Is there a farmer down the road retiring and selling his ground? Is there an 80 that you can pick up nearby? What will it take to expand your farming operation with newly purchased acreage? There is no question that higher commodity prices are one factor that has pushed land prices higher, and with higher land prices go cash rents. Values will vary across the Cornbelt, but the forces that push and pull on land prices are all the same. So what is driving land prices?
There are concerns that land prices are going up too far, too fast and creating a bubble that will burst with wreckage of the farm economy strewn everywhere. There may be a bubble, but there may also be some solid factors that are pushing up those prices which will not deteriorate very fast. Purdue economists Brent Gloy, Christopher Hurt, Michael Boehlje, and Craig Dobbins take a look at the land price dynamics. They point to a return on the land, interest rates, and the cost of capital as all having a share in the formula, and they rhetorically ask, “Are future expectations of those fundamental drivers supported by historical evidence, as well as by the current and future expected business climate? In other words, what conditions have to exist for land to be overpriced and how close are we to those conditions.”
Many investors will pay extra for farmland with the comment, “They are not making any more of it.” The Purdue economists say while that is true in a literal sense, “The decline in crop acres could easily be misinterpreted to suggest that there is a shortage of cropland. However, it is partially due to innovations that have increased yields and reduced the need for cropland.”
Their initial premise for farmland values is based on higher incomes, “farmland values are positively impacted by higher net incomes or margins (resulting from higher productivity, higher product prices, or lower cost of production). The second major driver in the income capitalization model is the capitalization rate – a higher “cap rate” resulting from higher interest rates, higher risk premiums or lower expected rates of growth in income will result in lower land values.” However, another factor is the return on farmland investments compared to alternative investments. That is correlated with the hedge that farmland will also increase in value over time, as well as the dynamic that investors may believe that capital gains taxes may decline and higher land values will be realized in their bank account rather than on their Form 1040.
To meet the demand, there has to be a supply of farmland on the market, and much of it is held by older individuals. A considerable amount of land is being given to heirs without an impact on the market, and a recent Nebraska survey determined that only 1.5% of the farmland will be sold in a given year.
Another major issue affecting farmland prices is the price of commodities and profits made from crop production. Commodity prices recently have been a function of world income growth, biofuel production, the weaker dollar compared to other currencies, and the combination of yields, production and ending stocks. The Purdue economists say the missing factor is farm policy, which used to be a significant factor in land prices, but no longer is significant.
The final major dynamic is the expected returns from farmland, which are a critical driver of values. They use an economic model which is based on cash rental rates as an indicator for income. “The relationship between current income, discount rates, and income growth can be (put into operation) in the capitalization model of farmland. This model of farmland values argues that increases in farmland values can come from increases in income, decreases in the discount rate, or increases in the growth rate of income produced by farmland.”
The Purdue economists say, “Expectations of future earnings and interest rates are always at work in determining the value of farmland.” Looking at the period since the early 1980’s, they say net farm income stabilized and increased with an average of $48 billion in the decade of the 1990’s and an average of $65 billion in the past decade, which have been favorable to land prices. From the 1987 lows to the current day, average farmland values have increased 358%.
When they analyzed farmland value and farmland earnings, the economists report “an investor would pay $20 for the right to receive the one dollar per acre of current and future cash rents associated with the farmland. In other words, if the current income were $150 per acre, the resulting land price would be $3,000 per acre.” But they say the investor who used a 20 cash rent multiple in the past 10 years did well with an average yield of 5.7%; compared to the investor of the 1980’s who received a rental return of only 4.7%.
The Purdue economists say, “When farmland prices outpace reasonable growth expectations, it creates the potential for a substantial correction in farmland prices as was experienced in the 1980s.” But how important is that potential growth factor when it comes to determining how much to pay for farmland? Operators are able to achieve more output, but both operators and owners of farmland have to give up some of that income growth to the input suppliers who charge more as yields go up. Also there are shifts in demands for products that might result in income growth as well as inflation, greater demand for food, population growth, and growth in consumer wealth.
All of that goes into the additional $10 per acre someone might pay to get more farmland, if their bid is based on economic calculations and not emotion.
Many individual farms may have been purchased by emotion, but across the broad landscape of farmland, values are determined by a complex set of dynamics. Those include the return expected on the farmland, interest rates, net income, and the supply of land, the demand for land, and its potential for growth in value, inflation, and a variety of demographic issues related to consumer demand for food products.