Are farmland values sustainable?

8/3/2019 Are farmland values sustainable?

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I s su e 2w w w. K an s a s C i t y Fe d . o rg / O m a h a 1

What are the Risks in Todays Farmland Market?by Jason Henderson, Vice President, Omaha Branch Executive andBrian Briggeman, Economist

Farmland is a bellwether to the

nancial health o the U.S.

arm sector, accounting or 85

percent o U.S. arm assets. Its value

is typically based on the expected

revenues rom agricultural production.

Sparked by surging grain prices, U.S.

armland values soared to recordhighs at the end o 2010. However,

the double-digit gains in cropland

values outpaced the rise in cash rents.

Thus, many observers question the

sustainability o such high land values

and suggest that other actors, such as

low interest rates, are driving current

armland values.

Farmland values oten rise with

persistently low interest rates andstrong crop prices. Low interest rates

lit armland values by reducing the

discount on the uture income stream

produced by the land. In addition,

low interest rates depress the value

o the dollar, which in turn boosts

agricultural exports, raises commodity

prices and enhances arm revenues.

Conversely, rising interest

rates can reduce armland values by

widening the discount on the value o

uture income streams. In addition,

research has shown that higher interest

rates can depress commodity prices,

arm revenues and armland values.

Higher interest rates in a strong

economy increase the risks o alling

armland valueswhich in turn couldcut arm assets, boost leverage ratios

and impair arm balance sheets.

This article takes a closer look at

risk in todays arm real estate market.

Ater describing current trends, the

article analyzes whether the recent

surge in armland values to record

levels is sustainable. The article nds

that i interest rates rise to more-

normal levels and crop prices swoon,

land values could all, suggesting

that armers could experience a

deterioration in their balance sheets.

Farmland Value Trends

Ater sotening in the recent

recession, surging arm revenues ueled

a sharp rebound in U.S. armland

values. Since June 2010, U.S. corn

and wheat prices have doubled due to

strong export demand and tight crop

inventories. In response, crop prots

have soared to record highs, liting

Midwestern cropland values.

F e d e r a l R e s e r v e B a n k o f K a n s a s C i t y S e p t e m b e r 2 0 1 0

Economic informationfor the Cornhusker State

T H E

E C O N O M I S T :

F e d e r a l R e s e r v e B a n k o f K a n s a s C i t y Issue , 2011

Main StreetAgricultural and Rural Analys i s

T H E

E C O N O M I S T

if interest rates rise to more-normal levels and crop prices swoon,

land values could fall


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Prior to the recession, armland

values were rising at the astest clip

since the 1970s. Ater jumping 20

percent in 2005, U.S. armland values

grew 7.5 percent annually rom 2005

to 2008 (Chart 1). The recession

reversed this trend. Heading into 2009,

residential demand or armland ell,

global ood demand plunged and crop

prices suered. Although U.S. housing

markets remained weak in early 2010,the global economic recovery led to

a modest rebound in agricultural

commodity prices and land values at

the beginning o the year.

In the second hal o 2010,

crop prices rose unexpectedly with

burgeoning exports and tighter crop

inventories. Stronger economic activity

in emerging countries, especially

China, led to stronger-than-expectedexport activity in 2010, with U.S. grain

exports rising roughly 13 percent. At

the same time, drought conditions in

Russia and wet weather in the United

States cut world grain inventories.

Consequently, 2010 ended with the

combination o strong demand and

tight suppliesU.S. grain prices

doubled, and crop prots soared.

In response to surging crop pricesand prots, gains in Midwestern

cropland values quickly accelerated.

In the ourth quarter o 2010,

Federal Reserve surveys reported

that Midwestern cropland values

jumped almost 20 percent above

year-ago levels (Map 1). The strongest

gains emerged in the western Corn

Belt, where cropland values rose 18

percent. Other surveys o armland

values reported similar increases,

and expectations or urther gains

continued to build.

With armland values rising aster

than cash rents or revenues rom crop

production, questions naturally arise

about the sustainability o current

land prices. According to the U.S.

Department o Agriculture (USDA),

U.S. cropland values have soared

more than 40 percent since 2004,

outstripping the 17 percent gains in

cash rents. The Federal Reserve Bank

o Kansas City reported near the end

o 2010 that land values were rising

at twice the rate o cash rents.1 This

apparent decoupling o land values

and cash rents suggests that other

market actors, such as low interest

rates, are driving armland values.

Interest Rates, Farm Revenues

and Capitalization Rates

Concerns about the sustainability

o armland prices tend to surace in

periods o low interest rates. Farmland

values are based on the capitalized

value o expected economic returns

to arm production, which are shaped

by demand and supply orces in the

market. Low interest rates boost the

capitalized value o armland in two

Main StreetECONOMISTTHE


w w w. K an s a s C i t y Fe d . o rg / O m a h a 2

Chart 1Real U.S. Farm Real Estate Values

0

500

1000

1500

2000

2500

1940 1950 1960 1970 1980 1990 2000 2010

Constant 2005 dollars per acre

Source: USDA


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ways. First, low interest rates push

down the capitalization rate.2

Second, arm revenues are oten

higher when interest rates are low.

Low interest rates lead

to higher armland values

by lowering the discount or

capitalization rate. In general,

people preer to have a dollar

today over the promise o

earning a dollar tomorrow.

When compared to the value o

current income, uture income

streams are valued at a discount.

The size o the discount depends

on interest ratesthe investors

required rate o return. Low

interest rates shrink the discount

on the current value o uture

income streams. As a result,

armers and other nonarm

investors will bid against one

another in agricultural real estate

markets or ownership o these uture

revenue streams, thus capitalizing

these uture revenues into current

armland values. As interest rates all,

the investors required rate o return

declines, pushing down the discount

and capitalization rate, in turn liting

armland values.Historically, low long-term

interest rates have spurred rising

armland values by lowering the

capitalization rate. Since the mid-

1990s, ater adjusting or infation,

yields on the 10year U.S. Treasury

security, which is a risk-ree rate, and

the interest rate on arm real estate loans

have both trended downward. In act,

since 2000, these interest rates have

averaged their lowest level since the

1970s. These lower long-term interest

rates have coincided with a decline in

the cash rent-to-land value ratio, a proxy

or the capitalization rate (Chart 2).

In addition, low interest rates

lit armland values by strengthening

arm revenues. Low interest rates place

downward pressure on the value o

the dollar and make U.S. agricultural

products more aordable to oreign

consumers, thus boosting the demand

or U.S. exports, raising agricultural

commodity prices, and liting arm

revenues (Chambers and Just). More

recently, research has shown that

commodity price infation responds

much more quickly to shits in

monetary policy (Saghaian, et al.).

When short-term interest rates all,

commodity prices rise, in turn boosting

arm incomes. Since 1970, real net

arm incomes were higher during

times o low short-term interest rates,

measured by the infation-adjusted

yield on the one-year Treasury security

Map 1Non-irrigated Cropland Values(Percent change 2009:Q4 to 2010:Q4)

Kansas19.3%

Nebraska17.6%

Texas 4.9%

Oklahoma 5.0%

WyomingColorado

NorthernNew Mexico4.0%

Iowa18.0%

Montana 13.6%

NorthernIndiana12.0%

North Dakota23.7%

SouthDakota 9.8%

Minnesota19.3%

SouthernWisconsin

7.0%

NorthernWisconsin

10.7%

NorthernIllinois

11.0%




Source: Federal Reserve District Surveys

(Chicago, Minneapolis, Kansas City, Dallas)


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Chart 2Real Interest Rates and Capitalization Rates

Sources: USDA , Federal Reserve, BLS

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1970 1975 1980 1985 1990 1995 2000 2005 2010

Nebraska Cash Rent-to-Land Value Ratio

Yield on 10-year U.S. Treasury Security - adjusted for inflation

Interest Rate on Nebraska Farm Mortgages - adjusted for inflation

Percent Percent

Chart 3

Real Interest Rates and Net Farm Incomes

Sources: USDA , Federal Reserve, BLS

-5.0

-2.5

0.0

2.5

5.0

7.5

0.0

25.0

50.0

75.0

100.0

125.0

1970 1975 1980 1985 1990 1995 2000 2005 2010

Real Net Farm Incomes Less Government

Payments (Left Scale)

Yield on 1 Year Treasury - adjusted for inflation

(Right Scale)

Constant 2005 dollars (billions) Percent

(Chart 3). Conversely, real net arm

incomes were lower with higher interest

rates.3 The combination o stronger arm

revenues and lower capitalization rates

sparked the sharp armland value gains

at the end o 2010.

Capitalizing Future Revenues

I historical relationships hold true,

Midwestern cropland values hinge on

arm revenues, interest rates and theirrelationship with the capitalization

rate. Assuming average Midwestern

crop yields, various combinations o

corn prices and capitalization rates can

rationalize current cropland values.

However, all o these combinations

assume historically high crop prices

or historically low capitalization rates,

which raise the risk in land markets.

With economic models suggesting that

todays historically high arm revenues

have been capitalized at historically low

rates o return, agricultural real estate

values could all sharply i crop prices

sag or uture interest rates rise.

To illustrate the risk acing

armland values, a straightorward

net present value model is used to

determine the capitalized value o

uture crop revenues (Lamb and

Henderson). Assuming constant

revenues in the uture and a constant

capitalization rate, cropland values can

be determined by:

Cropland values = Future revenues

Capitalization rate. (1)

In this model, uture revenues

are limited to the returns that are


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reinvested into the land or the

amount received by the landowner.

While the returns to land vary with

arm protability, the portion o

gross revenues allocated to land

owners has remained airly constant

over time. Over the past three

decades, USDA costs o production

data indicate that land owners

receive about 25 percent o all grossrevenues generated rom cropland.4

Thereore, uture revenues can be

estimated as a quarter o expected

arm revenues, based on expected

crop prices and yields. As discussed

earlier, capitalization rates can be

proxied with historical cash rent-to-

land value ratios.Using equation (1), current

armland values appear to refectcurrent market conditions. For

example, the current average market

price or irrigated cropland in eastern

Nebraska is estimated to be roughly

$5,300 per acre.5 Assuming an average

corn yield o 200 bushels per acre, an

average 2010 arm-level corn price

o $5.35 per bushel and Nebraskas

average 2010 capitalization rate o 5.1

percent, the capitalized cropland value

is estimated at roughly $5,300 per acre

($5.35 *200 *0.25 0.051 = $5,245).6

Analyses o armland values in other

regions o the nation produced similar

results, also suggesting that current

armland values refect high arm

revenues and low capitalization rates.

Nevertheless, armland values acesignicant risk. I returns on alternative

investments rebound, capitalization

rates could increase and cut armland

values. For example, with prices

remaining constant and capitalization

rates rising to their historical average o

7.5 percent, eastern Nebraskas irrigated

cropland values could drop by almost a

third (Chart 4).

Farmland values could also all

i arm revenues decline. In response

to todays current high commodity

prices, U.S. armers are expected to

expand their crop production.7 With

larger production, crop inventories are

projected to rise, placing downward

pressure on crop prices. In act, by

2013, USDA projects U.S. corn prices

to all to $4.10 per bushel with larger

inventories. I these expectations are

realized and corn prices all to $4

per bushel, irrigated cropland values

in eastern Nebraska could all more

than 20 percent, even i capitalization

rates remain at todays historically low

levels (Chart 5).

The worst-case scenario is a

combination o higher capitalization

rates and alling arm revenues. In

1981, the spike in real interest rates

pushed capitalization rates to historic

highs. At the same time, high interest

rates contributed to higher exchange




2000

3000

4000

5000

6000

7000

8000

9000

10000

3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 8.0%

Farmland capitalization rate

Dollars per acre

Eastern NebraskaIrrigated Cropland Value = $5300

Chart 4Capitalized Revenues on Nebraska IrrigatedCropland at Various Capitalization Rates

Authors calculations assuming 200 bushels per acre,a corn price of $5.35 per bushel and 25% of gross revenues capitalized into land.


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Farmland values soared at the end

o 2010. Strong demand and tight

supplies ueled a spike in U.S. crop

prices, while low

interest rates

contributed

to both lower

capitalization

rates and highercommodity

prices. Across much o the Midwest,

rising armland values have

outstripped the increases in cash

rents, raising questions about the

sustainability o current values.

In the long-term, uture arm

revenue expectations and interest

rates should determine armland

values. Today, the interest rate risk

to armland values is high. Record

high armland values are based

on expectations o interest rates

remaining low or an extended period.

As the economy

strengthens,

however, interest

rates could rise,

which may lit

capitalization ratesand lower arm

revenues. Events such as these could

become a recipe or alling land values

and the erosion o arm wealth.

rates, lower agricultural exports, alling

commodity prices, and cuts in arm

revenues. From 1981 to 1987, the

combination o higher capitalization

rates and alling revenues contributed

to a 40 percent decline in real U.S.

armland values, with even larger

declines in nominal armland values.

I similar events occur in todays

environment, armland values couldplummet. For example, in eastern

Nebraska, i capitalization rates return

to their historic average o 7.5 percent

and corn prices all to $4 per bushel,

then irrigated cropland values could all

nearly 50 percent to about $2,600 per

acre. Other regions ace similar risks.




In the long-term, future farm revenueexpectations and interest rates should

determine farmland values.

Chart 5Capitalized Revenues on Eastern NebraskaIrrigated Cropland at Various Corn Prices

1000

2000

3000

4000

5000

6000

7000

8000

2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5

Corn price (dollars per bushel)

Dollars per acre

Eastern Nebraska

Irrigated Cropland Value = $5300

Authors calculations assuming 200 bushels per acre, a 5.1% capitalization rate and 25%of gross revenues capitalized into land.

Summary


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endnotes

Brian Briggman and Maria Akr. . Farmland ValClimb and Crdit Condition Improv Srvy o nthDitrict Agricltral Crdit Condition, Fdral RrvBank o Kana City, Tird Qartr, http://www.kansascityed.org/publicat/research/indicatorsdata/agcredit/AGCR3Q10.pd

For mor inormation on capitalization rat and armlandval Jaon Hndron. 9. Will High FarmlandVal Hold? Main Strt Economit. Fdral Rrv Banko Kana City, I VI, http://www.kansascityed.org/publicat/mse/MSE_0609.pd

3In a rgrion o crrnt and laggd val, -yar trary yildadjtd or ination wr ond to b ngativly and ignifcantlycorrlatd with contmporano ral nt arm incom.

4In th cot o prodction data, cah rnt i th amont orvn rtrnd to th land ownr.

5In Fbrary , irrigatd cropland val in atrn Nbrakawr rportd to b almot $49 pr acr. Aming prcntgain in land val a rportd by Fdral Rrv Bank rvy,irrigatd cropland val wold b $538 pr acr.

6Nbraka corn yild rom irrigatd prodction wr obtaindrom th USDA. Farm lvl corn pric wr th avrag U.S. pric obtaind rom USDA World AgricltralSpply and Dmand Etimat (WASDE).

7Crop prodction and pric inormation obtaind rom

USDA Agricltral Projction to www.ers.usda.gov/Briefng/Baseline/

RefeRences

Chambers, Robert G. and Richard E. Just. 1982 AnInvestigation o the Eect o Monetary Factors onAgriculture.Journal of Monetary Economics, Vol. 9, pp. 235-247.

Henderson, Jason. 2008. Will Farmland Values Keep Booming?Economic Review, Second Quarter. pp. 81-104. www.kansascityfed.org/PUBLICAT/ECONREV/PDF/2q08henderson.pdf.

Lamb, Russell and Jason Henderson. 2000. FAIR ActImplications or Land Values in the Corn Belt. Review of Agricultural Economics, Vol. 22, pp. 102-119.

Saghaian, Sayed, Michael R. Reed, and Mary A Marchant.2002. Monetary Impacts and Overshooting o AgriculturalPrices in an Open Economy.American Journal of AgriculturalEconomics, Vol. 84, No. 1, pp. 90-103.

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Are farmland values sustainable?