Depreciation is a natural part of practically every asset or product in the world. It’s something that real estate investors need to consider when they buy or sell properties or when they purchase materials for their investment businesses.
While it’s easy to know the initial value of a property or asset (the asking price, essentially), it’s a little tougher to know an asset’s “residual value” or the projected value for an asset once it’s no longer useful or at the end of its lease term. However, you can calculate residual value through a few different methods and formulas. You need to know how to understand the eventual value of a property before you invest in it. Today, we’ll break down what exactly residual value is, how it relates to real estate leases, and how you can calculate it efficiently.
What is Residual Value?
In a nutshell, residual value is the estimated value for a fixed asset at the end of its useful life or a lease term. For example, the residual value of a single-family home is its projected value after taking its lease term into account. Typically, an asset or property’s residual value is lower with longer lease terms or useful lives. Residual value can also be called “salvage value.”
Why does this matter? A real estate investor or seller needs to understand the projected residual value for a property to learn how they want to handle the asset at the end of its lease term (i.e., do they want to re-lease it, do they want to sell it, etc.).
By using residual value calculations, lessors can also understand how much value their home or another valuable asset will have after a lessee has used it. Note that different industries will use and calculate residual value differently. The residual value for a car is how much value it has after a lease term plus how much it was used. For real estate, the residual value of a single-family home is its value after the lease term expires.
Residual Value vs. Resale Value
It’s also crucial to understand resale value, which is similar to residual value but not identical.
Remember, residual value is the estimated worth of an asset at the end of its lease term or useful life. Residual value is usually expressed as a percentage of an asset’s suggested retail price. Say that you have a multifamily home worth $300,000 on its mortgage price with a residual value of 50% after 20 years. In that case, the home would be worth $150,000 in residual value at the end of its lease term.
Resale value refers to the value of an asset like a property or car after it has already been purchased instead of leased. In this way, resale value also refers to the value of an asset after it has been traditionally depreciated (i.e., used) and potentially damaged. Put another way, residual value is:
- Pre-determined based on projections from the company or owner of the asset
- Based on the original asking price for the asset
Meanwhile, resale value is:
- Based in part on market conditions
- Can change based on use, damage, etc.
- Determined at the time of a new sale or listing for sale
How to Calculate Residual Value
Now that you understand residual value, you need to know how you can calculate it when determining whether an investment property is a good choice or figuring out what to do with an investment property whose lease term is ending soon.
While residual value is usually calculated differently based on industry-specific factors, residual value is almost always calculated using this basic formula:
Residual value = (estimated salvage value) – (cost of asset disposal)
In this way, the residual value is how much salvage value is expected to remain in the property minus how much it may cost to dispose of or get rid of the asset.
“Salvage value” can often be calculated using comparable assets in the market. For instance, if you have a multifamily home in a neighborhood, you can calculate the estimated salvage value by looking at the value of similar properties in the same area. You can also determine residual value based on past models, future estimates, and any other projection tools or equations you may have.
Let’s break down an example so you fully grasp how to calculate residual value.
Say that you have a home with a mortgage price of $350,000
The lease term is for 20 years, and you’ve calculated the residual value to be about 70%
Furthermore, disposing of the property will cost you $10,000 in various fees, expenses, and more
You can plug the example numbers into the formula like this:
Residual value = ($350,000 x .70) – ($10,000)
Residual value = $235,000
In this example, the residual value was calculated by taking the property’s asking price and determining its residual value by looking at similar properties in the area, projecting the value of the property due to market conditions, and more. Then you subtracted the disposal fees to find the true residual value overall. Given this information, you can then determine:
- How much rent should be for any tenant living in the property
- Whether you should keep the property or try to sell it to another investor
As you can see, residual value is very important for real estate investors.
How Residual Value Works
While the above equation is useful, you’ll still need to fully grasp how residual value works at its core to use it effectively and accurately.
Imagine that you want to buy a new car because your old set of wheels isn’t running as well as it used two. Because you don’t care too much about purchasing a vehicle outright, you’ve decided that leasing a vehicle is better for your budget. As you shop around, you keep finding the term “residual value” on the lease contracts. That’s because your car lender is using residual value when determining how much they will charge you for your monthly lease payment. They (and you) can determine residual value by:
- Deciding on the vehicle’s cost (and subtracting any trade-in value or down payments you make)
- Obtaining the desired lease term and determining the residual value
- Determining the depreciation of the vehicle. For cars, this is the starting cost minus the residual value
- Adding the depreciation amount to any rental charges or lease payments. They do this by taking the total depreciation amount and dividing it by the number of months in the lease term
Say that you want to lease a $30,000 vehicle. The depreciation rate is supposed to be 20% over a single-year lease term. The residual value for the vehicle at the end of the lease term will be $24,000. Because of this, you’ll pay $6000 for the vehicle’s depreciation since it’s $30,000 minus the residual value. Since you divide the $6000 amount by 12 months (the lease’s term in months), you have to pay $500 per month before any extra fees and taxes.
You can transfer this same principle to your real estate calculations and pass the cost of depreciation onto your tenants. This is a great way to make the most out of your investments and ensure that you get your money’s worth out of a rental contract for the duration of the lease term.
Benefits of Understanding Residual Value
Still don’t know whether residual value has meaning for your investment goals? There are lots of benefits to understanding residual value.
You can’t know the total worth of your investment assets if you don’t know how to calculate and project their depreciation over time. In many cases, the depreciation of an asset affects its actual starting value. A savvy investor will know whether it’s worth purchasing an asset if it is set to depreciate relatively quickly. You wouldn’t drop several hundred thousand dollars on a property set to depreciate by orders of magnitude in just a couple of years, right? Residual value helps to calculate eventual or likely depreciation and, therefore, avoid making investment mistakes.
Choosing Wise Lease Rates
The successful real estate investor will know how to set the perfect lease rates for their tenants or renters. Through residual value, you can know exactly how much you need to charge your tenants to recover from residual value and to ensure you make a profit over the long term, not just in the short term.
Make More Educated Investments
Above all else, understanding residual value allows you to make more educated investments in real estate. This is the main goal you should be focused on at the beginning of your investment career, as it will affect how much money you make in your first decade or so of investing and how valuable your portfolio becomes over time.
All in all, residual value is a key tool that real estate investors – and regular folks looking to understand their rental bill or lease payments – can and should use as often as possible. Since residual value is simple to calculate, there’s no reason not to incorporate it into your decision-making process when deciding whether you want to buy an investment property or what rent rate you should set for your property tenants.