Economic Depreciation

What it is

Economic depreciation is the decline in an asset’s market value over time caused by economic factors. Unlike accounting depreciation, which follows a predetermined schedule, economic depreciation reflects actual changes in what buyers are willing to pay. It is most commonly discussed for real estate but applies to any asset whose market value can change due to external conditions.

How it works

• Economic depreciation is driven by market forces and external events: changes in local development, neighborhood quality, infrastructure projects, broader economic downturns, or shifts in demand.
• It is observed through market prices or comparative appraisals over time rather than a fixed formula.
• Asset owners and analysts monitor economic depreciation when preparing to sell assets, valuing portfolios, or forecasting future cash flows and revenues.

Economic vs. accounting depreciation

• Accounting depreciation:
• Allocates an asset’s cost over its estimated useful life according to set methods (straight-line, declining balance, etc.).
• Used for bookkeeping and tax purposes; produces a book value on financial statements.
• Is scheduled and generally smooth over time.
• Economic depreciation:
• Reflects the asset’s actual market value changes, which may be irregular, sudden, or gradual.
• Not typically recorded on standard financial statements unless assets are marked to market.
• More relevant when assessing sale value or market-based forecasts.

Depreciation vs. appreciation

• Depreciation reduces market value; appreciation increases it.
• Both are driven by the same market dynamics but in opposite directions. For example, during the 2008 housing crisis some markets saw house values fall by large margins (in extreme cases reported declines around 60% in hardest-hit areas), while subsequent policy and market recoveries produced significant appreciation in later years.

Valuing assets and practical implications

• Appraisals and observed market transactions are primary ways to measure economic depreciation.
• Liquidity matters: liquid assets (stocks, bonds) can reflect economic depreciation or appreciation quickly, while illiquid assets (real estate) may show larger year-to-year swings and be slower to adjust.
• Companies pay more attention to economic depreciation for assets they mark-to-market or plan to sell. Investors monitor it across portfolios because it directly affects net worth and expected returns.
• Financial forecasts and cash-flow models should incorporate potential economic depreciation when projecting future revenues affected by market conditions.

Key takeaways

• Economic depreciation measures actual market-value decline caused by economic factors, not by a preset accounting schedule.
• It is most visible through changing market prices and appraisals and is particularly relevant for real estate and other assets exposed to local or market-wide shocks.
• Accounting depreciation remains important for tax and reporting; economic depreciation is essential for transaction decisions, valuation, and forecasting.
• Liquidity and the method used to value assets determine how quickly and accurately economic depreciation is observed.