I’ve been talking about farmland bubbles and whether the current rise in farm and ranchland valuations (almost a 60% increase over the last ten years) represents a speculative bubble or a genuine increase in value. “Bubbles” are periods of irrational growth in asset prices, where investors and speculators bid up the price of economically productive assets beyond what the returns on those assets would justify.
Here’s the thing. One man’s bubble is another man’s intelligent investment. Some bankers think that we’re in a bubble because land values have increased at a rate higher than the rate of appreciation of other types of assets; other bankers think the valuations are rational because they are supported by the incomes that can be earned from the farm properties. On balance, I think the more optimistic bankers are correct. We aren’t seeing the typical signs of asset overvaluation that are normal for bubbles – exaggerated debt levels, marginal deals by nonfarm players, prices being paid at absurd multiples of expected income.
But in a very real sense, this is missing the trees for the forest. Farmers don’t farm a market, they farm a particular piece of land. Investors in equity index funds might be buying into the success or failure of an entire sector or the market as a whole; farm investors are buying into the success or failure of a discrete farm or ranch operation. If you buy a farm for $10 million, and derive a net income of $1 million a year from that farm, then your farm is profitable and successful – even if land prices change and your farm’s paper valuation drops to $5 million in the first year after you bought it.
To some types of investors, that scenario represents an enormous loss: the investor paid $10 million for something that now could only sell for $5 million. Farmers, however, do not buy farms in order to flip them at a profit; they buy farms in order to use the land, to grow and sell crops. A crash in the land value might make the farm illiquid, it might reduce the farmer’s ability to take out a loan – but it doesn’t make the farm unprofitable. A farm that produces a return of 10% annually on an initial investment is a great farm – never mind what the current asset price is.
We have a tendency to fall prey to the idea that prices have some absolute meaning – that something with a price tag of $5 million is worth $5 million, objectively and forever. But prices in a market economy are not objective values, they are simply a consolidation of a large number of opinions. Your farm is worth $X because the people who might be interested in buying or selling it today or in the near future think “it would bring” or they could get $X. That opinion might be very important, if you’re trying to sell the land. Especially if you are trying to sell it fast.
But if you aren’t trying to sell the land, or get someone to loan you money against the value of the land, then those opinions are completely irrelevant. Does it matter what neighboring farmers think of your tillage practices, or of how you lay out your orchard, or what color you paint your barn? Nope. All that matters is your soil quality, the yield compared to expectation, and whether YOU like the color. In the case of land valuation, what matters is whether you can make a profit from farming the property, and whether that income is sufficient to pay off any debt you incurred in buying it.
If a farm is viable and makes money, then that farm was a good investment to the farmer regardless of what the outside world thinks of it. Land values may rise and land values may fall, but the smart farmer will understand that what matters is whether or not the farm can operate and make money going forward. If it can, then the asset was appropriately priced; if it can’t, then you paid too much. Farmers are in a better position than investors to understand this because farmers are in it for the long haul, not for a quick buck on a turnover or land flip. You don’t need to worry about whether land values are overinflated or not; all you need to worry about is whether the purchase you may or not be making will make sense for your farming operations.
Previous writing on this topic in 2010:
Dec 6, 2010
Dec 2, 2010
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