What is Residual Value – Importance, Calculation and Examples
An important aspect to consider regarding any asset is its potential for depreciation. This is particularly relevant for real estate investors, who need to account for depreciation when buying or selling properties. It is also relevant for people looking to purchase materials or equipment for a business.
Knowing the initial value of an asset or property is not very difficult. It is essentially the price set by the first seller. However, the real problem arises when the residual value of an asset needs to be calculated. The residual value of an asset is its value at the end of the lease term, or after it ceases to be used. Various methods and formulae can be used to calculate the residual value. This allows potential investors to find out what a property will eventually be worth, and to decide whether to go ahead with an investment or not.
Let’s take a closer look at the meaning of residual value, its significance in real estate leases in particular, and how to calculate the residual value of an asset.
What is Residual Value?
As indicated above, the residual value of an asset is the estimated value of that asset once its useful life or lease term ends. The residual value is typically lower for properties with longer useful periods or lease terms. It is also referred to as ‘salvage value’.
This value helps asset owners determine what to do with their assets once their lease term is over. An owner can decide whether they wish to sell the property, re-lease it, etc. There is also a concept known as ‘guaranteed residual value’, which refers to the residual value of a leased asset that is guaranteed by the lessee or a third party.
There are different residual value calculators for different industries that take into account the usage of the asset, its standard life, etc.
How Does Residual Value Work?
Investors can use the concept of residual value effectively and accurately only if they understand how it works at its core.
The residual value of an asset is estimated by the lender who holds the lease contract. All lenders have a different way of arriving at this value, irrespective of the industry resources they refer to. This value is one of the primary factors that is used to calculate the monthly lease amount.
For instance, let’s suppose that you are leasing a vehicle. The steps given below will be used to calculate its residual value:
- The lender will finalise the vehicle cost with the lessee
- Any trade-in value or down payment cost will be deducted from the decided cost
- The lessee will inform the lender about the desired lease term
- The lender will use their residual value calculator to calculate a residual value based on the agreed-upon cost and the lease term
- The lender will then calculate the depreciation on the vehicle by subtracting the residual value from the starting cost
- Other costs like rent, taxes, fees etc. will be added to the depreciation amount and the resultant figure will be divided by the number of months in the tenure. This will yield the monthly payable amount
Thus, if a vehicle worth Rs. 2,00,000 is being leased, and the expected depreciation is 20% over a 1-year lease term, the vehicle’s residual value will be Rs. 1,60,000. Rs. 40,000 (the depreciation amount) plus rent, fees and taxes will be divided by 12 to get the monthly payment amount. The higher the residual value of the vehicle, the lower will be the monthly payments that the lessee will incur.
The same principle can be applied to real estate calculations, and the depreciation can effectively be made up for by tenants. In this way, real estate investors can make the most of their investment and ensure that they get as much value as possible from their rental contract for the lease duration.
Importance of Residual Value
Calculating the residual value of assets is extremely important for investors and asset owners. Here are two key benefits of understanding and calculating the residual value:
- Computing depreciation: It is impossible to figure out whether an investment decision is wise or not if the total future worth of an investment is not known. Knowing how the value of an asset depreciates can help determine a fair initial value. Savvy investors can also stay clear of investments that may seem attractive at the outset but may depreciate very quickly. Thus, understanding residual value can help you avoid expensive investment mistakes.
- Determining profitable lease rates: The idea behind handing over a piece of property to a tenant is to keep the property safe and earn income from the investment. However, if the depreciation is higher than what you earn, it defeats the purpose. Residual value helps you understand exactly how much needs to be charged as rent or lease to ensure profitability.
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How to Calculate Residual Value
While there are various residual value calculators online, it is important to understand the concept behind the calculation to make sound decisions.
While industry-specific factors determine the precise details of how residual value is calculated, here is the basic formula:
Residual value = (estimated salvage value) – (cost of asset disposal)
According to this formula, the residual value is the expected salvage value of an asset minus the cost associated with getting rid of the asset. The calculation of salvage value is done based on comparable assets available in the market.
Residual value can also be calculated based on past models, future projections, and other available equations or projection tools.
Example of a Residual Value Calculation
Here is a residual value example that illustrates how it is calculated:
Imagine you own a house with a mortgage price of Rs. 25,00,000. Take the lease term to be 20 years and the estimated salvage value to be 70%. Additionally, property disposal may further cost Rs. 1,00,000 in fees and taxes.
Based on the above formula,
Residual value = (Rs. 25,00,000 * 0.70) – Rs. 1,00,000
Residual value = Rs. 16,50,000
This example takes into account the asking price of the property and determines its salvage value by looking at the values of similar properties in the area and projecting them based on market conditions and other factors. The true residual value is then determined by subtracting the disposal fees.
The resultant value can now help the asset owner determine the rent they can demand from a tenant. It will also help the owner decide whether they should keep the property or sell it to another investor. Thus, residual value is of great importance to real estate investors.
Calculating Depreciation/Amortisation Using Residual Value
Residual value plays an important role in calculating a company’s depreciation or amortisation. Suppose a company buys new software for a specific task within the organisation. Take the initial cost of the software to be Rs. 1,00,000 and consider that it will be useful for 4 years. For accounting purposes, the amortisation can be calculated using the software’s residual value or its worth at the end of four years.
If the value of the software at that point of time is zero and the company used the straight-line method to amortise it, they must subtract the residual value from the initial value of Rs. 1,00,000 and divide it by its useful life of 4 years to get the yearly amortisation. Here, the annual amortisation would be Rs. 25,000.
In case the owner wishes to calculate the value of tangible assets like computers or machinery, they would carry out the same calculation, but use the term ‘depreciation’ instead of ‘amortisation’.
Residual Value vs. Salvage Value
The terms ‘residual value’ and ‘salvage value’ are often used interchangeably. However, the term ‘residual value’ is used more often in the context of leases. It is used to find the projected value at the end of the term. Salvage value, on the other hand, is a more general accounting term that can be regarded as the value that can be recovered from the asset’s sale once its useful life ends.
For instance, the salvage value of a vehicle is the amount that the insurance company can salvage by selling the parts to a yard.
For such a vehicle, the salvage value may be lower than the residual value, and that depends on the condition of the vehicle when the lease ends. While a lender computes the residual value based on the lease term and the decided cost of an asset, an insurance adjuster estimates the salvage value based on the costs associated with the disposal of the vehicle, and the auction values of cars that were similarly salvaged.
Special Considerations With Respect to Residual Value
- When you are looking to lease a vehicle for a fixed amount of time, opting for one with a high residual value is ideal. This will ensure that the monthly payments are lower.
- If you wish to purchase a vehicle once the lease term ends, it is a good idea to look for one with a lower residual value. In this case, the monthly payments will be higher, but the cost when the lease ends will be lower.
- The residual value is not the sole factor to be considered. There are other aspects like the down payment, interest rate, fees and taxes, etc. Be mindful of all these factors before making a decision.
Final Word
The residual value of an asset is an important tool for real estate investors, asset owners, and people looking to decipher their rental bills or lease values. It enables people to make sound investment decisions, and helps them decide what they should do with their property. It is easy to calculate, so there is no reason to keep it out of the decision-making process. It can be immensely helpful in deciding the amount of rent to charge or whether to buy a property. It is wise for everyone dealing with assets to pay attention to it.
FAQs
Ans. The residual value of an asset is an estimation of its value at the end of its lease period or useful life.
Ans. Various different formulas for residual value can be used, based on the industry. However, the most general formula is:
Residual value = (estimated salvage value) – (cost of asset disposal)
Ans. The residual value of an asset is used to compute its selling price after the completion of its useful life. It helps determine the worth of an asset after the lease period ends, and also helps investors and owners make decisions regarding assets. It also helps asset owners come up with an ideal rent value for an asset.
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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