As illustrated in the income capitalization model, interest rates play a role in determining the value of farmland as they are a fundamental determinant of the opportunity cost of capital and thus the capitalization rate. Lower interest rates reflect a lower opportunity cost of capital, reducing the discount applied to future earnings received from farmland, and increasing the farmland valuation multiple.

The interest rate on 10-year Treasury bond is often used to represent the risk-free interest rate on long term investments. Figure 3 shows the average interest rate paid on 10-year U.S. Treasury bonds from 1970 to 2010. Rates have fluctuated widely over this period. Starting in 1970, interest rates started to climb, almost doubling over the next decade and reaching a peak of 15 percent in the early 1980s. Since then, interest rates have declined dramatically, falling to around 3 percent  today. While the exact impact of interest rates on farmland prices is difficult to measure, the large increases of the early 1980s should have had a negative impact on farmland prices, and the large declines since the 1980s should support rising farmland prices.

Assuming that the risk premium and income growth rate remain constant, a decline in the risk-free component of the discount rate decreases the capitalization rate. At low capitalization rates, the impact on land values can be dramatic. For instance, a capitalization rate of 4 percent which is consistent with current economic conditions would result in an earnings multiple of 25 being applied to each dollar of current income, while a capitalization rate of 8 percent which was consistent with the late 1980’s would produce a multiple of 12.5. When put into the context of actual land values, these changes are striking. Using the simple capitalization model, land that produces cash rent of $200 per acre with capitalization rates of 8 percent and a multiple of 12.5 would be valued at $2,500. In contrast, the same cash rent with capitalization rates of 4 percent and a multiple of 25 would be valued at $5,000 per acre.