What Is Economic Depreciation?
Let me tell you directly: economic depreciation is how we measure the drop in an asset's market value over time because of various economic factors at play. This mostly applies to real estate, where things like unwanted new buildings nearby, closed roads, a neighborhood going downhill, or other bad influences can cut into a property's worth.
How Economic Depreciation Works
In economics, depreciation means the value an asset loses from factors that hit its market price. If you're an asset owner looking to sell at market value, you should pay more attention to economic depreciation than the accounting kind. It directly affects what you can get when selling, and you might want to track it closely. In business accounting, though, we don't usually note economic depreciation on financial statements for big capital assets—accountants stick to book value for reporting.
You'll see economic depreciation in several financial analysis scenarios. Real estate is the classic example, but it comes up elsewhere too. It can even factor into forecasts for future revenues from goods and services.
Key Takeaways
- Economic depreciation measures the decrease in an asset's market value over time from influential economic factors.
- You can analyze economic depreciation in various scenarios.
- It's crucial for asset owners who plan to sell in the open market.
- Economic depreciation differs from accounting depreciation, which reduces value on a set schedule over a specified period.
Economic Depreciation vs. Accounting Depreciation
Calculating economic depreciation isn't as straightforward as accounting depreciation. In accounting, a tangible asset's value drops over time on a fixed schedule. But with economic depreciation, the value loss isn't uniform or planned—it's driven by economic factors.
This often happens with real estate. During economic slumps or housing market drops, economic depreciation can lower market values. The overall housing environment matters, but so do specific issues like bad neighborhood builds, road closures, declining area quality, or other negatives. Any adverse economic factor can cause economic depreciation and a lower appraisal. The gap between appraisals shows a property's economic depreciation.
Appraisals are essential for grasping economic depreciation—they happen for all asset types and are often the main way to spot it. Financial analysts might also factor in economic depreciation for future projections and cash flows, basing it on expected revenue drops from goods or services due to negative influences.
Accounting Depreciation
When people mention depreciation, they usually mean the accounting version. This is about spreading an asset's cost over its useful life to match expenses with the revenue it generates. Businesses set up these schedules with taxes in mind, since the IRS allows depreciation as a deductible expense.
Most businesses depreciate assets down to $0 book value, figuring the asset's value and expenses are fully matched to its revenue over its life. Sometimes companies keep some book value after full depreciation.
Remember, an asset's book value and market value are typically quite different. Financial statements might not show economic or market value, but that's what you'd get if you sold the asset.
Depreciation vs. Appreciation
Both economic depreciation and appreciation can shift an asset's market value. Sometimes, from one appraisal to the next, you see an increase—that's positive appreciation or essentially negative depreciation.
Take the 2008 credit crisis and housing collapse: subprime loans with little or no down payments, combined with huge value drops, left many U.S. homeowners underwater, owing more than their homes were worth due to economic depreciation. In hard-hit spots like Las Vegas, home values fell by up to 60%.
On the flip side, economic factors can boost values too, leading to appreciation. After the 2008 crisis peak, regulators and the central bank stepped in to improve conditions, sparking a housing rebound and major appreciation in real estate values between appraisals.
Valuing Assets
All assets face risks of economic depreciation and appreciation. Companies and investors handle these differently. A company might not worry much about how economic depreciation hits the market value of its tangible assets. But everyone watches how market forces affect liquid assets like stocks, bonds, and money market accounts.
Companies track depreciation and appreciation more for assets they mark to market regularly, as it impacts performance directly. Investors definitely monitor it in their portfolios, since it can swing net worth day to day.
Liquidity matters too when analyzing this. Real estate might see big yearly swings from economic effects. With more liquid assets, you view depreciation or appreciation differently because economic factors can change values overnight.
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