farmland values and the twenty-seven PE

26 Apr

In Iowa, farmland values are up 25% year-over-year, a boon to the financial health of the state and especially farmers’ net worth, of which farmland comprises the majority. I recently came across a very interesting paper that discussed farmland values. (The creative title “Farmland Values: Current and Future Prospects,” pretty much sums up its contents.) For those interested in more information on the asset class that has been speculated to hold the “next bubble”, it is an enlightening read. I wanted to touch on a few things mentioned in the paper and expound on a few points.

As with all assets, farmland value is derived from the income it generates as well as by the discount rate (opportunity cost of capital) and growth rate assumptions. First, and not surprisingly, current farm income is healthy. Commodity prices are high and cash contribution margins (roughly, profit/revenues) are elevated, increasing farm income and boosting current (and potential) cash rents – what an absentee landowner earns by renting the land for productive use. The discount rate is very low, with ten-year Treasury bonds, the ‘risk-free’(?) benchmark rate), at just 3.4%. I discuss the growth rate assumption more below.

I’ve used price-earnings ratios in past posts, mostly for stocks. They are valid, though, for a variety of assets. Today, stocks trade around 18 times trailing twelve-month earnings. Using the inverse of their interest rate, ten-year Treasuries trade at 29 times ‘earnings’ while farmland is 27 times. The latter two are pretty high numbers. Now, which has shown historically higher growth? The growth rate for corporate (stocks’) earnings tend to track nominal GDP, or about 6%. Bonds don’t grow in value, the yield is mostly fixed as is the payoff at maturity. Farmland, which has lower earnings volatility than stocks and, like them, a (theoretically) infinite life, has tended to grow with the general rise in inflation plus another 2% for productivity improvements (same land, more crop). On a price-earnings ratios alone, it looks like stocks are the best relative deal. Still, cash remains attractive given the below-average projected returns on several asset classes. Cash has the advantage of what I call the “opportunity yield” – the ability to take advantage of cheaper prices when investors revise their return requirements higher.

On the most striking revelations in the piece was that farmland turnover – the percentage of land stock that changes hands in a given year – was lower than its historical average of 3-5%. (Currently, turnover is estimated to be about 1.5% annually.) As we know, the more demand there is for an asset, the greater prices tend to rise. Couple this with a constrained supply of land being ‘offered to the market’ and prices can quickly rise. This is because the whole of the land stock is priced off these marginal, infrequent sales, making the whole appear more valuable on paper. Annually, 98.5% of landowners aren’t buying/selling; it’s the 1.5% that make the 98.5% a lot of paper wealth. This ‘low turnover combined with high demand’ phenomenon is also evident in the secondary market trading of several Web 2.0 companies today.

So is the current PE sustainable? As with most investment questions, the answer is nuanced. Farm income can experience sharp corrections when commodity prices sink. This would bring the multiple (land value/farm income) even higher than it is today. In addition, interest rates are very low and have been trending down for most of the last three decades. Should rates rise significantly, investors’ opportunity costs rise and the cash rent ‘yield’ must rise, which means prices must fall. Today, I can’t say we’re in a bubble. What I can say is that the current expectations baked into the price – continuing high cash rents, low interest rates, and/or good growth rates – might prove to have been overly optimistic when viewed in hindsight.

Farmland is an intensely local market so each parcel is different. Further, prevailing prices are based (as mentioned above) on marginal sales which comprise a very small portion of the total land stock. As long as landowners don’t lever up based on current land values to buy still more land, a sharp reduction in land values will not ripple through in the same fashion as the housing ‘collapse’. Current evidence suggests those taking on incremental farm debt are mostly larger operators, with younger farmers and livestock producers in the least-optimum financial condition. But anecdotally, I’ve heard that farmers know two things, ‘dirt’ (land) and (bank) CDs. The rate on the CDs become their comparison and these folks think, let’s buy more land with a 3% cash rent yield if a three-year CD is paying less than 1%. Thinking that way could put more than a few in trouble. So if there are to be detrimental economic impacts in the future should farmland prices come down, the $64B question is how much debt is being underwritten based on current values. Unfortunately, it’s probably more than we think.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: