What is Depreciation?

Depreciation: the decrease in value of an asset over time.

Why does a car decrease in value over time, but houses usually don’t? What do people really mean when they say something has depreciated?

Depreciation really comes in two flavors: physical depreciation and value depreciation.

Physical Depreciation:

Physical Depreciation is the actual degradation of an asset over time. 

This is what many people think of intuitively when it comes to depreciation. Think of the wear and tear of a car. Car engines are not built to last forever, so it makes sense that a brand new engine is worth more than an engine with 50,000 miles, as the older engine will require replacement sooner.

Perceived Value Depreciation:

Perceived Value Depreciation is the decrease in value of an asset due to a drop in its perceived value.

This kind of depreciation is more nuanced, but consider the common phenomena that a car loses 20% of its value the second it drives off of a dealership lot. The car has not experienced any sort of wear and tear, yet its re-sale value plummeted. Why?

There are a few reasons, but there is one main one. As consumers, we add a value premium to anything considered ‘new,’ and discount anything we consider ‘used.’

Another common example of value depreciation is when an asset is overpriced in the first place. 

Consider another common example. Jim buys an un-reliable, overpriced luxury car for $100,000. After one year, he goes to re-sell it. It only has 10,000 miles on it, so he lists it on a marketplace for $75,000 but gets no interest. He drops the price to $65,000, but still no interest. Eventually, someone makes him an offer for $50,000.

How did Jim’s car lose half of its value in just one year? No one thought the model Jim bought was worth that much money. 

Some customers may have seen that model and said to themselves, “That’s a nice car, but it’s not $100,000 nice.” 

Just because Jim paid $100,000 for it does not automatically make it a valuable car.

Ultimately, the value of something is whatever someone is willing to pay for it.

When do Cars Appreciate?

Cars appreciate in value through the opposite of those two flavors of depreciation: physical and perceived value. 

If you buy a beat-up old car and install a new engine, replace the tires, and give it a fresh coat of paint, you will likely be able to sell it for more than you bought it.

Similarly, if you buy a car that is really high in-demand, another customer may be willing to pay you more than you bought it for, even when considering the physical depreciation that occurred while you owned it.

Why Don’t Houses Depreciate?

As we discussed in our article about Negative Equity, houses can actually decrease in value. However, in general, while cars tend to decrease in value over time, houses tend to increase in value. Why?

1. House vs. Land - Although the house does physically depreciate (paint peels, appliances break, windows need replacement, etc.) the land beneath it generally does not. Land is a finite resource. As the population grows, the demand for the same amount of land increases while the supply of land stays the same. Through the laws of supply and demand, which we discuss at length in our article on inflation, this will cause the price to increase over time.

2. Maintenance, remodeling, etc. - Although a house bought for $400,000 one year and sold two years later for $500,000 might seem like a great profit, often hidden are the costs that go into keeping a house functional and any improvements that went into it. A house that just had a $40,000 kitchen remodel will be worth more than before. 

3. Inflation - Although housing prices seem to always be rising and are exorbitant in some areas of the country, often housing prices move generally in-line with inflation. This means that the actual intrinsic value of the house stays constant, its price tag just increases to match the devaluation of the currency. 

4. Miscellaneous - There are many other reasons a house can increase in value. A big company could move into town and suddenly there are a lot of well-paid employees looking for housing, driving home prices in the area up. Or, a house could be re-zoned into a better school district, making it more attractive for families. 

Those who are financially literate often prioritize buying appreciating assets vs. depreciating assets, as one will build your wealth over time, while the other will destroy it.