The Wonderful World Of Depreciation
Ah, depreciation! It’s a fascinating money topic that doesn’t get nearly enough attention. If you happen to find yourself talking about deprecation … say at a dinner party, you’ll quickly find yourself no-longer being invited to those dinner parties.
Depreciation is about as popular of a conversation subject as say … differential calculus. That is to say, it’s extremely unpopular. Discuss either topic in polite company and you’re bound to experience very a similar outcome — People’s eyes just glaze-over and they quickly find an excuse to be elsewhere.
“Wow, that’s fascinating stuff. If you’ll excuse me, I need to… uh… use the restroom. Well catch up later, OK?”
That’s too bad, because in my opinion depreciation is anything but boring. Depreciation is actually one of the more interesting topics in personal finance. Without hesitation, I can say that if you take the time to truly understand how depreciation works, you’ll be a far wealthier person because of it.
Wear & Tear
First, I suppose we should cover what depreciation actually is — Depreciation is an accounting idea used to approximate the real-world wear and tear on physical stuff.
Yep, you heard it here first folks: Stuff wears-out in the real world. Your car, your phone, your house, your favorite pair of jeans, and even your TV. They’ll all wear out. Sooner or later each and every physical thing you own is going to eventually wear out.
This wear and tear over time is measured by a concept called depreciation.
Now, earlier I mentioned depreciation was an approximation. This is because perfectly measuring the usable life left in an object is next to impossible in the real world. Depreciation simply helps us guess at the correct value.
Say for example, you buy the latest iPhone for $1000. Once you start using that phone, putting your greasy fingers on the screen and so forth, it’s going to start losing value. The rate at which that iPhone wears out is determined by a depreciation schedule. Everything depreciates at different rates, but most computers and consumer-grade electronic devices are considered fully-depreciated at the end of 5 years.
This means, your iPhone is going to be only worth “scrap value” in five years according to the rules of depreciation. The gold and other rare-earth metals in your phone are pretty valuable, so lets say that iPhone has a scrap value of $100.
Here’s what we know about the value of your phone so far:
Year 0: $1000 (still in the box at the store)
End of Year 5: $100 (scrap value)
The concept of depreciation helps us fill in the gaps to figure out what your phone is worth at any point in time. Using a “straight-line” depreciation method (the most common) this means your iPhone is going to “lose” $180 in value every year. Your phone would depreciate in value like this:
Year 0: $1000
End of Year 1: $820
End of Year 2: $640
End of Year 3: $460
End of Year 4: $280
End of Year 5: $100
Again, it’s important to remember that depreciation is just an approximation. Most people don’t actually manage to keep their phone in working order for 5 years. They either trade it in early, or the phone breaks before those 5 years are up.
For example, if your phone happens to permanently break during year 3, you’ll probably only get scrap value for it. However, if you take really good care of your phone, by putting a case on it and charging the battery properly, it could very-well last longer than 5 years.
For example — My Samsung Galaxy Note 2 is nearly 6 years old now. I’ve taken decent care of it, and the phone just keeps on working. It’s important to remember that what depreciation “says” and what happens in the real world can be two entirely different things.
Depreciation is an idea dreamed up by accountants to help humans understand the value of physical stuff as it wears out. Sometimes assets can live well past their expected lives and incur very little maintenance costs.
Other times depreciation can be a very real expense…
A Hidden Cost
For example, lets say you decided to buy a car after college to commute to your new job. Since it’s a new car, you’ll have a 3 year limited warranty to cover any defects. Driving to work everyday, you incur regular expenses like the cost of gas, and insurance. It won’t be until after year 3 that you’ll need to start paying for repair expenses out-of-pocket.
In the case of cars, depreciation is a very real expense — If you don’t take good car of your car with regular maintenance, it’ll stop working. You’ll need to pay cash for oil changes, tire rotations, fluid changes, new tires, and any repairs for stuff that breaks outside of the warranty.
So who pays for the cost of repairs in those first three years? The dealer? Nope — You do, but it’s a hidden cost. You paid for the warranty as part of that high-price, when you purchased a new car. The purchase-price covers the cost of depreciation in the first three years.
This is what’s known as opportunity cost. Instead of being able to invest the extra cash in an index fund for the last three years (and realizing some very good gains), you own a warranty on a car. Is it a good investment?
When it comes to paying now, or paying later — paying later is usually the better option in my opinion.
There’s a ton of debate in the personal finance universe on the “correct’ answer to this new vs. used car question, but my feelings on the topic lean toward ‘used’. Mainly because of that opportunity cost. There’s also the fact that when driving a “beater car” you don’t really worry about trying to maintaining everything in tip-top condition. A little imperfection is OK.
Depreciation And Investing
There’s a lot more to depreciation than just keeping up a house and buying used cars — knowing a little about how depreciation works can pave the way for some incredible investing returns.
This is what I did back in 2009 when the global economy went to hell. During that time, hotel REIT preferred shares went on sale. When most people were running for the exits, I was cherry picking the best hotel REIT preferred shares. It was investing heaven! Preferred shares that should have been selling nearly $25/share were selling at $11 or $12/share. Dividend yields on these preferred shares were between 12% and 18%.
Most people saw the losses hotel REITs were wracking-up and figured it would be “game over” soon. They ran for the exits, but I saw something different — a fantastic opportunity. I invested a huge amount of my spare cash…
You see, even though most hotel REITs were racking up business losses, I knew that depreciation is a non-cash charge and hotels REITs have massive amounts of depreciation. They were still generating quite a bit of cash, enough to keep afloat until better days anyway.
In the event of a cash shortfall, it’s possible for hotel management companies to defer maintenance capital spending for awhile … at least until the economy gets better.
Think about it — If you own a home and get laid-off during the next recession, you probably won’t be replacing the carpets, finishing a kitchen renovation, or build that nice big deck onto the back. No, you would probably start conserving cash, and only paying out only what was absolutely necessary to stay afloat. This is exactly what many hotel REITs were doing back in 2009.
Through some careful hand-dancing on a calculator, I was absolutely certain these investments would turn out OK over time. There were also additional features built into the preferred shares that made dividend cuts extremely unlikely.
I then “backed the truck up” and bought preferred shares in names like LaSalle Hotel Properties, Sunstone Hotel Investors, Felcore Lodging, and others. It was a once in a lifetime opportunity that paid-out extremely handsomely… all because I knew a little about how depreciation works.
Conclusions And Further Reading
Obviously I’ve only scratched the surface of depreciation here in this blog post. There’s tons to learn about the subject, including different depreciation methods for some assets, different depreciation schedules, and a better understanding of how depreciation and actual cash maintenance requirements vary over time. ‘
Obviously I know not everyone wants to become an expert on accounting, but the key is knowing enough about accounting so you can make smart decisions in your own life (as well as your investments). I was just lucky enough to take a few courses on accounting in college, and that made a huge difference in my life.
Topics like depreciation and amortization of intangible assets might sound pretty boring to most people, but when understanding these ideas can add hundreds of thousands (if not millions) of dollars to your net worth, you tend to sit-up and pay attention in class.
Not everyone has the same opportunities I did however, so I recommend further reading to anyone that hasn’t had similar exposure to accounting. Books like “Basic Accounting Concepts, Principles, and Procedures” by Gregory Mostyn are great primers on the topic for beginners, and come highly recommended.
It’s very possible to dive much deeper into the topic of accounting… but when you’re still learning to swim, there’s plenty to learn, earn, and apply from the shallow end of the pool!
[Image Credit: Flickr]
Ciao Tako san,
Very interesting read, can I ask you if you have a source where you screen these preferred stocks? It’s something that I was considering for my PF too, but apart from some big banks Preferred Stocks I do not know many others… Thanks for the help and ciao!
Stalflare
Preferreds are a little tricky to find. Quantumonline.com is a good source, but sometimes their information is a bit out of date.
Good stuff! Depreciation is a huge topic in real estate as well. So many people pay more in taxes because they don’t take depreciation on their homes or rentals. They also don’t factor in the potentially huge tax bill when they sell several years after buying. That is because the tax is calculated based on the depreciated home value.
Curious, how were you able to purchase preferred shares of the REITs as opposed to common stock? I don’t know much about preferred shares. I just thought they were reserved for employees or private investors
Thanks for the read!
Many preferred shares are traded on regular stock exchanges. You just need to know the symbol. Some preferred shares are private listings, but often you can find ones that are publicly traded.
Depreciation is a tricky concept. We know things are usually worth less as time goes by, but we rarely analyze it. Do you think it’ll be a good idea to write up an amortization table for everything you buy? That way we can be more aware of the real cost. Some stuff holds their value much better than others, especially used.
Nice move on the hotel preferred shares. Can you write a post about that? I thought preferred shares are kind of like bonds.
I’ll try to get that book from the library. The title is a contender for the most boring title in the world, though.
Enjoy your summer!
I have a post about preferred shares here that might interest you: https://www.mrtakoescapes.com/investing-in-preferred-shares-ftw/
It might be what you’re looking for. Really, preferred shares are hybrids between bonds and stock.
Great post and besides depreciation of cars most people don’t think about it. And you are mastering the smartphone game. In that 6 years that you’ve had your Samsung the average American has gone through 2 or 3 $800 iPhones.
My $99 LG X Power is 2 years old and still going strong. It may not last 6 years, but I paid under hundred bucks and it works like a charm!
It’s crazy to me how much people spend on phones today. If they’re buying a new $1000 iPhone every couple of years that’s a $500/yr bill just for the price of the phone! Crazy!
As someone who has spent less than $5 since August on phones you would think I would agree with you – but I do not.
I am not very interested in phones and do not use them much so spending loads on a phone would be crazy for me. My latest phone (obtained as I triggered FIRE in August) was a gift from my daughter when she upgraded and free wifi is everywhere where I live so I find usage charges are miniscule.
But my daughter loves her phone and uses it several times everyday and for lots of uses that I can only imagine. So it has huge utility to her and so she can justify spending a lot of money on it. I personally would not spend money in this way – but I can see why she does – our wants and needs are very different.
For me a good measure of value is $ per use. If you are going to use something lots and you like it or need it then, on this measure, the high cost can actually be seen as better value than things you buy that are much cheaper but only get rarely used. For example my wife bought me a hedge trimmer that months later is still in its original box! It did not break the bank but on $ per use a really bad buy.
Very informative post! I think it highlights that knowledge is power. I recently wrote an article on living life from a position of strength and highlight that the more you know, the more of a position of strength you’ll be in for a given situation, whether that be making a purchase, or negotiating a deal. With your example, I think your knowledge of depreciation played a key role in netting that sweet hotel preferred shares deal back in 2009.
I as well do not know much about preferred shares investing. Would love a post sometime. As far as the phones go, I’m still on my first smartphone (2nd phone) iPhone 6. Been having a few issues though so I can definitely see the effects of depreciation (the concept in the physical state)
I do have a post on preferred shares here: https://www.mrtakoescapes.com/investing-in-preferred-shares-ftw/
It’s one of my earlier posts, so it’s not the best, but it does cover some of the basics of preferred shares.
I wish I understood depreciation back in the day when I used to buy new cars – that could’ve put us ahead quite a bit of where we are now!
Depreciation works to our advantage with the rental property we own. Being able to take that expense every year for decades on our taxes helps it seem like the business lost money for the year. That’s a huge benefit! Unfortunately, you need to recapture the depreciation when you sell, but if you don’t sell, that’s not much of a problem.
— Jim
Absolutely. Depreciation can be good or bad depending upon how its used!
Depreciation along with business expensing are why I think it is such a good idea for most people to have a side hussle. Just take your blog. You have income so you can depreciate or even Section 179 depreciate a new laptop when you need one because you use it to produce the blog. People regularly take as a business expense or depreciate all sorts of electronics, services such as internet and phone, life insurance, mileage for the business, business vacations like going to FinCon, etc… Just be careful of the home office expense as this one backfires on a lot of people. Depreciation and expensing are truly the tools the rich use.
Indeed! Being able to expense many things and writeoff business asset depreciation is an incredible tax deduction!
Well said. I always love to think of the depreciation schedule / assumptions as something I need to beat – when you think of the carelessness / poor maintenance / human nature that goes into the assumption, it’s fun (well, fun for me…) to see how excellent maintenance and taking good care of things can beat those assumptions handily. Your Samsung is a great example of what’s possible and how you can still have great value from a fully depreciated / “worthless” product.
Love your site but I noticed something. You maximized your phone investment by purchasing a phone with a removable battery and you loaded Lineage on it. Most people don’t hack the boot loader and install lineage. Being a big android fan, the one glaringly obivious detriment is upgrades and updates. Manufacturers and carriers screw us on keeping them up to date. Apple doesn’t do that as much. So your upgrade gave you droid 7.1 but most people would be stuck with 4.4 if it was left to Samsung.
I am not trying to be a jerk to you. Just pointing out it is hard to use an android for 6 years without a diff OS. I like to buy my phones used (great condition) and Ebay. Use them for 3 years and sell them for another used one. Being in cyber security, I need patches.
Thanks for the expert posts. I have learned a lot.
Tako –
Coming from a CPA, depreciation/Amortization are great pieces to understand. The Non-Cash amounts are quite astounding, depending on the industry and how you truly are able to calculate earnings.
Further, on a personal side – depreciation should be considered in all things you do. Like you said – you pay for it either up front or you can pay later.
Obviously, depreciation is your friend when it comes to real estate.
-Lanny
Depreciation is gold for a real estate investor.
Depreciation for tax purposes allowed me to pocket $200,000 in cash without paying a cent in income taxes.