Farmland Value Components - Part Two

Alex Tiller - Tuesday, March 27, 2012

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.

Sources:

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.)

Time for an Energy Policy Based on ENERGY INDEPENDENCE

Alex Tiller - Monday, March 19, 2012

Like him or not, we can all agree it’s time for an aggressive energy policy based on ENERGY INDEPENDENCE.

 

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Farmland Value Components - Part One

Alex Tiller - Friday, March 16, 2012

I talk on this blog about farmland value quite a lot, both from the point of view of financial investors (who often know a lot about capital management but not a whole lot about farming) and from the point of view of farmers (who tend to know something about both). With farmland prices on yet another upward binge, this is a good time to take a brief look at the components that go into the price of farmland – and to see how these components can predict changes in that price over time.

Noted economists Barry Falk and Bong-Soo Lee wrote a paper back in the late 1990s that took an intensive look at the way Iowa land values moved, comparing the price levels with a whole slew of things thought to be components of the basic price of land. They came up with two important insights: first, that there are different types of price components, and the different types of components respond differently to changes or shocks in the market. Secondly, that short-term changes in land prices were almost always caused by “fads” – temporary or transient changes in relatively non-fundamental components of land price, while long-term trends were almost caused by “fundamentals” – core elements of the price.

That second insight is extremely important in assessing the farmland market and deciding whether it is going to continue to expand, or if it has overheated and is ready for a contraction, so let’s unpack it a bit. Without getting too technical – I don’t want to write about multiple regression analysis and you don’t want to read it – Falk and Lee divided the components of farmland prices into three different types of components. These are:

Permanent fundamental components – The two major components here are farmland rents, and nominal interest rates. “Farmland rents” is an extremely useful concept to an economist because it boils down a whole host of information about what you can earn on a piece of farmland into a single value expressed by what it will cost to rent that piece of farmland from its owner. Nominal interest rates in the United States, of course, are set by the Federal Reserve. The recent run of near-zero interest rates has been a major factor in the expansion of farmland prices. A third permanent fundamental component is farm technology changes and the impacts of same, but this component always changes in the same direction (getting better) and at a fairly steady rate, so it is not nearly as significant as the rent and interest components.

Note that when economists call these “permanent” components, they mean that they usually adjust slowly and with advance notice, not that they never change at all. The Federal Reserve doesn’t suddenly announce new interest rates at random, for example, but rather on a regular schedule. When a piece of property is bought on a mortgage, that transaction usually has a fixed interest rate (unless you re-finance later). Similarly, farm rents are locked in by contract for periods of months or even years.

Temporary fundamental components – These are components that are important to farming, but that change with much greater rapidity than the permanent components. Technically, this category covers components that can change the rental rate of farmland or, less likely, the interest rate. For example, a transient change in local interest rates owing to a credit crunch might increase the spot cost of borrowing money for operations. However, the main temporary fundamental component is the weather.

Non-fundamental components – Everything else which does not in and of itself affect farmland rents or the interest rate. For example, an outbreak of a corn disease, or a war that disrupts trade between agricultural nations, or the development of a non-farm technology that increases or decreases the demand for a particular crop, but does not impact the agricultural sector as a whole.

So how do these components interact, which components control prices over the short term and the long term, and where are they all headed? More on that next time.

Sources:

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.)

Strong Fundamentals Continue in 2012 US Farm Industry

Alex Tiller - Friday, March 09, 2012

You may remember that back in December of 2011 I discussed how low interest rates and a sagging national economy were helping to fuel an expansion in farmland prices. This phenomenon is caused by a combination of two factors. First, with poor returns in conventional investments, a continuing residential and commercial real estate bust, and financial instruments paying almost nothing, investors have been pouring into the farmland sector as being one of the few good places to earn a solid return. Second, low interest rates make it possible for operating farmers to take out loans to expand their land holdings, and – despite the high prices of good land – make the investment pay, simply because the ongoing mortgage payments are relatively low.

That second factor can often cause some head-scratching. How can a difference of just a few points on an interest rate make the difference between a profitable or unprofitable land investment? A quick back-of-the-envelope calculation should make it plain. If Farmer John takes out a 30-year loan for $1 million and uses that to buy prime land on which to expand, he’s going to be making payments on that loan for 360 months. The size of the payments will depend on the interest rate. Not too many years ago, Farmer John would be lucky to get that million at 7% interest. At 7% interest, his amortized payment would be $6653 per month. But the current prime interest rate (the rate set by the Federal Reserve) is just 0.25% - about as close to zero as we can get. Farmer John doesn’t get to borrow money at 0.25%, unfortunately for him, but if he’s on good terms with his bank he can get a loan at 3%. And at 3%, his monthly payment on that land is only going to be $4216 per month – less than two thirds of what he would have had to pay a few years ago. A few percentage points of interest can mean a difference of hundreds of thousands – even millions – of dollars on the total price paid for the land.

Many farmers are also in an expansionary position because these low interest rates have allowed them to refinance old debt at the new rate – which can put thousands of dollars a month of cash flow into the operational stream. Since crop prices continue to do well overall, the best possible use for that cash flow is very often expanding existing operations – which again means buying more land. Even farmers who don’t immediately expand are able to pay down old debt and improve their positioning for later land acquisition. (In fact, during 2011 total US farm debt declined from an estimated $246.9 billion to $242.5 billion, even as farmers were taking on new loans to fuel expansion – and an actual decline in total debt is a very unusual thing to have happen.)

And land values have continued to steadily appreciate – almost 6% in 2011. That means that the ongoing expansion of farmland prices is based on real accruals in equity via improvements in fundamental land values, not just on speculation and loan-driven expansions or acquisitions. (If a lot more investors are scrambling after the same, largely fixed, supply of farmland, then a “bubble” in farmland prices can begin to form…and bubbles tend to be bad for farmers and most investors alike. We are seeing an influx of investors – but we are not seeing an artificially inflationary rate of price growth on the land. I’ll discuss this more in some upcoming blog entries.)

One key metric to look at in assessing the financial health of the farming industry, whether from the perspective of someone looking to farm or from the perspective of someone looking to invest in farming, is the overall debt to income ratio and debt to asset ratio of the sector as a whole – that is, how much do farms owe vs. how much do they bring in, and how much are they worth. Farm economists call these “solvency ratios” and they are very informative figures to track. The USDA’s economic research service forecasts that from 2011 to 2012, total farm debt will go from $244 billion to $254 billion – but total farm assets will jump from $2.3 trillion to almost $2.5 trillion. That means the debt:asset ratio will fall to 10.3 (lower is better) – continuing a multi-year steady decline in the ratio. Income for 2012 is projected to be $91.7 billion, a debt:income ratio of just over 27, another very solid figure.

These figures are the best they have been, not in years, but in decades. Farms haven’t been so ahead of the debt game since the 1950s, while incomes continue to grow (for some sectors) or hold steady for others. This is the happy opposite of the farm crisis of the 1980s, when sky-high interest rates and flat commodity prices put many farmers out of business. There are many factors that farmland investors need to keep an eye on – and I will discuss some of those factors – but financially speaking the sector has not been on a sounder footing in living memory.

Sources

http://www.ers.usda.gov/briefing/farmincome/wealth.htm

http://www.ers.usda.gov/features/farmincome/

http://www.nationalaglawcenter.org/assets/crs/R40152.pdf