During a time when the value of farmland continues to rise, some operations may begin to experience what is called ‘the wealth effect,’ which can distort the view of the farm’s profitability. This may prompt some farmers to make certain decisions because they are feeling wealthier, even if the farm isn’t generating more revenue.
“The ‘wealth effect’ is the idea that when people feel wealthier, they spend more money and disconnect between actual earnings,” said David Widmar, a lender with Farm Credit Services of America. Widmar recently discussed the topic of “Unearned vs. Earned Equity Changes” in a recent webinar hosted by the lender. “Farmers may choose to expand the operation or plan family vacations on the feeling of being wealthier, not on earnings.”
The tendency to fall into the ‘wealth effect’ is noteworthy for farmers, as the value of farmland has sharply increased in recent years.
In some parts of the country, farmland that was valued at $500 an acre in 2001 has shot up to $3,000 in 2021. The value of equipment and other farm infrastructure has also increased as inflation and post-COVID supply chain issues have pushed up the costs of these items.
However, knowing the difference between this “unearned equity” and actual earnings or “earned equity” is critical, according to Widmar.
“Unearned equity is essentially irregular events like gifts, inheritances, and changes in capital assets,” Widmar explained. “It’s value that didn’t come from actual farm activities like raising soybeans or livestock.”
The problem with unearned equity is that the increases in face value don’t account for costs down the road. Increased land and equipment values are subject to later capital gains taxes or fees associated with selling the property. Some land may also have deferred tax liabilities that may be significant.
“We want to observe unearned equity but remain dubious of it,” Widmar said.
In addition, unearned equity can give farmers a false sense of security when it comes to borrowing money. Farm Credit Services lender Chad Jacobs said farmers need to make borrowing decisions in relation to the revenue coming in.
“The ‘wealth effect’ can get you away from looking at the repayment capacity of new debt,” he said. “One of the ways to avoid this is to make sure you are doing your balance sheet at the same time every year.”
Widmar said being aware of how non-farm contributions affect the balance sheet is also critical.
“You have to look at the family living component and how things like an off-farm job affect the balance sheet,” he said. “The earned equity is that number we get from net farm income minus the family withdrawals. It’s essentially how much money is going back into the business.”
Maintaining a regular balance sheet and keeping in mind the long-term costs of short-term “unearned equity” spikes can help an operation make better management choices, Widmar said.
“It helps farmers weather the emotional influences of feeling wealthy one year because farm value is up and then feeling bad because the next year the equity is down,” he said. “The farmland real estate market has been red hot, but it is cooling some.”
