Is Every Item You Own Considered an Asset?
You buy something at a store, and you use it for a few years. Then, the item is no longer useful to you and you decide to sell it on eBay. You get much less than you paid for it. Would you consider this item an asset for the time that you owned it?
Technically, anything you own is an asset. However, in pure investing terminology, an asset is something that earns you money or has the potential to do so. To get a better understanding of this concept, let’s turn to the accounting equation.
In accounting, assets equal liabilities plus owner’s equity or shareholder’s equity for corporations. If you think in terms of the mathematics, this equation doesn’t make much sense. How can a liability added to the equity be equal to an asset?
A better way to imagine this is consider a home purchase. When you are ready to buy a home, your mortgage company or bank will require you to put 20% down. This amount is considered equity in your home. You now have 20% ownership of this home. The bank owns the rest, which is 80%.
Suppose the selling price that you buy the house for is $100,000. While it’s difficult to get a house for this price, it makes the percentages easier to work with. With a down payment of 20%, $20,000 of the home would be your share. $80,000 would be how much the bank owns. When you add the $20,000 and the $80,000, you can clearly see that adds up to the purchase price of the home, i.e., $100,000.
So, the home, which is supposedly an asset, is equal to your share (equity) plus the bank’s share (liability). But, is this house truly an asset?
Is a House an Asset?
In pure accounting terms, it can be considered an asset. However, from an investment standpoint, it isn’t. Why not?
The reason is you owe more than you own, and the asset is not generating any income during the holding period. One could argue that the price would appreciate over the long term, but there is no guarantee of that. You also need to factor in repairs, property taxes, and any other expenses that may hit along the time frame, including the interest that you’ll pay over the life of the mortgage which is substantial. With these factors, it’s possible (and some would say, likely) to break even or suffer a loss.
Smart business people evaluate the risks of their investments. Based on the scenario in the previous paragraph, a house from the standpoint of an investment is a risky proposition. After 30 years, there is no guarantee that you’ll earn any income from the house.
This isn’t meant to discourage anyone from buying a home to live in it. A house is part of the American dream and is a great means to raise a family. Just don’t get too caught up with the idea that it’s a great investment. It’s not.
Rent Out Your Home
Suppose instead of living in your home, you decide to rent it out. In this case, your house is an asset. You won’t be paying the mortgage because your tenant will cover that cost for you. In many cases, you’ll charge more than your mortgage and taxes. This means after the mortgage obligation is satisfied (paid off), you’ll earn a profit. Granted, there will be occasions where you’ll have to pay to fix the home. But, if you have several houses, or even better, rental units, the costs will be minimal. It’s not likely that all the units will break at the same time. You can set up a fund with your earnings to account for these problems. There is also insurance available to landlords for bigger repairs, etc.
When evaluating investments, you have to look at the opportunity costs of the investment. Assets that cost too much should be avoided whereas lower costs will lead to higher returns. This seems like common sense, but you’d be surprised how many people ignore the concept. It’s a bit of an abstract concept, which is the reason why most don’t grasp it.
There are assets that businesses will buy or lease that won’t earn money. But, most of these purchases could be classified as expenses. They are necessary for the operation of the business, even though they don’t add to the bottom line.
There are some gray areas here, too. For instance, buying a computer is generally considered to be an expense. But, a software company would use that computer to create it’s core product. Therefore, shouldn’t it be considered an asset in this case? Computers can also help employees increase productivity. This translates into profits somewhere down the line.
Getting back to the accounting equation, you can think of an asset in terms of how it is funded. For instance, the house example was 80% liability and 20% equity. Without putting the house to use , i.e., rent it out, etc., it’s going to take a long time before we own more than we owe. This is because mortgages are mostly front-loaded with the interest, meaning you pay more interest in the beginning of the loan than the end. Conversely, renting out the home allows us to fund 100% of our mortgage.
How Does All This Tie into Investing?
You may be wondering what any of this has to do with investing. If you are in the real estate business and want to earn rental income, this will become an important concept for you. The key is to choose the assets that have the most potential for returns. You could accomplish this by finding low-priced properties and charging the highest possible rents. Of course, this is an ideal situation. The reality is you’ll meet somewhere in the middle.
With stock investments, this concept is a bit more subtle. You have to find a way to learn management’s intention with the assets they buy or borrow. Are they borrowing too much to pay for assets that aren’t producing a good return? This will hurt the company over time. Borrowing can be a great tool when used correctly and a horrible one when it’s not.
How will you know? If sales are increasing but net profits are decreasing, you should investigate the reasons why. If the assets the company uses to earn its keep are costing more both in terms of initial cost and financing cost, that could be a red flag and you should put on your detective hat.