The serious financial downturn in U.S. ag has caused farm producers to aggressively search for ways to lower costs and improve cash flow. In the short-term, one of the most obvious ways that farmers can improve cash flow is to delay capital expenditures. That is exactly what they have done. Since 2014, U.S. farm capital expenditures have been in free-fall. This week we take a look at USDA’s recent forecast of capital expenditures to see if they have continued to fall and whether further declines are likely.
The USDA’s Economic Research Service estimates that in 2017 U.S. farmers will make roughly $30 billion of capital expenditures (not including operator dwellings). In today’s dollars, this amount is 63% of the level hit in 2014 and roughly equivalent to the levels seen in 2010. This is hardly the first time that capital expenditures have taken a roller coaster ride.
Although today’s declines have been sharp, the past has seen even bigger declines. Figure 1 shows how capital expenditures have evolved over time. The very large expansion in capital expenditures of the late 1970’s is very apparent in the figure. At its peak in 1979, capital expenditures were the equivalent of $55 billion in today’s dollars. As the farm crisis unfolded, they dropped precipitously, bottoming in 1986. At that point they had fallen 70%. From that point capital expenditures started to trend slowly higher reaching $30 billion by 2004.
That capital expenditures had been on a steady uptrend prior to their rapid increase from 2010-2014 is not entirely surprising. This is in part due to agricultural production’s continuing substitution of capital for labor. Over this time period it is also true that the composition of capital expenditures has shifted.
Figure 2 shows the percent of total capital expenditures made for four different categories of capital expenditure; tractors, trucks, autos, and machinery. This chart clearly shows that autos share of capital expenditures has fallen dramatically over time. Likewise, the share of capital spending on machinery has fallen somewhat over time, but still accounts for the largest share of expenditures. Spending on tractors has seen the strongest upward trend in share of capital expenditures.
As farm cash flows have tightened it is apparent that many farmers have delayed some of their capital investment. In figure 3 we show the ratio of capital expenditures (excluding operator dwellings) to the value of farm production. This ratio currently stands at 7%. This means that farmers are spending about 7% of the value of farm production (a proxy of gross receipts adjusted for inventory changes) on capital expenditures.
As a percent of value of production, capital expenditures are clearly down from recent levels. The ratio has also been lower in previous time periods, for instance the late 1980’s to the late 1990’s. The ratio was also much higher prior to the 1980s. However, we feel that is unlikely to be wise to compare current levels to the 1960-1970’s time period because agriculture was going through a substantial period of mechanization.
So where does that leave us today? If one looks at the values of this ratio from the late 1980’s to today, it is difficult to conclude that capital expenditures are either really high or really low relative to the value of farm production. At times it has been quite a bit higher, for example in 2014 it reached 9%. It has also been this low as recently as 2010.
Our take is that further meaningful reductions (say another decline of 1 to 2 percentage points) in capital expenditures relative to the value of farm production are not likely. In other words, based on the history in this chart, the ratio rarely falls much below 7%. The most recent example of this is the period coming out of the farm crisis and on the heels of a period of intensive capital investment. However, keep in mind that we are not saying capital expenditures won’t fall, just that it seems likely that they won’t fall much further in relation to the value of production.
Capital expenditures on U.S. farms have fallen rapidly as the farm economy contracted. In recent years, capital expenditures have declined more rapidly than the value of farm production. This contraction is reaching a level at which it will likely slow down. In other words, it will probably be difficult for farmers to hold capital expenditures at levels much below 6-7% of the value of farm production. This may be welcome news for providers of capital equipment.
However, this does not mean that capital expenditures will necessarily increase in the near future. If the value of farm production continues to decline, look for capital expenditures to also decline. How that unfolds will depend largely upon how harvest and commodity markets evolve in the coming months.
According to the USDA, the aggregate value of U.S. ag real estate is more than $2.5 trillion and represents 83% of total farm assets. For the last 25 years, U.S. farm real estate values have increased in a relatively steady manner, with some rather large increases occurring in the last decade. In recent years, agricultural incomes have fallen, and it is important to consider how the current values compare to the income generation of the sector.
U.S. farm real estate values were collected from the balance sheet estimates made by the USDA’s Economic Research Service (ERS). Inflation adjusted (real 2017 USD) values for each year since 1960 are shown in Figure 1. The figure has a couple of notable features. First, the large increase and decline associated with the 15-year period from 1971-1986 are clearly seen in the figure.
The second feature is the long upward trend starting in 1992. Since then, real estate has steadily increased, with only six years showing modest declines (the largest of those was a 2% decline notched in 2007). In contrast, three years saw double digit percentage increases. Since 1992 the appreciation in U.S. farm sector real estate has averaged a 4% real increase. This has taken farm real estate values roughly $500 billion above the inflation adjusted peak seen in 1981. Keep in mind all of the changes are real changes, having removed the impact of inflation which makes the performance all the more impressive.
Often when we examine farmland valuation in our posts we are looking at a specific type of agricultural real estate (for instance high-quality farmland in Indiana). The analysis that follows is different in that combines all types of real estate and all sources of income. It is important to understand that we are considering the aggregate value of farm real estate and income. It is also important to realize that the U.S. farm sector is quite diverse, with a wide range of crops and livestock produced. The real estate that is used in agricultural production is also quite different from region to region and application to application. As such, one cannot infer that all farm real estate is over or under priced, rather we are trying simply to look at the overall trend in the sector
Farm real estate derives its value from the income that it can produce. The value of farm production consists of the value of crops and livestock produced by U.S. farmers. It is adjusted for changes in inventory values as well as other farm-related income. It might be thought of as a rough proxy for gross income. We chose this ratio over cash receipts because it makes adjustments for changes in the value of inventory.
Figure 2 shows the ratio of the real value of farm production to real farm real estate values. Over the time period shown, this ratio averaged 25%. In other words, one dollar of farm real estate generated $0.25 of production. As the ratio declines, farm real estate generates less production relative to its cost. In other words, as the ratio falls real estate becomes more expensive relative to the value of production that it generates.
The ratio has seen several periods when it was well over 25%. For instance, prior to 1975 and from 1985-1999 the value of farm production was at least 25% of farm real estate values. It has also spent considerable amounts of time below 25%. From 1975-1985 and since 1999 it has been below 25%.
Today, the ratio stands at 16%. This is the lowest value that it has ever registered. At the sector level, a dollar of farm real estate has never produced a smaller value of farm production. In other words, farm real estate is valued quite high relative to the amount of farm production it is producing. This is a warning flag about the current level of farm real estate values.
The value of farm production ignores the costs of production as well as the impact of government farm program payments. Figure 3 shows the ratio of net farm income to real estate values for the same period. This ratio has averaged 6% over the time frame shown. Although it appears more volatile than the previous measure, this is largely a function of the scale on the axis. The standard deviation of this series is 2% compared to 4% for the value of production to real estate values.
The same basic pattern can be seen in this data as in the previous graph. While today’s value of 2.5% is not the lowest in the data (that occurred at 1.9% in 1983), it is among the lowest ever seen. In short, from a historical perspective sector level farm real estate values are high relative to sector level net farm income.
Of course, there are many different types of real estate and types of agricultural production within the farm sector. The analysis above combined all of these sub-industries and regions in an effort to provide a general picture of the U.S. farm sector. That picture suggests that, at the sector level, one should be cautious about the level of farm real estate values. The other alternative remedy is for farm income to start rising more rapidly than real estate values.
The inflation adjusted value of farm real estate has risen steadily in the last two decades. At this point, the value of real estate on the farm sector balance sheet is historically high relative to both the value of production and net income produced in the sector. This does not mean that farm real estate is set to fall, incomes could increase, capitalization rates could stay low, or various combinations could occur. However, it does seem like such ratios indicate that a warning flag is flying at the sector level.