September 14, 2022
In the last three decades, the Federal Reserve has adopted an accommodative monetary policy with low interest rates and a greater money supply that has created an economic environment flush with liquidity. In the same timeframe, baby boomers were saving and investing in their prime earning years.This has led to residential real estate, equity markets, and farm real estate values surging. To put it in perspective, the Dow Jones Industrial Average (DJIA) was under 2,000 points in the late 1980s.
By the year 2000, the index was above 10,000 points, it doubled in the next decade to above 20,000, and peaked at more than 36,000 points. A comparable increase occurred for residential real estate and apartment buildings. Farmland values have followed a similar pattern, accelerating during the commodity super cycle and again when government payments supported incomes during the pandemic.
Whether it is stocks, residential real estate, farmland, or cryptocurrency, this increase in valuation is called appreciated net worth or paper wealth. This is contrasted to dividends, earned net worth, or retained earnings on the balance sheet. Unearned net worth can be a very important driver of the economy as a result of behavioral economics. When a stock increases in value, holders tend to spend four cents more because of the “feel good” effect.
Every one dollar increase in real estate value means nine cents more in spending. When a paper market corrects, the loss aversion principle occurs. The negative emotions associated with a paper loss result in spending being reduced by double what it increases in the appreciation cycle. For example, we tend to spend eight cents less for every one dollar of stock market correction and $0.18 cents less for every one dollar of real estate decline.
What are the dangers?
Paper wealth often gets one out “ahead of your skis.” In other words, there is a tendency to stretch borrowing limits on collateral beyond the ability to service debt through earnings and cash flow.
Transition planning becomes much more difficult as sibling rivalries occur over paper wealth gains.The siblings remaining on the farm are required to service the debt through earnings that are far below the net earning potential of the inflated values.The result is farms and ranches are broken up into smaller units that do not support a business.This often results in the parcels of land being sold to investors or others who have the equity base or earnings to support the paper values.
Paper wealth gains can sometimes result in unexpected deferred tax issues. This is why careful vigilance is needed when assessing real net worth after deferred tax liabilities.
The question becomes, will the Federal Reserve kill the paper wealth goose? One can observe it already in the stock market, residential real estate, and cryptocurrency. Is farm real estate next?
Source: David Kohl, who is solely responsible for the information provided and is wholly owned by the source. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset.
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