When Assets are Liabilities

by JT McGee

sears, sears holding corporation, assets and liabilitiesThe personal finance equation is quite simple: assets must grow faster than liabilities.

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.

False Assets

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:

  • Location
  • 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.

Valuation

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

{ 15 comments… read them below or add one }

Darwin's Money January 11, 2012 at 20:33

Even in my personal finances, I don’t really like counting my home as an asset. it’s illiquid, if I sold it I’d just need to outlay funds to live somewhere else and the valuation is never what you think it is.

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Jonathan January 12, 2012 at 11:38

I’d always consider it an asset regardless of your points for a few reasons. First of all, when you sell it you could choose to rent; you could choose to move to a lower cost of living area; you could choose to buy a much smaller house; you could choose to travel the world for years without ever having a permanent residence. Under all of those scenarios, the sale of the house (an asset) would provide funds to do those things. Secondly, and primarily, your house has very real value. If you have a mortgage, I’m sure you include that as a liability; why wouldn’t you balance that with the asset it is backed by in a net worth calculation?

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JT McGee January 13, 2012 at 11:59

I guess the big benefit is that people who value their house at $0 never over-value it. 😉

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101 Centavos January 14, 2012 at 10:57

Right!
Even without considering the associated loan liability, homes could be considered non-producing assets.
Even though a home’s basic function is shelter, it requires constant inputs in the way of heat/air/water and regular maintenance on top of that.

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LaTisha @YoungAdultFinances January 11, 2012 at 23:49

No one. Which is why Sears is not doing so hot right about now. I read something in Forbes about trying to make it the next Berkshire Hathaway. I don’t see it but it’s a possibility.

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JT McGee January 13, 2012 at 12:00

ROFL. That’s hilarious! Best of luck to Sears in that venture.

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Juan January 12, 2012 at 17:02

It can be difficult to differentiate the differences between quality assets and time bombs. Just like all of those banks before 08 people had no idea what the true value of the off balance sheets assets and the derivative exposure for those large banks like lehman brothers and investors were forced to pay the price.

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JT January 14, 2012 at 12:25

Ehhh, that’s because there was no market for the assets, which is almost true of expensive, large-sized commercial real estate.

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Doctor Stock January 12, 2012 at 22:50

The first thing I thought of when you talked about assets becoming liabilities was CAR! Absolutely, what a drain on almost any net worth.

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JT January 14, 2012 at 12:26

I’m wondering when mine will decide to become a super-liability.

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Wayne @ Young Family Finance January 13, 2012 at 21:03

I believe this is why so few retail operations own their store fronts. They are able to smooth earnings with the lease expense and not tie up cash on the balance sheet like Sear/Kmart.

Also from a business standpoint, the store front is a waste in cash investment. There business is to move clothes, kitchenware, home products. Their business is not to sell storefronts. It doesn’t make a lot of sense to have spent so much on assets that aren’t really going into the products you sell.

It’s really a lesson in cash management.

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JT January 14, 2012 at 12:28

You know, I was thinking about this angle a lot as I wrote this article. I concluded that maybe it might have been a sign of the times – Sears was one of the first BIG retail department stores and it might have been that building their own storefronts was the only option? Obviously that doesn’t excuse the fact that they could have sold them later with a lease agreement, but you get the idea.

I run my own business, and at no point would you convince me that I should buy my office space rather than rent it. Businesses are supposed to be more fluid – my industry is especially more fluid than real estate – so buying my own space wouldn’t really make a lot of risk-adjusted sense to me.

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World of Finance January 13, 2012 at 21:17

Nice article! Random fact, did you know assets are listed in order of liquidity on a balance sheet. I’m sure current assets were quite minimal for Sears.

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JT January 14, 2012 at 12:29

Sears has tons of current assets! They just also have tons of current liabilities. 😉

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Bill Swan January 16, 2012 at 13:15

The car is an excellent example. An offshoot of this is buying a bike instead of a car when your job is that close. Now, as a business I would be looking for the cheapest way to get to a location that still allows the pay I expect. This is why I find Dunkin Donuts and McDonald’s in partnerships with convenience stores. This is why I have a Subway in a Walmart nearby. They use probably half the needed structure of a free-standing building, and they already have the foot traffic and exposure.

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