Calculating depreciation of real estate assets is one of the crucial factor in finding the true value of any asset. As the real estate property gets older with time, it diminishes its value.
Hence, an investor needs to track these depreciation values and properly factor these in the books of accounts. This will not only help in attaining fair valuation, but also provide tax benefits to the investors.
What is depreciation
Depreciation is defined as the decline in the value of an asset over use with time. This decreases the value of assets with time. As you know, any asset with over a period of time will lose all its value. In the case of real estate assets, the typical lifespan of a building is 40-50 years.
The asset will have no intrinsic value after the lapse of the total duration. Thus, in order to avoid the direct loss of the real estate property at the end of 50 years, investors tend to evenly reduce the value of the asset yearly. This provides a realistic approach in calculating the true value of any real estate asset.
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There are 2 methods to calculate the depreciation of real estate assets
- Straight line method
- Declining balance method
Let us understand the calculation procedure in detail.
Calculating deprecation of real estate assets
Straight line method
Straight line method is mode of calculating the depreciation value evenly until the usable life span of a real estate asset is reached. This is the most frequent and easy approach for calculating the depreciation value of real estate.
Formula for straight line method
Depreciation = (Cost of real estate – Salvage value) / Total life span of the asset
The cost of the real estate required to acquire the item, including all taxes, fees, and charges (Excluding the cost of land, if any).
Salvage value is the scrap value of the real estate asset that it will have after it completes the total life. The value it will possess after demolition of the real estate. Usually, this value is taken as zero. This is because the real estate buildings have very negligible value after demolition.
Total life span of the building is the total years the real estate can be used. Similarly, the maximum usable life of a real estate asset is about 50 years.
Example of straight line method
If a real estate asset was brought for Rs. 1.5 Cr. and the life span of the building is about 50 years. Hence, the yearly depreciation can be calculated as (considering the salvage value to be zero):
Depreciation = (Cost of real estate – Salvage value) / Total life span of the asset = (1,50,00,000 – 0) / 50 = Rs. 3,00,000/- per year.
This means that every year the value of the real estate asset will be reduced by Rs. 3 lakhs year on year.
Advantages of straight line method
- This method is great for small real estate assets.
- Easy to calculate.
- This value will be common for every year and will grow uniformly.
- At the end of total span, the total value of the asset will be zero even if it has some intrinsic value.
Disadvantages of straight line method
- Since the depreciation value is uniform throughout, one cannot take advantage of the initial high depreciation of real estate assets.
The above disadvantage has been taken care by the declining balance method.
Declining balance method
The declining balance method is a sort of accelerated depreciation that allows the investor to write off depreciation expenses in the early stage of the asset’s life and reduce the tax liability.
Therefore, the real estate investors can take advantage of the initial heavy depreciation of assets and properly record them in the books of accounts.
This can be beneficial for large real estate properties where the initial cost of facility management is extremely high. Thus, this can be balanced out in the form of high expenses in the form of depreciation.
Formula for Declining method formula
Depreciation = (Cost of real estate – Salvage value) X Depreciating factor
The cost of the real estate necessary to acquire the item, including all taxes, fees, and charges (Excluding the cost of land, if any).
Salvage value is the scrap value of the real estate asset that it will have after it completes the total life.
Depreciating factor is a value which the valuation decides to give to the real estate property. This factor depends on the location and the type of real estate.
The depreciating factor lies between 0.15 to 0.30, depending from case to case.
Example of declining balance method
For example, the cost of construction of a mall is Rs. 150 Cr. and the depreciating factor is 0.17. Considering the salvage value to be Rs. 10 Cr.
Thus, the depreciation of the first year can be calculated as:
Depreciation (First year) = (Cost of real estate -Salvage value) X Depreciating factor = (150 – 10) X 0.17 = Rs. 23.8 Cr.
Now the revised value of the mall after 1 year will be = 150 – 23.8 = Rs. 126.2 Cr.
Similarly, the depreciation for the second year is calculated as:
Depreciation (Second year) = (Cost of real estate – Salvage value) X Depreciating factor = (126.2 -10) X 0.17 = Rs. 19.75 Cr.
Thus, it is to be noted that the depreciation for the first year was Rs. 23.8 Cr. and second year it turned out to be Rs. 19.75 Cr.
Similarly, as and when the year will pass the depreciating vale of the real estate asset will reduce with time.
Advantages of declining balance method
- It allows the investors to accelerate the rate of depreciation during the early stages of the building.
- For commercial properties, the depreciation value can be considered on a higher side.
- The life span of the building does not affect the depreciating value of the real estate property.
The difference between the two methods
|Straight line method||Declining balance method|
|This method can be used for real estate assets for a small value (less than Rs. 1 Cr.)||This method is used to calculate the depreciation for high value real estate projects (More than Rs. 1 Cr.)|
|The rate of depreciation is uniform year on year||The rate of depreciation is not uniform. The depreciation is high in the beginning and keeps declining as the years pass.|
|Does not help in initial tax benefits||Helps in early tax benefits|
|In order for the asset value to turn half its value, the duration spent needs to be half||In this method, the the half value of the real estate is attained much before the half duration.|
In conclusion, these are the two ways for calculating the depreciation of any real estate asset.
To summarize, the straight line approach is a more straightforward method that may be utilized on low-cost properties. For large-scale projects, however, the decreasing balance technique can be applied.
Also read: How To Reduce Liquidity Risk On Real Estate Investments
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