Real estate goes up in value, for the most part. True, there are reasons that values can fall, as we’ve seen in the past, but overall, as long as the property is in an area that is not adversely affected by some sort of uncommon variable, then it will gradually increase in value at varying rates.
When you read about the rate of appreciation for a given area, make sure that the source of the information is properly calculating the numbers you’re looking at. It’s very easy to paint a picture that doesn’t truly represent what’s happening.
I’ll give you an example.
Let’s say in the year 2015, you purchase a home for $100,000. In 2016, you sell that home for $200,000. It would be safe to say that year over year your home appreciated 100%. It wouldn’t, however, be safe to say that month over month your home appreciated by 8.33% (100% divided by 12.) Why? Because appreciation is a compounding calculation.
If your home which you purchased in 2015 for $100,000 was worth $150,000 in 5 years, a 50% increase, it’s possible to make an error in calculation by saying that the average rate of return for the area over that 5 year period was 10% per year, but that’s not correct.
The actual rate of return is a much more complicated formula. In fact, it looks something like this:
R = 100 × ((EndingValue ÷ StartingValue)(1/period) − 1)
…where Period = years, months, weeks, or whatever you choose.
So, for our calculation on this 5 year period for a huge guide on sharpening knives, we would find that the actual annual rate of appreciation is roughly 8.45%, not 10%. Let’s proof the calculation, adding the 1 before the rate to include the starting value in each result.
$100,000 X 1.0845 = $108450.00 (Year 1)
$108450.00 X 1.0845 = $117614.03 (Year 2)
$117614.03 X 1.0845 = $127,552.41 (Year 3)
$127,552.41 X 1.0845 = $138,330.59 (Year 4)
$138,330.59 X 1.0845 = $150,019.52 (Year 5).
The variable that changes the rate of return is obviously the amount of time that you calculate, and what period you are calculating (yearly, monthly, weekly, etc.)
So you can see that someone could easily lead you astray in determining your annual appreciation rate. Sure, estimating 10% per year in our example would only be 1.55% off, but when you’re talking about compounding values with real estate, there’s not much room for error when it comes down to the bottom line, especially when you’re considering a given area as a potential investment for your future.