Recent declines in commodity prices combined with the potential for rising interest rates could trigger a decline in agricultural land prices in coming months, according to a Texas A&M AgriLife Extension Service economist.
Dr. Levi Russell, AgriLife Extension economist in Corpus Christi, said corn and cotton, important Texas crops, have recently suffered dramatic price declines recently. While corn will likely level off on stronger demand, there is still substantial downside price risk for cotton.
“Low interest rates have provided support to growing land prices over the past 20 years,” he said. “Farmland rents in Texas have not kept pace with rising land prices, largely because a falling interest rate environment provides little justification for high returns. However, the low interest rate environment is likely to change. Other commentators have made similar arguments about the Corn Belt, and many have suggested that the price bubble in land is beginning to burst.”
The Federal Reserve is scheduled to effectively end its bond buying program known as quantitative easing this month. While many Federal Reserve economists expect rate hikes in mid-2015, recent statements by the Federal Reserve Chairwoman Janet Yellen have “muddied the waters a bit,” Russell said.
“Still, whether the Fed pushes rates higher on their own or price inflation down the road puts a premium on interest rates, it’s likely that rates landowners pay to finance land purchases and producers use to finance their operations will climb at some point,” he said. “A rising rate environment will cause either farmland rents to increase or farmland prices to fall.”
Russell said this is a simple present-value calculation where the land price is the capitalized value of cash rents. If interest rates climb, the capitalization rate will rise and put downward pressure on land prices unless cash rents increase proportionally. As rates rise, returns on other “safe” investments like bonds also rise.
“This creates an incentive for landowners to sell land and buy other assets with similar risk and higher returns, such as bonds,” Russell said. “While a rise in cash rents would mitigate this factor, increasing the return to land (through cash rent) will likely be more difficult due to a bearish commodity price outlook. Additionally, increased interest rates also strengthen the dollar relative to other currencies, which puts downward pressure on exports. This would also be bearish for commodity prices since demand from exports is an important component of the Texas marketing chain. The implication is that farmland prices will likely fall as rates begin to rise.”
Russell said one can look at capitalization rates for irrigated and dry land in Texas, and the 10-year treasury bond rate from 1997 to 2013. Over this period, capitalization rates fell 22.8 percent and 41.1 percent for irrigated and dryland, respectively; while the 10-year treasury bond rate fell 63 percent. The declines in capitalization rates are due to a explosion in land prices in general over the period.
While capitalization rates have dropped dramatically since 1997, both irrigated and dryland capitalization rates have ticked up in recent years, Russell said.
“The uptick in capitalization rates for irrigated land is due to increases in land rents over the last few years, likely due to higher grain prices.”
However, in the case of dryland, land prices fell from 2012 to 2013 while rents continued to rise. This may be a response to an uptick in bond rates in 2013 and is likely an illustration of what may be on the horizon for land prices as we move into next year, Russell said.
“A common objection is that, due to the development of oil resources in recent decades, Texas represents a special case,” Russell said. “Land prices, it is held, are highly unlikely to fall due to the dramatic rise in the non-agricultural value of rural land. While it’s true that development contributes to higher land prices, those activities are themselves dependent on low rates. Housing developers and oil companies have had access to cheap credit in recent years, which has lowered the cost of investment in long-term projects. If rates rise, those costs will rise. That doesn’t bode well for rural land prices.”
Russell said the Texas Real Estate Center at Texas A&M University has some interesting data on farmland prices.
“Their research indicates that inflation-adjusted land prices from 2004-2013 were, on average, 31 percent higher than they were during the last major land bubble (1973-1985). Though agricultural productivity has increased since that time, historically low interest rates and record high grain prices have certainly contributed to a bubble in land. The speed of the price decline will likely be determined in part by interest rate policy at the Federal Reserve and changes in commodity prices over the next year.”