 per ounce. That’s a price appreciation of about 3,700 percent.

Takeaway

Appreciation is like a tree you planted and forgot about…

The environment (rain, sunlight, and soil) represents the market conditions (like inflation or increased demand) that happened to work in its favor. Over time, the tree grew and bore fruit (increased in value) without you doing anything.

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How does appreciation work?

Any type of asset — both tangible (physical) and intangible (nonphysical and non-monetary) — can appreciate in value. For example, real estate home values can increase thanks to rising demand in a particular area.

Let’s say you purchased a home for $331,400 (the median price for US homes sold in Dec. 2019). If home values appreciate 4.3 percent in 2020, as the National Association of Realtors predicts, the value of your home would increase to $345,650.

The owner of an asset does not automatically realize (or profit from) the higher value. He or she can report the increase by recording the asset’s new value on a financial statement, such as a balance sheet, to show a “paper gain.” That means the current price of the asset is higher than what the owner paid for it, but it’s still in the owner’s possession.

Once the owner sells the asset, the appreciation turns into “realized gains,” or actual profit. Suppose an investor buys a stock for $50. Let’s say one year later the stock is trading at $60 per share. Thanks to appreciation, the investor receives a return of $10 if he or she sells the stock. In other words, the stock appreciated by 20% ($10 / $50). When the investor sells, the $10 represents realized gains and may be subject to capital gains taxes.

What causes appreciation?

Appreciation happens because of different market conditions:

Supply and demand

When there is increased demand or reduced supply for an asset, its value will typically appreciate. For example, if the cost of building materials rises, there may be a shortage of new construction, and therefore new homes for sale. If the housing market has a scarcity of inventory, prices will likely go up.

Inflation

In economics, inflation occurs when the general prices for goods and services increase. The US inflation rate averaged 1.54 percent between 2015 and 2019. While certain asset prices may increase due to inflation, the country’s currency is likely to depreciate because it has less purchasing power. Conversely, a decrease in the inflation rate in the US would decrease the supply of dollars in other countries and increase demand for dollars abroad, causing the currency to appreciate.

Interest rates

Some assets, such as bonds, come with fixed interest rates. When market interest rates drop, investments these investments become more attractive if their interest rates are higher than the market rate. Demand for these assets goes up, which pushes the price up (in other words, appreciation occurs).

Demand for money also increases as interest rates fall, since there is a higher opportunity cost to holding cash compared to investing it. Higher demand may cause the value of a currency to appreciate.

What’s the difference between appreciation and depreciation?

Appreciation is an increase in value, while depreciation is a decrease. Most people hope that their investments appreciate in value, whether those are stocks, bonds, or precious metals. Intangible assets (nonphysical, non-monetary assets), such as trademarks, can also rise in value, perhaps because of increased brand recognition.

However, most tangible assets (physical assets that have value), such as machinery, cars, and equipment, tend to depreciate. As they get used, they progressively lose value. They have a finite lifespan before they need to be replaced. For instance, a new car depreciates, or loses value, as soon as you drive it off the lot — It becomes a used car that has accumulated miles and wear-and-tear from driving.

Real estate is an asset that both appreciates and depreciates. It generally appreciates in value over the long term, although the specifics depend on factors such as location and condition. However, the physical structure of the house itself depreciates. For example, the toilet, sink, and roof break down as they progress through their lifespan. If a property’s value increases because you replaced or upgraded parts of it, that does not count as appreciation.

What happens when a currency appreciates?

Currencies exist in a global market. When one currency appreciates, it increases in value in relation to another currency. Excluding any government intervention, currency appreciation changes the exchange rates between two currencies on the foreign exchange (forex) markets.

For example, on Dec. 18, 2019, USD/INR traded at 70.926. In other words, one US dollar could buy 70.926 Indian rupees. On Dec. 31, 2019, USD/INR traded at 71.34, so one US dollar could buy 71.34 Indian rupees. Since one US dollar now trades for more Indian rupees, the dollar became more valuable (appreciated), while the Indian rupee decreased in value (depreciated).

Currency appreciation affects the prices of international transactions. If a country’s currency appreciates, imports become cheaper. The local currency has a higher purchasing power. Now, residents can afford to buy more foreign goods, which leads to increased demand for imports. On the other hand, when a country’s currency appreciates, its goods become more expensive to foreign customers. As a result, exports tend to decline.

How do you calculate the appreciation rate?

You can find out how much an asset has appreciated as a dollar amount and as a percentage. To calculate the percentage change rate, take the difference between how much the asset is worth now and how much you paid, and divide that number by the initial price.

If you bought a stock for $100 and it’s now trading at $120, the difference — or capital appreciation — would be $20 ($120 - $100). Now, divide $20 by the initial price that you paid ($100), and multiply by 100 to get a percentage. Your stock appreciated, or increased, by 20 percent.

How do you calculate an asset’s future value based on appreciation?

You can also estimate the future growth of an investment if you know the initial price of the asset and its estimated annual average rate of appreciation. Although past performance does not guarantee future returns, this calculation may be useful when comparing investments to identify which option is likely to be more profitable.

First, take the appreciation rate, expressed as a decimal, and add 1. So, if the annual appreciation rate is 3 percent, add 1 to 0.03 to get 1.03.

Now, raise that to the number of years the asset will appreciate. Finally, multiply the result by the initial purchase price.

For example, let’s say you are looking to get into real estate investing by purchasing a single-family home. The average home price in your area is $200,000, with a 2.5 percent annual appreciation rate over a time period of 10 years.

0.025 + 1 = 1.025.

1.02510 = 1.28008454.

1.28008454 * $200,000 ≈ $256,016

After 10 years, your home may have an appreciated market value of about $256,016.

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