Several weeks ago, it was reported that an 80 acre piece of land in northwest Iowa sold for $20,000 per acre. We all know farm land has been rising significantly for the past 10 years, but the ($64,000 Question) is can farm land sustain its accent?
A recent article in the Choices Magazine "Are Economic Fundamentals Driving Farmland Values?", discusses this issue. (Read article). They do a wonderful job of determining the value of farmland by using valuation methods commonly used when valuing stocks and other capital assets.
The study charts the profitability of farmland versus cash rent values. This is similar to the "net profit" margin of a stock.
Budgeted Contribution Margin and Cash Rental Rate for
Average Quality Indiana Farmland, 1991-2011
The budgeted contribution margin is calculated by subtracting the variable costs of production from revenues and is what remains to cover all overhead costs including land, machinery replacement, family labor, and management. Today’s contribution margin is at its most favorable level in recent times. The chart also shows that cash rental rates have risen steadily, but not as rapidly as contribution margins. Given the large increases in contribution margins, one would expect that rental rates will continue upward at least in the short-term. One of the most important considerations influencing land values is whether these higher contribution margins and cash rental rates will be maintained into the future.As you can see, it has never before been more profitable to be a farmer which possibly explains a major reason for rising farmland values.
Next, they attempt to put a valuation on farmland to determine if it is expensive or cheap. This is similar to examining the Price to Earnings ratio (P/E RATIO) for stocks. A high P/E ratio typically means stocks are expensive while a low P/E ratio means a stock is cheap. For this study they calculated a ratio called "Value to Cash Rent Multiple" which is plotted in the chart below (left axis). A high ratio means farmland is expensive while a low ratio means farmland is cheap or adequately priced.
The June 2010 survey of Indiana (Dobbins and Cook, 2010) shows a farmland price for average quality farmland of $4,419 per acre, and the associated cash rental rate was $161 per acre. These values produce a capitalization rate of 3.64% . With 10-year U.S. Treasury bonds at 3.25%, these values imply that investors were willing to accept rates of return only slightly higher than the yield on the 10-year Treasury bond for owning farmland, or that they expected substantial income growth from farmland (Gloy, et al., 2011).
If interest rates increase, it would likely put substantial pressure on cash rent multiples and farmland values. Holding other things equal, if capitalization rates would increase from 3.64% to 4.64%, the multiple would decrease from its current level of 27 to 21.5. In order to maintain land values, expectations of future income would need to rise and/or investors would have to accept a lower risk premium. For example, if the multiple decreased to 21.5, the current cash rent on average quality Indiana farmland would have to rise from $161 per acre to nearly $205 per acre to maintain land values.
While there are many factors which support the case for increased farmland income in the future, one must be very careful in assuming growth rates beyond the general rate of inflation and the rate of productivity growth in agriculture. Sustained growth beyond this level would require substantial demand growth that would manifest itself in continually higher agricultural product pricesI applaud this study since it looks at farmland from a purely numbers standpoint, from the view of an outside investor not a local farmer. I must say, I wish this study would have taken into consideration the effects of a "strong dollar / weak dollar" environment, but we will just have to save this study for another day.
