Assets are probably the least understood part of financial statements. Like I’ve mentioned before, I have a lot of education about finances and also work as a full time finance professional. But even after all that technical education, I still did not have a fundamental common sense understanding of them.
Firstly, standard, technical definitions of assets all orbit around the concept of how much an asset can be sold for. The normal understand that most people have of them is that they are the big tangible things you own such as house, real estate, car, art work, tools, etc. Both are correct …ish.
The definition that I use is more nuanced than those. I think that assets are on a scale between bad assets (that actually have characteristics of liabilities) and good assets. The diagram below hopefully illustrates this. Any asset falls in one of these boxes. I know that some have characteristics that might make it hard to categorize them such as a rental that has both positive cash flow from the rent payments and often times has negative cash flow for the mortgage payments. But if the net of those in’s and out’s is positive, then it has positive cash flow.
Depreciation/Appreciation Buying assets that are going to hopefully appreciate is essentially betting that its value will go up. Which might depend on the economy staying strong, interest rates staying low, demand going up faster than supply etc. For myself, I like appreciation, but I go into it with a full realization that it has elements of gambling and that the appreciation depends on many factors outside of my control or ability to predict.
Cash Flow This is the net cash flow that an asset produces from operations (positive cash flow) or takes to run (negative cash flow). These can be rentals, dividend paying stocks, bonds, businesses, etc. In my opinion positive cash flow is better than appreciation for several reasons.
- In good times – Positive cash flow will probably lead to appreciation anyway because as cash flow goes up, it increases in value to future buyers/investors who are looking for higher cash flow.
- In down times – assets depreciate. And cash flows might drop. But there is usually less of a drop in cash flow than there is a drop in value. Why? Because people in your rentals still have to have a place to live and have to pay rent. Bonds that you own still have a pretty good chance of paying. Even in bad times. But the fact that the cash flow doesn’t take as much of a hit helps weather those bad times. I live this out over the past 5 years during the real estate downturn with my rentals. Also, when the cash flow stays steady in the down times it becomes more valuable to other cash flow investors.
- Flexibility – Owning lots of gold won’t let you quit your day job. You’ll still have to buy groceries. Positive cash flow has the potential to replace my regular 9-5 job in the future and give me more financial freedom. And safety. If I lose my job, cash flow assets will help me through the dry times.
House is a liability?
Notice that house is under negative cash flow. Someone told me this a LONG time ago I vigorously disagreed with them. It took me years to realize they were right. Our house has luckily increased dramatically in value. We bought in 2009 for $210k and even though all the housing prices were down, this one was even lower because it was a fixer-upper. You can see by our current balance sheet that it is worth somewhere in the neighborhood of $380k now. So, don’t get me wrong. I really really like appreciation but appreciations doesn’t pay the monthly bills and we have to set money aside each month for repair and maintenance. And since those upkeep costs are a payment that I am committed to making, it is kind of like a liability in that way. Those monthly maintenance “payments” combined with our mortgage payment make it my favorite asset to love and hate.
The Hidden Cost of Assets
One thing I’ve learned is that all things I own have an “operating cost” or negative cash flow. When we installed a fence around our yard, it was great. We had saved and saved and when it was done, I thought “Great! I don’t have to save for this anymore.”. But in reality I now have to set money aside to buy weatherproofing stain and supplies each year to maintain it. Another example is our computers. I bought my first laptop late last year and have realized that we have to save for when it breaks and we have to fix or replace it. And that is why we have “buckets” that we use to manage our money. Several buckets are saving to repair or replace our assets when needed.
When I introduced the “Money Machine” diagram, I tried to show it as a way of looking at your financial situation and forming a strategy broken into a series of strategies around each box in the diagram. Assets can, and probably should, be a huge part of your strategy. Hopefully this article helps get you take an inventory of your current assets and think about what assets you want to either get rid of or accumulate and use in your strategy. Personally we have owned two rentals during the past 5 years. We sold one last month, so we’re down to one. We absolutely learned a LOT and we want to get back into them more in the future.
Just a quick note here. When you are tracking your asset values, be very thoughtful and conservative. When I list our real estate on our balance sheet I use the Zestimate from Zillow.com and reduce it by 10% because I know that it will cost at least that much to sell it. I’ve found the Zestimate to be pretty accurate in the past and our real estate is pretty “normal” for our neighborhoods, so I think that the Zestimate should be pretty close.
Finding Good Assets
I’m going to write some articles about finding good assets but to get you started, think about assets that might produce cash flow. They are the harder types of assets to find and it takes a paradigm shift for most people to think about. Maybe the prospect of rentals is daunting because of the cash you need upfront to buy them. If that is the case, think about peer-to-peer lending, vending machines, dividend stocks, etc that require often times just $25-100 to buy into. They will help build your cash reserves for that big future rental or franchise purchase.
Make sure you realize what your biggest cash producing asset is at any given point in time. AND what asset has the most potential for future cash flow. Right now mine is my career. Yes, my career. And yes, it’s not listed on our Balance Sheet. But if I’m looking at things in terms of cash flow, I have to realize that it has the best current and near term (5-10 year) potential cash flow. So that is currently where I put my efforts. It would be extremely easy to allow myself to be distracted and start pursuing other side efforts to produce cash flow but I know that right now I have to be focused on my career while we pay down debt.
Do you have an asset strategy that you are aiming for or have implemented? If so, what is it? We would love to hear your thoughts on this.