The traditional income capitalization model provides a straightforward approach with which to view the economic fundamentals of farmland values. This model simplifies the farmland valuation problem and expresses current farmland values as a function of current income produced by farmland, the opportunity cost of capital or discount rate, and the constant rate at which income is expected to grow in the future, as shown below:

This model argues that increases in farmland values can come from expectations of increases in income, decreases in the discount rate, or increases in the growth rate of income produced by farmland. The cash rental rate in $’s per acre is frequently used as a proxy for the income produced by an acre of farmland. The discount rate represents the opportunity cost of invested funds or the rate of return that an investor would require in order to own this asset. This rate can be thought of as the rate of return on risk-free securities plus an upward adjustment for the risk associated with the farmland investment. The rate that could be earned on an investment of comparable risk is another way to think of the opportunity cost. The growth rate is the rate at which the returns to farmland are expected to grow. The model assumes the growth rate is constant into perpetuity. The difference between the discount rate and the growth rate is often referred to as the capitalization rate.

Although the income capitalization formula provides a mathematical relationship between expected income, expected income growth, and expected opportunity costs, it is a simplification of reality. Nonetheless, it can be used to provide useful insights about the impact of different economic conditions on farmland values. However, one must be aware that evaluating the “reasonableness” of various expectations is a very difficult task. Earnings from agricultural production can be quite volatile and difficult to predict. This is also true when considering the opportunity costs facing producers. Although the present opportunity cost is known at the time of investment, these costs will change in the future. Reasonable people can have very different views of the future prospects of these fundamental drivers of value. This is particularly true during periods of high volatility or rapid change in the forces that influence future returns and opportunity costs. When market participants underestimate the risk that the consensus view is overly optimistic or pessimistic, the market can become over or under priced.

Complicating this situation is the fact that the amount of farmland that is sold in a given year is a relatively small amount of the total quantity of farmland. Because there are relatively few transactions per year in farmland, a very limited number of buyers and sellers have a chance to express their forecasts of the future. A 2010 Nebraska survey indicated that farmland turnover—changes in ownership—which typically is 3-5 percent per year, is currently only about 1.5 percent per year, less than one-half the historical average (Johnson, 2010). Contrast this with ownership claims on a publicly traded company such as Microsoft where investors trade roughly 0.74 percent of the outstanding equity shares on a daily basis, based on the 50 day average daily trading volume and shares outstanding on March 29, 2011, as reported in a summary quote for Microsoft, (MSFT) on www.NASDAQ.Com.

So what is the present situation for farmland income, and interest rates, and what do current land values suggest about expectations for these drivers in the future? By understanding these drivers we can start to answer the second and much more difficult question as to whether current land values are “reasonable”.