Last time we talked about Falk and Lee’s development of a new economic model for evaluating farmland prices. Their model divided the components of farmland value into fundamental and nonfundamental components; fundamental components were those relating to interest rates and the rental rates charged on the market for farmland. Fundamental components can be permanent (meaning slow to change) or temporary (meaning changing rapidity). There are also non-fundamental components; elements that are relevant to farm prices but that do not directly impact rents or interest rates.
At the time Falk and Lee were writing (the late 1990s), economists were somewhat in a muddle over farmland prices. Traditional economic models of prices, models that worked very well at explaining and even predicting the prices of other resources, did not work at all well when applied to farmland prices. Falk and Lee, by studying farmland prices and their relationship to a variety of other factors over a long time span, made a profound discovery - one that has serious implications both for farmers and for farmland investors, so listen up.
Their analysis showed (and later predictions compared with actual outcomes confirmed) that most of the short-term variation in land price is caused by fads, short-time-horizon changes in the temporary fundamentals and the nonfundamentals. Most medium- and long-term variation in price is explained primarily by changes in the permanent fundamentals. In the long run, farmland prices tend to be very rational and set by the components that traditional economics would predict, but in the immediate term the prices tend to be set by factors that are, if not irrelevant, at least not of lasting importance or significance.
What does this information mean for farmland investors? I think it means a great deal and has about a dozen important lessons to unpack, but here are a couple of the most obvious ones.
1. The upward farmland price trend is not a short-term trend, it is a long-term trend. The fads are up and down; the permanent fundamentals of farm rent and interest rate are both pointed in the growth direction. There may be overpricing due to speculation in the farmland market, but that is a local phenomenon caused by overreaction to the genuine long-term trend. In the long haul, this land really is worth this much and is going to be worth more.
2. Farmland prices in the short term respond very strongly to things that are not fundamental changes. The savvy farmland investor needs to be able to assess and identify farm economy news, and understand what kind of change is coming. Short-term deflationary trends can be capitalized on by the investor who recognizes that the long-term trend is running in the other direction; short-term inflationary trends can be noted as good times to “let the money rest” by bargain-conscious investors who recognize that there’s no need to pay a 20% premium on land that will be cheaper – but still heading up – six months from now.
I’m going to take one more look at the components and bring them into a little closer focus, to help you understand what kind of news item goes into each category, in my next entry.
Fads versus Fundamentals in Farmland Prices, Falk & Lee. http://www.jstor.org/discover/10.2307/1244057?uid=3739568&uid=2129&uid=2&uid=70&uid=4&uid=3739256&sid=47698761047467 (Retrieved March 2012) (JSTOR Subscription required.)