No matter how simple the concept, we simple humans make it complicated. We’re exceptionally good at making easy things hard.
In my view, one of the biggest dangers to our finances is confusing assets and liabilities. It happens far more than it should.
When Assets Become Liabilities
I have a perfect example for liabilities hidden as assets. Unfortunately, it’s a corporate finance example, but it works very well.
Sears Holdings Company (a combination of Sears and Kmart stores) has a ton of assets. In fact, investors let the firm go for less than half its current book value. Normally, this is one of those companies that I’d jump on like a mad man. I love when I can buy $1 for $.50.
But sometimes that $1 isn’t actually $1.
In the case of Sears, I added it to my Fool.com account as a short. I left a comment, though looking back it was one of my lazier ones.
Most of Sears’ assets are in commercial real estate. Now, I’m not a fan of commercial real estate. But this isn’t reason enough for me to avoid an investment. I’m a fan of investments that make sense, so I don’t really care what it is that I’m buying as long as it fits within my criteria of investing like the Pawn Stars.
Basically, I like to buy stuff and sell it for more than it’s worth. That’s a pretty easy to understand investment thesis.
One could try to make the case that Sears is selling for less than it’s worth. If you took the company, broke it into pieces and auctioned it off you should be able to make a profit. If you buy it for $.50 on the dollar, you can sell the assets at 50% of their value and still make a profit.
Simple logic, right? If you pay $.50 for a $1 bill, you can’t afford to sell that $1 bill for less than $.50.
Action vs. Words
The problem with Sears’ assets is that they aren’t assets at all. Consider the types of real estate that Sears Holding Corp. might own. You’ll quickly come to the conclusion that they own really big stores – they do! Fantastic conclusion.
Now, what do you know about real estate? How does commercial real estate earn its value? I would say all these things make commercial real estate valuable:
- Foot traffic; car traffic
- Average income within +/- 10 miles
Are those hard and fast rules for commercial real estate valuation? Ha – by no means! I’m no real estate expert, but I could probably pretend to be one on TV.
But now let’s hone in on Sears’ commercial real estate. Sears’ commercial real estate has the following traits:
- It’s large in terms of square footage
- It’s likely older, since accumulated depreciation is worth >56% of Sears’ property and equipment.
- Sears’ real estate holdings are anchor store properties.
These qualities are very important when it comes to determining the value of Sears’ properties.
The problem with Sears’ real estate holdings is two-fold. The first problem relates to accounting, the second problem is highly-relatable to personal finance:
1. Depreciation tax benefits – On the sale of property, Sears’ would have to pay more cash income taxes to balance the depreciation benefits it received over the life of the property. If we’re selling this property at a discount, this becomes a double whammy!
2. Value isn’t intrinsic – The simple fact is that Sears’ real estate is worth more to Sears’ than anyone else. Partially due to the tax benefits and partially due to the fact that it’s not easy to sell real estate when the anchor store departs. In the same way, there aren’t many big stores that can fill this space. Less demand equals lower prices, assuming supply remains constant.
Real Estate Meets Cars
Cars are a great personal finance equivalent of something lacking in intrinsic valuation. Cars allow us to get from point A to point B. Getting from Point A (home) to Point B (work) generates cash flow to our personal finance equation.
But a $50,000 car, in no way, adds more to our earnings than a $5,000 beater. We still get to work, and we still make the same amount of money.
When people confuse assets for liabilities, they make really dumb decisions. You know the types – people who buy a $25,000 car after getting a new job. “But I needed a new car to get to work!” Maybe you did, but you didn’t need a $25,000 car when a $5,000 car could get the job done.
That extra $20,000 between $25,000 and $5,000 is a liability. It’s lost money. It’s lost time value of money, too.
This is just another example of the kind of thinking that, no matter how pervasive, leads to really bad financial decisions. The car discussion is almost always limited to financing depreciating assets – don’t do it, dude!
Yeah, whatever. How about we stop worrying about how we buy and instead focus on what we buy? If what we buy is going to be consumed at a rate above the average of an alternative, then it is very clearly a terrible investment. If what we buy is most valuable in our own hands, we’ll never resell it for what we paid for it. That’s just how it works.
Since the real estate on the books at Sears’ is worth more to Sears’ than anyone else, it isn’t a real asset. At least, it’s not worth nearly as much as is stated on the balance sheet. Thus, book value is irrelevant and you’re not buying assets at a discounted price. You’re buying a liability.
Who wants to spend good money on a liability?
Photo by: justj0000lie