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Year: '2018' - Month: '2'

What's Supporting Farmland Values? Part 1

Cathy Maurer |


What’s Supporting Farmland Values? Part 1
Although off their highs, U.S. farmland values have held up remarkably well. This post discusses rental rates & farm economics in the context of the farmland.

Posted On January 15, 2018
By Brent Gloy
Although off their highs, U.S. farmland values have held up remarkably well.  A continuation of a very low-interest rate environment along with a strong cash rental market appear to have been some of the factors that have made the strongest contribution to this trend.  I discussed some of these trends at the recent DTN Ag Summit.  You can download my slides here.  This and a subsequent post will provide a summary of my comments.  The first discusses rental rates and farm economics in the context of the farmland market and the subsequent post will examine farmland valuations.

It is important to understand that our perspective on the land market is driven by a belief that the farmland market is ultimately driven by economic decisions.  While people may cite a number of reasons to justify farmland purchases, in the long-run we believe that economic decisions dominate.  In other words, expectations of future farmland earnings and opportunity costs (interest rates) are the primary drivers.  As a result, those are the factors upon which we focus most of our attention.  The biggest challenge with this view is that expectations can, and do, change rapidly.  This being said, let’s take a look at some of the economic fundamentals in the farmland market.

Farm Profitability and Economic Conditions
It is no secret that commodity prices and farm incomes have fallen from the highs seen in the early 2010’s.  Although fertilizer prices have fallen and farmers have reduced capital expenditures, farm budgets remain tight.  One of the factors that have contributed to these tight budgets is stubbornly high cash rental rates.  This is not to say that rents haven’t adjusted at all.  Figure 1 shows that annual percentage change in cash rental rates for average quality Indiana farmland.

Figure 1.  Annual Percentage Change in Cash Rental Rates for Average Quality Indiana Farmland, 1976-2017.

We can see from Figure 1 that 2016 produced a substantial (-11%) decline.  This was preceded by a slight decline in 2015.  However, the declines ended in 2017 when rents edged up slightly.  We have discussed this chart numerous times in the past, and the lessons remain the same. First, rent declines are not all that common. Second, although not all that common, during times of financial distress rents can fall by a significant amount.  At this point, it appears that the conditions have not been unfavorable enough to trigger even bigger declines in cash rents.

Figure 2 shows that cash rental rate measured in dollars per bushel of expected production. This was constructed by dividing cash rent by the expected production on average quality Indiana farmland.  It has not been adjusted for inflation but has been adjusted for changing yields.  One can see that today’s rental rate of $1.27 per bushel of expected production is well off its 2013 high of $1.53 per bushel.  So rents have come down, but it remains an open question of whether the decline is sufficient to account for commodity price declines.

Figure 2.  Cash Rent Rate per Bushel for Average Quality Indiana Farmland, 1976-2017.

 

To examine this issue a bit further we calculated the budgeted expected return to farmland before cash rent.  This measure subtracts all budgeted costs except land rent from budgeted returns.  We then normalize it by dividing by cash rent.  So a value of 100% means that the farmer would expect to pay all of their costs and be left with 100% of their cash rent.  Values over 100% result in a budgeted economic profit, whereas values below 100% represent a budgeted economic loss.  These values are shown for average quality Indiana farmland in figure 3.


Figure 3.  Expected Return to Farmland as a Percent of Cash Rent, Average Quality Indiana Farmland 1991-2017.

 

 

In 2017, the expected return to farmland as a percent of cash rent was 14% and unchanged from 2016.  This means that at budget time, farmers expected to generate enough returns to pay all of their costs and only 14% of their cash rents.  It is obvious that this value is very low in the context of the data since 1991. However, it is not unusual for this value to fall below 100%.  The average over the time period shown is 72%.

This means that in order to pay all their costs, farmers must produce yields or commodity prices better than budget or have better cost control than budget.  If not, the cash payments to rent must come from reduced spending in other areas, most likely capital equipment replacement.  I often say that if things go according to budget, farmers can expect to pay for either their land or their equipment, but not both.  One has to question how long such a situation can persist.

Farm Financial Conditions Continue to Deteriorate
The tight budgets facing farmers for the last 4 years have taken a toll on farm financial conditions.  We have discussed this in numerous posts (1, 2, 3), in the last year.  Perhaps the most striking figure that we have shown illustrates how the working capital in the farm sector has dropped.  Figure 4 shows working capital in the farm sector from 2012 to 2017.


Figure 4. Working Capital in the U.S. Ag Sector, 2012-2017f.

 

Due to ERS’s update, the chart differs from the one in the previous post and the slide deck.  In particular, ERS increased its estimate of the working capital in the farm sector by $17 billion dollars from February 2017 to November 2017.  This is a large increase and projected improvement, but the general conditions and conclusion that would be drawn don’t change significantly.  The amount of working capital in the sector has dropped sharply.  In short, farmers do not have the liquid financial reserves that they had in previous years.  This will likely reduce farmer willingness/capacity to purchase additional farmland from existing cash reserves.

The decline in farm sector liquid cash reserves is mirrored by a reduction in longer-term borrowing capacity in the sector.  The debt service ratio is shown in Figure 5.  The debt service ratio indicates the proportion of the value of farm production that is used to meet principal and interest payments. Today, 27% of the value of farm production is consumed by principal and interest payments. This ratio has clearly been higher in the past, but the times in which it was higher were generally characterized by difficult financial times in agriculture.

While it is most definitely true that one can only learn so much about financial conditions by looking at aggregate data, the trends are not heading in a direction that would suggest farm financial conditions are improving.  In short, one wonders how much additional borrowing capacity lies in the farm sector.  As finances become tighter is will likely make it more difficult for farmers to purchase farmland.


Figure 5.  Debt Service Ratio, U.S. Agriculture, 1970-2017f.

Wrapping it Up
When examining farmland values, it makes sense to begin by looking at cash rental rates and farm economic and financial conditions.  Cash rental rates have seen some declines, but one must wonder whether more are in store.  Under recent budgets, expected income is not sufficient to pay cash rental rates and all other costs. The means that farmers are most likely subsidizing rental rates through reduced spending on capital expenditures and working capital erosion.  Of course, higher yields and better price can help ease this situation, but the aggregate data suggest that in aggregate farmers have not had such an experience.

Combined with continuing pressure for lower cash rents, farm financial conditions have deteriorated in the last 4 years.  This has likely reduced the capacity of the sector to purchase farmland.  Overall, the factors discussed in this post don’t paint a favorable picture for farmland value increases.  However, rents have remained relatively high.  As long as rents continue to hold at high levels, farmland prices will remain supported.  Given crop budgets and financial conditions, one must wonder how long rents can remain at levels that don’t appear to be economically profitable.

To answer the question posed in the title “What’s supporting farmland values?” the data here suggest it’s unlikely to be current farm economic and financial conditions. Perhaps it is expectations of better times ahead.  However, it is also likely a function of the low-interest rate environment.  We will discuss this in another post when we examine farmland valuations in more detail.

What's Supporting Farmland Values?? Part 2

Cathy Maurer |


What’s Supporting Farmland Values? Part 2
In a recent article on land values, we began the discussion by examining cash rental rates and farm financial conditions. This week we look at farmland valuation

Posted On January 29, 2018
by Brent Gloy
In a recent article on land values we began the discussion by examining cash rental rates and farm financial conditions. This week we look at farmland valuation.

Current Valuations Remain High
Because of our belief that farmland prices are ultimately driven by earnings expectations and opportunity costs we frequently examine farmland valuation with the farmland price to cash rent multiple.  This expresses farmland price as a multiple of current cash rents.  In other words, if the multiple is 25, farmland is priced at 25 times that current cash rental rate.  This valuation measure is shown in Figure 1.

2018 farmland values. ag economic insights

Figure 1.   Cash Rent to Value Multiple, Average Quality Indiana Farmland, 1975-2017.

2018 farmland values. ag economic insights

According to the Purdue Farmland Value survey, the 2017 cash rent multiple for average quality Indiana farmland was 34.  This meant that average quality Indiana farmland was currently being valued at 34 times the cash rent.  As one can see, this is among the highest multiples seen in the data, but off slightly from recent highs.  While this graph is made from Indiana data, similar multiples would be seen in the USDA data for most corn belt states.  The essential point is pretty clear.  Today, investors are willing to pay more for current earnings than at most times in history.

There are a variety of reasons that one might be willing to pay a high multiple.  First, you might expect that these current earnings will grow in the future.  For instance, if you expect cash rents to grow rapidly, paying a high multiple for today’s earnings would be sensible.  However, as we discussed two weeks ago, current economic conditions don’t suggest that rents will be increasing rapidly in the near future. In fact, they have been trending slightly lower.  However, one must remember that conditions can change rapidly.  Perhaps investors expect that earnings will increase in the future.

Interest and Capitalization Rates Remain Low
Another reason that people are willing to pay a high multiple for farmland is that the other options available to them are not attractive either.  We often examine this by looking at interest rates on alternative investments as a proxy for opportunity costs.  If the opportunity costs for capital are low, investors are often willing to accept low rates of return on farmland.  This is best seen by taking the inverse of the multiple, which is commonly called the farmland capitalization rate.  It is calculated by dividing cash rent by farmland prices.

In figure 2 we show the capitalization rates for farmland in three different states and the interest rate on the 10-year U.S. Treasury bond.  The farmland capitalization rates were calculated from USDA surveys in Indiana, Illinois, and Iowa.  The chart shows that since roughly 1985, farmland capitalization rates and U.S. Treasury bond rates have fallen.  Today, farmland capitalization rates are slightly higher than the interest rate on 10-year U.S. Treasury bonds.  This strong relationship provides fairly strong evidence that the high multiples paid for farmland are a function of the generally declining interest rate environment of the last 2 to 3 decades.  In other words, it appears that one reason capitalization rates are low (and conversely multiples are high) is the overall low interest rate environment that we are experiencing.

2018 farmland values. ag economic insights

Figure 2.  Farmland Capitalization Rates and the Interest Rate on 10-Year U.S. Treasury Bonds, 1967-2017.

2018 farmland values. ag economic insights

 

How Might Changes Impact Farmland Values?
Another way to look at the relationship between interest rates, returns, and farmland value is to examine them simultaneously.  This relationship is shown in Figure 3.  Here, we graph farmland value on the vertical axis.  Along the horizontal axis are different cash rent values.  The red, blue, and green lines farmland values under different capitalization rates. These values are found by dividing (multiplying) the cash rental income on the horizontal axis by the capitalization rate (multiple).  Three capitalization rates 3% (blue), 4% (red), and 5% (green) are shown.

The black lines (which are labeled) illustrate the current level of cash rent and farmland values.  As one can see the current land value and cash rental rate intersect the 3% capitalization rate ($6,928/$205 = 3%).  One can use this graph to think about what would happen if capitalization rates or cash rental rates were to change.  For example, if one were to expect higher (lower) rents and a 3% capitalization rate, land values would move up (down) the blue line.

2018 farmland values. ag economic insights

Figure 3.  Illustration of Average Quality Indiana Farmland Values Under Alternative Cash Rents and Capitalization Rates.

2018 farmland values. ag economic insights

Likewise, one can also think about how changing capitalization rates would influence values.  Increases (decreases) in the capitalization rate would push values below (above) the blue line.  If the capitalization rate increased to 4% values would fall to the red line for any given level of income.

There are a couple of important points to make here.  Because we are at very low capitalization rates, small changes in either income or capitalization rates can have a very large impact on farmland values.  For instance, in capitalization rates were to increase to 4% and rents stayed the same, land values would drop from the blue to red line.  This would put them at a $5,125 per acre as opposed to $6,928.  Likewise, at a 3% capitalization rate every dollar change in income is worth roughly $33 per acre of value.  With low interest rates investors do not put much of a discount on future income.  As a result, change in either in income or rates can have large impacts on values.

 

Relationship to Commodity Prices
Sometimes we are asked how this relates to current commodity prices.  With a couple of assumptions one can draw a similar graph with corn price on the horizontal axis.  In order to do this we need to make an assumption about how cash rent relates to gross revenue.  In this example, we will assume that farmers bid cash rent at 30% of gross revenue.  While one can quarrel with this assumption, let’s use that value for now.  As an aside, we would argue it probably should be lower if anything, but we will leave that for another day.

Given that rent would account for 30% of gross revenue and the estimate of current yields on average quality Indiana farmland of 169 bushels per acre we can calculate the implied corn price.  For example, a rent of $205 per acre divided by 30% yields an implied gross revenue of $683 per acre.  At a yield of 169 bushels per acre, this implies a corn price of $4.04 per bushel.

farmland values. ag economic insights

Figure 4.  Illustration of Average Quality Indiana Farmland Values Under Alternative Implied Corn Prices and Capitalization Rates.

 

Figure 4 is based on these calculations.  One can see that current situation with a 3% capitalization rate implies a long-term corn price of $4.04 per bushel with a long-term rent to gross revenue ratio of 30%.  This graph can be used in a similar manner as the one shown in figure 3.  One can see that if land values were to be maintained at current levels, but with a 4% capitalization rate the long-term corn price expectation would have to rise significantly, to roughly $5.50 per bushel.  Likewise, a decline in long-term corn price expectations to say $3.50 per bushel would shave roughly $900 per acre off of values.

Wrapping it Up
Overall, farmland in many areas of the country appears to have held up well, despite the farm economic downturn.  Although there have been slight declines in cash rental rates, farmland buyers have continued to pay a high price for current earnings.  The capitalization rates on farmland remain near the lowest levels seen in the last 40 years.  This has coincided with interest rates that are also at very low levels.

At present, it appears that stubbornly high cash rents and low interest rates are supporting farmland values.  As we discussed in part one of this series, cash rents are likely to remain under pressure and farmers financial conditions are unlikely to improve until commodity prices recover.  Given current return levels, it does not appear that farming is profitable at most prevailing cash rent levels.

The low interest rate environment and associated low capitalization rates on farmland are also providing strong support for farmland values.  Because rates are so low, relatively small changes can have a large impact on prices. If rates were to begin to move upward, this could put considerable pressure on farmland values.

 

 

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