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]