Third in a series
Farmland values are at the tipping point, according to a new analysis by Rabobank’s Food and Agribusiness Research and Advisory group.
A shift in fundamental drivers, i.e., increasing interest rates and falling commodity prices, are creating a need for an adjustment in U.S. farmland values.
According to Rabobank’s new report, land values have responded to fundamental drivers, however, those drivers are changing quickly.
“Land values have followed fundamental economic drivers up, but there exists the possibility that land values may not follow these fundamental drivers down,” says report author and Rabobank FAR group vice president Sterling Liddell.
The potential exists for development of an asset bubble in the U.S. agriculture land market. An asset bubble refers to an asset that has been inflated beyond its economic value.
Agriculture land has experienced a 12-year run in steep annual increases in value. Farmland value in Wisconsin has risen 58 percent from 2005 to 2013.
That is relatively modest compared with Iowa’s 190 percent increase compared with the same time, Illinois’ 121 percent rise and Minnesota’s 129 percent hike.
During that time, the major fundamental drivers have been strong commodity prices, low interest rates and limited sales relative to demand.
Now Liddell reports that the key indicators are signaling that this long-term growth pattern in the farmland market needs to change, or risk development of an asset bubble by extending the value-cost of land beyond its economic capacity to generate returns.
“An adjustment is needed starting in 2014-2015 to avoid the future development of an asset bubble,” Liddell remarks, adding that there also is a need for farmers to carefully manage land values as both an asset and a cost.
“A decrease in the revenues to value ratio is signaling that, due to falling commodity prices, continued growth in land values during the 2013-2014 and 2014-2015 seasons is out pacing economic returns generated by farming the land,” this report states. “The average gross revenue from Midwest row crop production operations in 2013-2014 and 2014-2015 is expected to drop below 10 percent of average Midwest land values.”
Until last year, rising Midwest land values were generally supported by similar increases in gross revenue generated from producing commodities, Rabobank details.
For the past 15 years, the ratio of gross revenue to land value has generally remained between 12 and 15 percent; however, a ratio below 10 percent for 2013-2014 and 2014-2015 means that in the past 2 years, on average, land values have grown quicker than economic return generated from farming that land.
“This revenue to value shift is not only represented in the balance sheet solvency of landowners, it also has a negative impact on the cost-return of land renters,” says Liddell. “During the long term, the additional net cost to land renters will drive economic margins below breakeven and force rental payments lower.”
“Land prices should decline to the point where costs become sustainable relative to returns during the long term. As this occurs, an asset bubble will develop if land purchases continue to be financed below the 10 percent gross revenue to value level,” he adds.
At Rabobank’s long-term price outlook for corn between $4.50 and $5 a bushel, land values would need to contract by more than 10 percent from current levels to allow revenue to regain the historic balance of 12 percent of land value.
For instance, an Iowa State University annual survey put the average farmland value in that state at $8,716 an acre at the end of last year. At trend line yields (182 bushels per acre by 2016), land values in Iowa would need to contract by more than 10 percent to bring that powerhouse farming state’s gross revenue to land value ratio back above the historic low near 12 percent.
Rabobank sees lower margins, due to significant commodity price declines this year and next, flattening growth in land rental rates. While input costs including fertilizer, chemicals and seed tend to increase quickly, if they decrease at all, they do so slowly, reports Liddell.
He adds that “land is the cost category that is generally squeezed as farm managers are forced to negotiate lower rental contracts to secure sustainable margins.”
“With the pressure of tight to negative margins, our outlook for rental values is flat to slightly lower during the near term,” Liddell continues. “While it may require one to two seasons of tight margins to fully incentivize renegotiation of rental agreements, rental rates are not expected to increase for the 2015-2016 growing season.”
Due to rental rates’ negotiability, Liddell says that any changes are a critical indicator of the value of land as an economic asset.
Thus rental rates should provide a guideline for the amount of mortgage payment that is sustainable under current circumstances. He says if land values continue to rise despite flat to lower rental rates, it is generally a result of decreasing interest rates that allow mortgage payments to remain competitive with rental rates.
Under such conditions, farmers will probably buy land on debt and gain the benefit of long-term ownership rather than renting; however, as rates increase, a return to renting over buying will probablly have the inverse effect, he explains.
Recent announcements by Federal Reserve Chair Janet Yellen suggest that increasing interest rates could be on the near horizon.
Liddell reports that historically low interest rates have accommodated higher land values by keeping mortgage payments competitive with rental payments; however, increasing interest rates from current historically low levels will mean land values will need to decrease in order to keep mortgage payments competitive with rental payments.
He says that while mortgage payments have increased to slightly higher levels than average rental rates in recent years, the difference has not been enough to deter land purchases in favor of land rental. As interest rates rise, mortgage payments also will increase unless there is a compensatory decrease in the actual value of the land being financed.
If the value of land does not decrease, Liddell cautions that the “resulting gap between the mortgage payment and rental payments will represent an asset bubble where land values extend beyond the economic value of the land.”
Rabobank offers this example, if land mortgage rates only rise from the current level of 5 percent, first quarter average reported by the 10th District Federal Reserve Board, to the 2010 rate of 5.8 percent, mortgage payments at current values will begin an alarming separation from both rental payments and economic returns.
For land mortgage rates to remain in a competitive range with rental payments and economic returns at a 5.8 percent interest rate, Rabobank estimates that a 15 percent reduction in land values from current levels would be required.
Rabobank says a contraction of land value is already underway, with no collapse expected. During the past 10 months, buyers in some areas are already showing caution.
While cultivating lower yielding marginal land was viable during high grain prices seen in recent years, Rabobank expects these producers to face the greatest challenge in the near future. As prices remain below breakeven levels, a contraction in acreage planted to primary crops will be needed.
During the past 5 years, high prices have stimulated a 5 percent increase in planted area.
“Marginal land with limited yield potential will probably face the most economic pressure to convert to other uses,” says Liddell.
Rabobank says farmers’ generally strong financial positions decrease the likelihood for a collapse in land prices. During the past 5 years, this agriculture lender estimates that the median row-crop farmer in the U.S. had the opportunity to accumulate 1 1/2 to 2 years of working capital from liquidity generated from farming operations.
While some of that was reinvested in their farms, a substantial amount of liquidity is probably still available this year. While this liquidity will remain supportive of land values, Rabobank expects farmers will become more conservative with investments when faced with tighter margins.
For more information, visit www.rabobank.com/f&a.