What is in this article?:
- Soaring farmland values have generated considerable national news attention and given rise to questions about the factors driving farmland values higher and whether current farmland values are reasonable. Many in the agricultural sector are worried that the farm sector is headed for a repeat of the farmland value bubble that collapsed in the 1980s.
In the Corn Belt, increases in net farm income have been driven in large part by substantial corn and soybean price increases. Demand shifts including a rapidly growing soybean export market in China and the rapid growth of the U.S. ethanol industry have been major contributors to price increases. These two demands now account for roughly 20 million acres of U.S. soybean production and 20 million acres of U.S. corn production or roughly one-quarter of the 2010 harvested acres of each crop (Gloy, et al., 2011). These demand shifts combined with recent production shortfalls due to adverse weather have led to historically low projected ending inventories relative to utilization for the 2010-11 crops.
As a result of strong demand and tight commodity stocks-to-use ratios, current crop prices are relatively high and volatile. Although input costs have also risen, the net result has been a substantial increase in the profitability of row-crop production in the United States. This is illustrated in Figure 1 which shows the budgeted contribution margin and cash rental rate for average quality Indiana farmland for the years 1991-2011. The budgeted contribution margin is calculated by subtracting the variable costs of production from revenues and is what remains to cover all overhead costs including land, machinery replacement, family labor, and management. Today’s contribution margin is at its most favorable level in recent times. The chart also shows that cash rental rates have risen steadily, but not as rapidly as contribution margins. Given the large increases in contribution margins, one would expect that rental rates will continue upward at least in the short-term. One of the most important considerations influencing land values is whether these higher contribution margins and cash rental rates will be maintained into the future.
Relationship between farmland value and earnings
The value-to-cash rent multiple is one of the most common metrics used to describe the relationship between land prices and income. The value-to-cash rent ratio describes how much buyers are willing to pay for each dollar of cash rental income—it is an analogous concept to the price to earnings (P/E) ratio commonly used in assessing values relative to earnings in the equity markets.
It is possible that cash rents have not fully adjusted to higher contribution margins and that future cash rental rate increases will bring the value-to-rent multiple down. Regardless, these value-to-rent multiple levels clearly indicate that investors have a very low opportunity cost for funds, they expect incomes to grow substantially in the future, or both.
When examining this chart it is tempting to argue that at present this multiple is abnormally high. However, one must be cautious about such conclusions based on this graph alone. The same argument could have been made in 1997. Why would an investor have paid $18.20 for each dollar of cash rent in 1997 and only $12.40 in 1986? Part of the answer is that investors likely had a more favorable future outlook in 1997 than in 1986. Whether those expectations materialize is another story. Another part of the story involves interest rates which were lower in 1997 than in 1986.