What is Economic Depreciation
Economic depreciation is a measure of the decrease in value of an asset over time. This form of depreciation usually pertains to real estate, which can lose value due to indirect causes such as the addition of new construction in close proximity to the property, road additions or closures, a decline in the quality of the neighborhood, or other external factors. Economic depreciation is different than the accounting depreciation expense on tangible assets, such as machinery or equipment.
BREAKING DOWN Economic Depreciation
In periods of economic downturn or a general housing market decline, economic depreciation must be considered when a property goes through an appraisal. During the credit crisis and housing market collapse of 2008, the combination of subprime loans requiring low or no down payments with the dramatic drop in housing values resulted in a significant amount of the U.S. home owners owing more money on a home than it was actually worth.
Factoring in Liquidity
Real estate’s lack of liquidity makes the impact of economic depreciation more profound for the owner. Liquidity refers to the ability of an owner to sell an asset, and assets that sell on exchanges, such as stocks and bonds, are more liquid than real estate and other assets. If, for example, an investor wants to sell 100 shares of IBM common stock, that investor can check the bid price on a stock exchange and place a trade to sell the stock on any business day. Real estate, on the other hand, requires the seller to find a buyer, and the two parties must negotiate until the parties agree on a price. In addition, the sale normally requires an appraisal of the property, and a real estate sale can take months to complete.
Differences Between Tangible and Intangible Assets
Economic depreciation is different than the accounting depreciation recognized for tangible assets as those assets are used to create revenue. While land does not depreciate, buildings and other tangible assets do recognize depreciation, which is the decline in value of a physical asset as the asset is used over time. Assume, for example, that a roofing company uses a truck to perform residential roofing work, and that the truck is used for seven years. As the truck is used each year to generate revenue, the company also posts depreciation expense for the decline in value of the asset. Intangible assets, such as a patent or other intellectual property, do not depreciate in value.