No discussion of capital appreciation would be complete without introducing the concept of cost basis.
Consider this scenario. Youbought a rental property for $100,000, and it's now worth $105,000. Sounds like a $5,000 gain, right? However, you spent $2,000 in closing costs when you bought it. All of a sudden, your $5,000 gain sounds more like $3,000.
When calculating capital appreciation, it's important to use your cost basis in the asset, not the purchase price. The cost basis is how much you paid for the asset, including any acquisition costs -- for example, a loan origination charge when buying an investment property would be a part of your cost basis. If you pay a sales charge for a mutual fund, that would also need to be taken into account.
Calculating capital appreciation
There are two main ways you can calculate capital appreciation -- in terms of dollars or as a percentage. Calculating the dollar amount of capital appreciation is easier; you simply subtract your cost basis from the asset's market value.
To convert this to a percentage, take the dollar amount of capital appreciation and divide it by your cost basis. Then multiply by 100 to express it as a percentage growth rate.
For example, if your cost basis in a stock investment is $10,000 and your investment is currently worth $11,000, your capital appreciation is $1,000. Dividing by your cost basis and multiplying by 100 shows that your percentage of capital appreciation is 10%.
Capital appreciation vs. income vs. total return
It's important to point out that capital appreciation isn't a broad term that refers to all investment returns. Specifically, income generated by investments is not a form of capital appreciation. Dividends paid by stocks, the interest rate paid by bond investments or savings accounts, and rental income from real estate are examples of potentially lucrative investment returns that are not included in capital appreciation.
For a bit more color, there are three general terms you can use to describe investment returns:
- Capital appreciation: The increase in market value an asset has produced since the date of purchase.
- Income: Any money that is paid out as a result of owning an asset, such as interest payments.
- Total return: The combination of capital appreciation and income that results from the ownership of an asset.
To illustrate this, let's say you're a real estate investor. You buy a rental property in an all-cash transaction at a cost basis of $100,000, and after one year, the property is worth $105,000. Over the course of that year, the property generates a net profit of $3,000 from rental income. Your investment has generated a total return of $8,000, or 8% based on your cost basis.
The Millionacres bottom line
It's important to understand capital appreciation because at the end of the day, investing is all about producing returns on your money. Knowing how capital appreciation works can help you assess the performance of your investments and determine whether they are outperforming or underperforming your goals.