Capital Appreciation to Capitalization

Capital Appreciation

In real estate investing and development, capital appreciation is the increase in the market value of real property (or other investments) after adjusting for capital improvements made.

Capital appreciation does not take into account any revenue or cash flow profits. Rather, capital appreciation is basically the profit your investment capital has earned from the rise in your property’s market value.

For example, Steve buys a Cape Cod home in a popular vacation spot. He pays $100,000 cash for the well-maintained home, which he promptly starts renting out to vacationers. Three years later, having made no capital improvements to the property, Steve has his investment Cape Cod property re-appraised, and the appraisal report comes in at $150,000. He just realized $50,000 in capital appreciation.

Similarly, if your commercial building increases in value by $100,000 after you have made $60,000 in capital improvements, your building has experienced a net capital appreciation of $40,000—for that capital improvement.

Note that capital appreciation doesn’t take into account any closing costs, financing fees, appraiser charges or other non-capital expenses. Capital appreciation only measures the market value and the capital investments made.

Capital Asset

Capital asset is an accounting and IRS term that distinguishes inventory assets from assets of a more permanent nature.

Inventory assets are meant to be re-sold. Capital assets are used for the production of income and/or appreciation. Real estate investments can be both inventory and capital assets.

For example, a developer builds a high-rise building, and the units are intended for resale to new homebuyers. Those condo units are inventory assets.

However, another developer builds the exact same type of building, but as an apartment building to be leased to tenants. That apartment building is a capital asset, which makes it subject to a different set of taxes.

Capital Expenditure

Capital expenditures are costs and expenses incurred for capital improvements. Capital expenditures are more significant than standard repairs and maintenance expenses, so it is not included in the operating expenses. Capital expenditures increase the life of the property, so they are calculated against the capital gain.

For example, adding a green roof to a building or replacing the 50-year-old furnace with a more energy-efficient unit would be considered capital expenditures.

However, repainting the hallway, repairing an existing furnace or fixing a leak in the roof would not be considered capital expenditures. Although an argument can be made that such repairs can extend the life of the property, they are not considered capital expenditures. Instead, such repairs primarily maintain the condition of the property or improvement.

Capital Gain

Capital gain is the profit generated upon the final sale of an investment. Another way to look at it is that capital gain is any gain realized from the sale of capital assets. Real estate is such a capital asset investment, and the profits from the eventual resale or transfer of a real estate property are considered capital gain. With real estate, capital gain is based on the resale price and the adjusted tax basis amount; the adjusted tax basis is the original purchase price plus any capital improvements made, but less certain depreciation deductions taken by the owner.

Capital Gain Tax

A tax on an investment’s realized capital gain. Long-term capital gains are currently taxed at 15%, although this is slated to return to 20%. Short-term capital gains are taxed at the taxpayer’s ordinary tax bracket. For example, Theodore buys a $50,000 handyman special and immediately invests another $25,000 fixing up his new investment property. He then sells it six months later for $200,000. After taking out his capital investment of $75,000 (purchase price and improvements), he has made $125,000 in gross capital gains. Because he has owned the property for only six months, his profits would be subject to short-term capital gain taxes—which are charged at his higher personal income tax rate.

Capital Improvement

Capital improvements refer to physical upgrades, additions or renovations that extend the life of a property and, typically increase its market value. All additions to real property are normally considered capital improvements. However, not all upgrades will necessarily increase a property’s value. For example, you could spend $75,000 installing $5,000 solid gold doorknobs throughout your home. But if all the comparable properties in your community are valued lower than your home—even if they don’t have doorknobs—your property’s value would not see much, if any, increase in value from those solid gold doorknobs. Note that repairs are not considered capital improvements, because they only maintain the value of a property.

Capital Market

The “capital market” is a loose term applied to the business arena in which investors, businesses and developers raise capital funds. The capital market includes individual investors, commercial banks, investment funds and even governmental entities. Specific capital markets can be both private (network of private investors with money to invest) and institutional (Wall Street and financial market). The real estate industry depends on the capital market for its health and continued growth. Developers and investors rely on it for funds to acquire, subdivide or improve real property. Homebuyers and sellers depend on the capital market, albeit indirectly, to provide the funds that many mortgage loan providers need to lend money.

Capitalization

In the real estate industry, capitalization is a measurement of a property’s value that is based on the property’s projected or actual income. Capitalization estimates a property’s (or business’) value according to the revenue it generates. This is commonplace in business, wherein the value of most small businesses is based on their cash flow. The value of income-generating real estate is likewise based on its cash flow… usually. There are periods, particularly during the high points of a boom, when speculators ignore the connection between revenue and value. The price/earnings (PE) ratio is a form of the capitalization metric, applied to securities. The equivalent in the real estate industry is the capitalization rate.