by Brent Gloy
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.
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.
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.
Figure 3. Illustration of Average Quality Indiana Farmland Values Under Alternative Cash Rents and Capitalization Rates.
Likewise, one can also think about how changing capitalization rates would influence values. Increases (decreases) in the capitalization rate would push values below (above) the blue line. If the capitalization rate increased to 4% values would fall to the red line for any given level of income.
There are a couple of important points to make here. Because we are at very low capitalization rates, small changes in either income or capitalization rates can have a very large impact on farmland values. For instance, in capitalization rates were to increase to 4% and rents stayed the same, land values would drop from the blue to red line. This would put them at a $5,125 per acre as opposed to $6,928. Likewise, at a 3% capitalization rate every dollar change in income is worth roughly $33 per acre of value. With low interest rates investors do not put much of a discount on future income. As a result, change in either in income or rates can have large impacts on values.
Relationship to Commodity Prices
Sometimes we are asked how this relates to current commodity prices. With a couple of assumptions one can draw a similar graph with corn price on the horizontal axis. In order to do this we need to make an assumption about how cash rent relates to gross revenue. In this example, we will assume that farmers bid cash rent at 30% of gross revenue. While one can quarrel with this assumption, let’s use that value for now. As an aside, we would argue it probably should be lower if anything, but we will leave that for another day.
Given that rent would account for 30% of gross revenue and the estimate of current yields on average quality Indiana farmland of 169 bushels per acre we can calculate the implied corn price. For example, a rent of $205 per acre divided by 30% yields an implied gross revenue of $683 per acre. At a yield of 169 bushels per acre, this implies a corn price of $4.04 per bushel.
Figure 4. Illustration of Average Quality Indiana Farmland Values Under Alternative Implied Corn Prices and Capitalization Rates.
Figure 4 is based on these calculations. One can see that current situation with a 3% capitalization rate implies a long-term corn price of $4.04 per bushel with a long-term rent to gross revenue ratio of 30%. This graph can be used in a similar manner as the one shown in figure 3. One can see that if land values were to be maintained at current levels, but with a 4% capitalization rate the long-term corn price expectation would have to rise significantly, to roughly $5.50 per bushel. Likewise, a decline in long-term corn price expectations to say $3.50 per bushel would shave roughly $900 per acre off of values.
Wrapping it Up
Overall, farmland in many areas of the country appears to have held up well, despite the farm economic downturn. Although there have been slight declines in cash rental rates, farmland buyers have continued to pay a high price for current earnings. The capitalization rates on farmland remain near the lowest levels seen in the last 40 years. This has coincided with interest rates that are also at very low levels.
At present, it appears that stubbornly high cash rents and low interest rates are supporting farmland values. As we discussed in part one of this series, cash rents are likely to remain under pressure and farmers financial conditions are unlikely to improve until commodity prices recover. Given current return levels, it does not appear that farming is profitable at most prevailing cash rent levels.
The low interest rate environment and associated low capitalization rates on farmland are also providing strong support for farmland values. Because rates are so low, relatively small changes can have a large impact on prices. If rates were to begin to move upward, this could put considerable pressure on farmland values.