Friday, February 16, 2018

"What’s Supporting Farmland Values?"

This is the second part (of two) from Agricultural Economic Insights, January 29:
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.
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.
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....MUCH MORE
What's Supporting Farmland Values? Part 1