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Monday, December 12, 2011

Land Prices:  What Is Driving This Vehicle Anyway?



 

Very few Cornbelt farmers are unaware that 74 acres of northwestern Iowa farmland reached the $20,000 per acre mark this past week, with one farmer purchasing the land from an out of state owner.  It was the second occasion in a short period of time that Sioux County, IA farmland established a new record for land values.  But what is driving those values?

As land prices push higher every week, growing concerns are expressed that the values will not hold and land prices will collapse into an economic meltdown for rural communities.  They point to the early 1980’s as an example.  Common to every discussion are questions about what is pushing prices higher and whether those prices are reasonable.  The latter is the tougher question of the two for a collection of Purdue economists who addressed land values, which make up 85% of agricultural production assets.

If you have just purchased farmland for a price that makes you wonder about whether you did the right thing, the economists say farmland is a capital asset that will produce earnings indefinitely into the future.  (Use that on your spouse if she is still in disbelief about your venture.)  That means the price you paid represents the present value of those future returns.  Subsequently, what those earnings are expected to be, are one of the drivers of farmland values.

The economists say another dynamic is the opportunity cost, which are the alternatives that might have been purchased with the same money.  The economists equate farmland value with its income, divided by the opportunity cost, from which the income growth rate has been subtracted.  The content of such a formula indicates increased values are derived from increases in income, decreases in the cost of money, or increases in the growth rate of the income generated by the farmland.

The latter is a function of commodity prices, and the Purdue economists admit that is a function of volatility and difficult to predict.  Another factor is the small amount of farmland sold each year, which has been estimated at 1.5% of the total amount available.  With so few transactions, limited buyers, limited sellers, and other associated with the sale have a chance to impact the future.

Earnings of Cornbelt farmland have been driven by corn and bean prices, and China and ethanol being major factors in commodity demand, they can account for 20 million acres in production shift from year to year.  The economists say shortfalls in production and increasing utilization of the crops have created shortages that pushed prices up and increased their volatility.  That has tended to increase revenue from row crop production, whether one is an operator or an owner.

The latter should be concerned about the value of the farmland, and whether cash rents can maintained into the future.  But the Purdue economists say the relationship between land values and cash rents are one of the most common in agriculture.  The ratio indicates how much buyers are willing to pay for farmland and how much rent they are willing to take in return.  They say it is like the price to earnings ratio for an equity stock.  For central Cornbelt farmland, some investors are willing to pay more for such an income stream.  And the specialists say it is possible that cash rents have not been fully adjusted to the higher land values of today.

Interest rates have a major role in determining the value of farmland, by affecting the opportunity cost for alternative investments and the cost of capital.  At low interest rates the impact on land values can be substantial.  If the capitalization rate was 4%, then an earnings multiple of 25 would be applied to each dollar of current income.  But an interest rate of 8% would produce a multiple of 12.5.  The economists say, “Using the simple capitalization model, land that produces cash rent of $200 per acre with capitalization rates of 8% and a multiple of 12.5 would be valued at $2,500. In contrast, the same cash rent with capitalization rates of 4% and a multiple of 25 would be valued at $5,000 per acre.”  Current values of farmland will have a wide range of capitalization costs, but if they increase, then pressure would be put on cash rental rates.

Summary:
Increases in farmland values have resulted from higher farm earnings and lower than usual interest rates. If earnings decline and interest rises, then land prices would decline.  If investors see less chance for income through cash rents, then they will not bid up prices.  Current prices might seem reasonable to some and unreasonable to others, however they reflect the investor’s belief that income will remain high and investors are evaluating the market as part of their bidding process.  However, when investors are using non-agricultural production reasons for making purchases, then clearer heads may not be prevailing.

Posted by Stu Ellis on 12/12 at 11:41 PM | Permalink

Comments

Have we forgotten what happened in the 80's?

Posted by: Kirk Petersen at December 28, 2011 8:08PM

Well written.

Posted by: Ron Geer at December 29, 2011 10:10AM

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