Towards a Conceptual Model for Determining



Towards a Conceptual Model for Determining

the Value of Farmland (and Cash Rents)

David L. Debertin

Consider for a moment the basic equation of capital valuation over an infinite time horizon. That is,

V = R/I , (1)

where V is the value of an asset, R is the annual net rate of return for the asset, and i is an appropriate discount rate or interest rate. If (1) is to be valid way to estimate the value of a capital asset, the annual rate of return R as well as the annual interest rate i must remain the same into perpetuity.

There are a number of problems in applying this simple equation in the valuation of farmland, although many of these problems also apply to other asset classes. First, annual net returns in farming (R) tend to be notoriously unstable from year to year, and an issue arises as to how this instability should be incorporated into the model, since in most cases a valuation is desired with respect to future not historic returns.

Second, interest rates (or appropriate discount rates, i) tend to be highly variable from one year to the next, such that the appropriate opportunity cost of capital invested in the asset tends to vary substantially over time.

Still, this simple equation provides a basic conceptual foundation for valuing farmland based on annual net returns along with an appropriate assumption with respect to the opportunity cost of capital.

Estimating Net Rates of Return

For many decades, farm management specialists have focused on calculating R by developing detailed farm enterprise budgets that carefully account not only for revenues but also for each input cost item. Farm management specialists often are preoccupied with farm budgeting at the enterprise level. Assuming that V is the value of an acre of crop land, then the costs subtracted from gross receipts include everything except the cost of the land. As a practical matter, the R used in most farm budget calculations probably represents a return to the operators own management and unpaid labor, along with a return to the operator=s own (but not borrowed) capital.

A basic question is how profitable is grain farming in an ordinary year. The answer to that question cannot be determined without considerable information about the farmer=s individual situation. Is the farmer owning or renting the land? If the land is owned are principal and interest payments being made on mortgages? What is the nature of the cost structure for the specific farm for inputs such as machinery and outside labor? There are a host of other similar questions specific to the farm involving issues such as how large the farm is and how fixed costs are to be allocated across acres and enterprises. The list goes on and on. However, given the current low levels for market prices for commodities such as corn wheat and soybeans, and in the absence of government payments, for many farmers grain production has been a break-even activity with zero returns to the farmer=s own investment capital, labor and managerial skill.

Let us assume for a moment that grain production in the absence of government payments is a break-even proposition. Thus, R is zero. If we were to apply our simple land valuation approach, this would mean that farmland would be worthless regardless of the assumed interest or discount rate. If this situation were expected to persist indefinitely and also applied to large numbers of farmers, then these farmers would be indifferent to producing or not producing. Indeed, over time farmers would move their own capital out of farmland in search of alternative investment opportunities yielding a positive rate of return. Assuming that farmland initially had a positive value, as the years continued in which farming was a break-even proposition, more and more farmers would exit and land values would continue to decline over time.

This is not what is happening. Farmland has been appreciating in value even as market prices for grain remain weak. Something else must be happening. There are several possibilities. The most obvious explanation is that for many farmers, grain production is better than a break-even proposition in an average year. Perhaps the cost structure is so individualized that many farmers can indeed make money even when the average farmer only breaks even, or that current budgets do not accurately represent reality for many farmers.

But the most likely explanation is the presence of government farm program payments. Assuming that other costs are covered by grain sales, government payments are pure profit. Then, if crop land is indeed valued on the basis of net returns, it is farm program payments that are ultimately critical in determining the value of the land.

If farm program payments are indeed being capitalized into farmland values, then collectively, farmers must have convinced themselves that either these farm program payments will persist indefinitely, or if they do not continue indefinitely, then world market prices instead will have recovered to a level whereby net returns are the same regardless. The farmer is indifferent as to whether the income is generated in the market or comes from the government. The rationale only hinges on expectations which suggest that a positive return will persist indefinitely into the future.

At this point, the problem on the returns side becomes a question in political economy, with farmers valuing farmland based on their expectations regarding the government=s continuing willingness to provide payments particularly if world market prices remain at or below break-even income levels. However, for a farmer to continue to receive government payments, the farmer must continue to farm.

All of this is intertwined with the outcome from voter behavior in the 2000 presidential election, along with the evolving drama relating to what could happen by the fall of 2004. In large measure, Bush won the states where a significant portion of Gross State Product is from agricultural production; Gore the largely urban states. Many people appear to believe that Bush was elected because of events that transpired in Florida and with the Supreme Court. But if even North Dakota, with only 3 electoral votes, had favored Gore, Gore would have been president and we would likely have a very different mix of policy proposals being discussed.

If one were to take a map showing the states which receive the lion=s share of government farm program payments, those states would be nearly identical to the states that voted heavily for George Bush. Bush won the election largely because of the support of voters in rural areas with a particular emphasis on the grain-producing states.

Bush=s number one concern is to not alienate the core constituency. In this regard, he is no different from any other politician. That is one reason why there was so little opposition to recent substantial increases in farm program payments even from those inclined toward free-market policy prescriptions. The 1996 experiment in moving US agriculture to a system that could survive on world market prices was a dismal failure.

So in valuing land, farmers are betting that Bush will continue to be indebted to them, and will have no problem, even as a conservative Republican, in continuing to make certain that the core constituency is well-treated. But Bush could lose the 2004 election. Democrats have always felt more strongly than Republicans about the need for government price supports and involvement in agriculture. So expectations by grain producers might very well be that the current level of farm program payments represents more nearly a floor under future net returns rather than a ceiling. Either that, or world markets could recover. If markets recover, then the outcome from the standpoint of returns remains the same.

Therefore, farmers value land based on expectations regarding future income streams, and take into account the possibility of a change in the presidency. They have correctly concluded that once expectations about government payments are considered , crop farming is profitable on a net returns basis. Land quickly is revalued consistent with a belief that these returns will, at minimum, persist indefinitely if not gradually increase over time.

Interest (Discount) Rates

The interest (i) half of the equation is equally interesting. Determining an appropriate discount or interest rate is a consideration that haunts almost any capital budgeting problem. A starting point is to look at the opportunity cost of money invested in the asset. Only a few years ago, most people would probably have chosen an interest rate in the 5-7% rangeBconsistent with what a risk-free 1-year bank certificate of deposit was paying. Now, however, 1-year bank certificates of deposit are paying about 2 %. If that interest rate were expected to persist indefinitely, assuming Returns (R) stays constant, this single change would be enough to cause the value of farmland to more than double in value.

Of course, few people believe that interest rates will remain indefinitely at current near historically-low levels, but few people also anticipate dramatic increases any time soon either. Perhaps 1-year CDs will go back into the 3-4% range and simply remain there, in which case the value of farmland should rise significantly due to this factor alone even if net returns stay constant relative to where we were when risk-free rates ranged from 5-7 percent.

From a land ownership perspective, just as in residential housing, the current interest rate environment represents near historically-low rates, assuming that the farmer can convince a creditor that current returns taking into account government payments will persist. The problem, of course, is that with interest rates at current levels, just as in residential housing, farmland prices are not going to remain constant as competing farmers who seek to own land bid up the price of available land.

Then there is the supply-side issue. It is no secret that a major share of the good crop land in the US is owned by retired farmers, elderly farmers nearing retirement or estates. These entities (individuals or estates) face their own opportunity cost problem. Should they hold on to the land and continue to cash rent it? Or should they sell it and move the proceeds into some other type of financial asset?

In the 1990s, with an S&P 500 index fund earning 20% or more annual rate of return, it made little economic sense to hold cash in farmland, even though a lot of people out of fear or ignorance continued to do so. But with three consecutive years of negative returns to the S&P 500. So the opportunity cost of holding cash in farmland is clearly no longer 20 + % , if it ever was.

What is the alternative? A bank CD earning 2% ? If that is the case, then the landowner is now FAR better off continuing to cash rent the land than to move the cash into some type of paper asset. The cash rent alone represents a very decent rate of return on the asset. This is even clearer if we add the potential for further appreciation in the land value itself.

So we now have a significant group of elderly and/or retired landowners or estates who are happy to continue to cash rent land and retain the appreciation for themselves, rather than to sell the land and try to invest the proceeds in a Arisky@ paper asset. Farmland is one of a small handful of asset classes that has done very well as an investment during the last few years. Furthermore, these landholders have probably also concluded that, given the current political and economic environment, cash rents will at least remain at current levels if not gradually rise. Meanwhile there are real farmers who are actively engaged in crop production trying to take advantage of current cheap credit and are bidding against each other for the meager supply of farmland that is coming up for saleBeven as landowners lose interest in selling land. The net result of these forces acting togetherBthat is, strong demand coupled with a restricted supplyBis a continuing rise in farmland prices.

On Cash Rent Determination

We could think of cash rent determination as a basic problem in supply and demand. The demanders of land for which a cash rent is paid consist of a group of active farmersBin the case of crop land, grain producers. The economic story of the 90s argued that it made increasing sense for farmers to cash rent rather than purchase farmland, particularly if considerable uncertainty existed with respect to future prices, the future level of government payments, the willingness of the government to provide disaster payments and other similar kinds of assistance in the event of widespread crop failure. Moreover, for the same reason Sears ultimately decided that for them it made little sense to have capital that could be more profitably employed elsewhere in their business in a 100+ story office building in downtown Chicago, it made similar sense for farmers to employ available capital elsewhere in the business than in the purchase of farmland. Reinforcing this was the fact that these other unknowns clouded the outlook for farmland appreciation. Had the outlook for gains in farmland prices been clearer, farmers may have been more willing to make farmland purchases and many more creditors may have been inclined to lend money. Overriding all of this was an interest rate environment in which the real interest rate (nominal rate minus inflation) remained relatively high, and creditors were reluctant to grant large loans for farmland purchases given the other uncertainties.

The suppliers of farmland available for cash rent consisted of owners of land who were elderly and/or retired and their estates. In retaining farmland, these entities had apparently decided that relative to the risk and reward potential of purely financial investments (i.e. bank CD=s, bonds, stocks) holding farmland was a reasonable option over a period of several years, even if it was not necessarily the option with the highest rate of return in any single year. Since farmland that is cash rented generally is owned outright by the entity renting it out, these entities would not be that significantly affected even if the land value deteriorated for a period of time. That was the risk associated with continuing to hold the farmland. Further, if better times were ahead for farmers, then cash rents and the value of the land would likely continue to increase, at least gradually. Active farmers were not that interested in buying, and unless an individual or an estate was desperate to divide assets, there was no particular economic reason to sell.

The level of cash rents is determined by the intersection of supply and demand. To the extent that the overall economic outlook for agriculture improves or uncertainty about the future returns is reduced, then those renting in land will pay ever higher cash rents as the cash rent price is bid up. To the extent that the entities who are the suppliers believe that the outlook for future appreciation in land values is weak, or a decline could be imminent, and to the extent that they believe that paper financial investments represent competitive, viable options, suppliers will be increasingly willing to place land on the market (at the margin) rather than continue to cash rent it. However, to the extent that these entities believe that rents and values will continue to increase in the future, and that other investments represent poor options in comparison, they will not place this land on the market.

Suppose an active farmer was renting land in on a cash rent basis, and suddenly the landowner for whatever reason decides to sell. The active farmer then faces the dilemma of trying to decide whether economic conditions warrant attempting to purchase the previously-rented land, or instead bid on other land to cash rent. This reduction in the supply of land available for cash rent could cause cash rents for land still available for rent to rise, as active farmers bid against each other for the now more limited supply.

Maybe We are Asking the Wrong Question

In my undergraduate finance class we deal with a lot of what I call Present Value/Future Value/Discount (interest) rate problems. The whole idea underlying these word problems is to teach students that capital budgeting problems almost invariably involve knowledge of two of the three variables (PV,FV, or i) and the problem is to find the correct solution for the third, or unknown variable.

Let=s look at our V = R/i equation and think about it for a moment. Agricultural economists pride themselves in their skills at estimating R despite some of the issues about what should properly be included in costs. The USDA keeps a consistent series on land values and their changes over time and these data are even available down to the county level. So it would be fairly easy to get an estimate of V, particularly for a county where farmland was primarily cropped in wheat, corn or soybeans and away from significant urban development pressures. If we can estimate R from a farm budget for a typical grain producer and know V from USDA data, then by making the assumption that our estimate of R will persist over time, then we should be able to derive an estimate of the discount rate currently being used by farmers who purchase land.

To illustrate, suppose that our estimate of R for an acre of crop land is $150, including per acre income from government payments. If the discount rate were 6 %, then this land should be worth 150/6 or $2,500 per acre. However, at a discount rate of 2%, this same land would be worth $7,500 per acre! Quite a difference!

Now suppose that we discover that land in this area actually sold for $4,500 per acre. Perhaps an explanation could be the net return R for this land is something different from what our budget estimates suggested that it could be. Assuming however, that this $150 represents a typical or average return in the area and for land in this sale, then we can reasonably conclude that the farmers who were willing to pay $4,500 per acre must have employed a $4,500/$150 or 3% discount rate in determining what to pay.

But that is well below what a mortgage interest rate would be even at current low interest rates, so how do we reconcile that? Well, farmers who are purchasing land generating an infinite stream of returns of $150 per acre for $4,500 an acre realize that suddenly any appreciation in the value of the land will go to the owner. So 3% may be a great enough of a return to justify the purchase once even a reasonable (2-4%) annual rate of appreciation in the value of the land is factored inBand this with money borrowed at an interest rate of 5 % or greater.

Or the farmer could be buying land using savings currently earning only a 2 % annual rate of return rather borrowing money from a credit agency. Given events of the 80's I suspect that this is fairly common. It would not be unreasonable to conclude that the farmland purchase is a considerably better option than the bank CD, and with reduced uncertainty about future returns because of the Federal government=s recommitment to stabilizing farm incomes by helping farmers in bad times, this may be a reasonable and not particularly risky thing to do.

The third possibility is that, as suggested above, grain farmers see the current net returns as more nearly a floor rather than a ceiling with respect to what returns from grain farming will be in the coming years especially given the evolving political dimensions. If we also introduce some potential appreciation in R through time, this also tends to tilt the equation in favor of higher land prices over time. Moreover, if R tends toward rising in most years, even if the increase is very gradual, this would tend to drive up farmland values over time which is a significant reason why farmers were interested in purchasing the land rather than cash renting in the first place.

Bubbles! Bubbles! Pretty Pretty Bubbles Everywhere!

In the 1970s, entrepreneurial farmers leveraged their assets and purchased as much land as they could to take as much advantage as possible of high rates of inflation and appreciation in land values. As any student of farm policy fully understands, all of this fell in a heap in the early 1980s, as the Fed ramped up interest rates and was ultimately successful at drastically lowering inflation. This evolved into an agriculture in which entrepreneurial farmers owned little farmland but increasingly rented in land for cash from another aging group of farmers, and reached its peak in the late 1990s as uncertainty about the future rate of return increased (also known as the 1996 Farm Bill).

We are now moving into a third phaseBa phase whereby land ownership is once again beginning to look attractive to younger, entrepreneurial farmers as the risk around expected returns is lessened by a renewed commitment by the government toward stabilizing farm income along with a very favorable interest rate market for borrowing money to make farmland purchases.

But meanwhile, the older landholders are rethinking their options. Holding cash in a bank CD earning 2 % or less is not attractive at all. There is way to much uncertainty with respect to stock market returns 3-5 years out to make that a viable option. (Remember, many of these are relatively elderly individuals perhaps already retired from farming.) Their best option may be to just continue to cash rent the land. If the variability of returns has stabilized, then so also should cash rents be stable or gradually increase. This certainty right now looks a lot better than either the uncertainty of the stock market or a fixed-return paper investment such as a bond or bank CD.

So the supply of land available for purchase is very limited right now, with potential purchasers wanting to take advantage of the attractive interest rate market and potential sellers deciding that they are far better off holding the land rather than the cash. And prices increase for what little crop land that becomes available.

What could turn this around? Interest rates will likely rise, but the question is AWhen?@ This would affect the balance in a number of ways. First the discount rate for the value/return calculations would need to be altered, lowering the estimated value for the land. Second, farmers seeking to purchase land will face either higher mortgage interest rates or higher opportunity costs for taking the money for land purchases out of savings. Some segment of landowners will decide that holding cash (with a higher rate of return than before) is becoming increasingly attractive, and more farmland at the margin will start to come available.

A stock market recovery could also affect the balance. However, most elderly farmers are not likely to take cash from the sale of farmland and put it into S&P Depository Rights (SPYDRS). However, a return to a double digit rate of growth in the S&P 500 would cause some younger farmers to rethink the idea putting every available dollar into farmland. Such a non-diversified portfolio of assets proved to be a disastrous approach in the early 80s, with a large bet now being placed on the federal government=s continuing willingness to support farm incomes above where they would be with no government involvementBeven as tax revenues plummet.

So are we moving into a price bubble for farmland right now? An excellent, but unanswerable question!

Epilogue

The vast majority of agricultural economists, me included, have an unwavering faith in the ability of free markets to generate efficient solutions and efficient allocations of resources. The 1996 Farm Bill was perhaps the closest we ever came to a real effort to attempt to apply market solutions to resource allocation problems in agriculture. But also by nearly all measuring sticks, the 1996 Farm bill was as close as we have ever come to a total farm policy failure. The results were hated not only by farmers (including many who initially thought they could make a ton of money once released from government controls and acreage limitations), but also hated, it turns out, by both Democrats and Republicans. By 2000 even very few agricultural economists could make a reasonable case for continuing the experiment in a largely market-driven agriculture.

The underlying hope was that with the 1996 Farm Bill, asset prices (such as farmland values) in agriculture would gradually be revalued such that it be profitable for farmers to produce at world market prices. That did become a period in which appreciation in farmland values in some areas probably slowed a bit, at least relative to what this appreciation might have been under a program with heavier government involvement. However, given the complexity of economic events that occurred between 1996 and 2000, it is difficult to establish cause and effect.

I realize that it is popular among some agricultural economists to suggest that the market-driven approach was never given a fair chanceBthat politicians of both parties almost immediately fell over each other coming up with various subsidies and aid packages before the market-oriented approach was ever given even a half a chance to work. But I am not sympathetic with this perspective.

We need to look at this from a larger perspective, a perspective that considers taxpayers, farmers and consumers.

A television commentator on one the financial news programs this recently noted that Ray Kroc, the long-time head of McDonalds who is credited with the franchised McDonalds we all know, was initially quite opposed to the whole idea of making french fry portions bigger. His lieutenants had surveyed customers and the customers told them that they would like a larger serving of fries than McDonalds was selling. This was in a period of time when the french fry serving was pretty small, but they were also one of the cheapest items on the menu. According to the story, Kroc observed that AIf people wanted more french fries, then they could just order another serving!@ The lieutenants knew that the fries were one of the least expensive items on the menu because they cost almost nothing to make. They thought not only that most customers would not order a second serving on their own, but also that it would be possible to significantly increase customer traffic in the store (which really determined how much money each store made) by almost giving away the extra fries. The lieutenants prevailed and this in turn set up supersizing, one of he great successes in the growth of the fast food industry over the last 15 or 20 years.

Now, consumer advocates are blaming the success of supersizing in part on the rapid rise in obesity in the US over the last 15 years, and research has found that for most consumers, if they are presented with more fries than they really want, they will still end up eating them rather than throwing them away. The same is true for the sugar calories found in extra-large drinks.

McDonalds correctly determined that once the restaurant was built and opened, the cost of the paper envelope that holds the fries was covered and the wages and benefits are paid for the employee who puts the fries in the envelope, then it matters little what McDonalds paid J.R. Simplot or Ore Ida for the frozen potatoes, or for that matter, what the farmer received for the grain used to make the frying oil. These latter costs are trivial in the overall scheme of things. Yet many agricultural economists remain focused on silly production system efficiency criteria and concerns over reducing further the cost of the grain used to make cooking oil as if consumers were somehow going to derive some real and significant benefits from that.

Whether consumers ultimately end up paying world market prices for grain or something different matters little in the larger scheme of things. In the US we have now chosen to keep market prices low and then subsidize farm income using tax dollars largely derived from a progressive income tax. Given the diverse array of other subsidies to specific industries by the federal government, this one is (no pun intended) small potatoes. In the process we may have taken tax dollars paid by high-income people and in effect made the food costs ever so slightly less than they would have been otherwise for relatively low-income people who pay little or no income tax.

If farmers are happiest receiving a significant share of their income in the form of federal farm program payments, disaster assistance, or another you name it subsidy rather than from the market, so be it. Unlike many of my peers and colleagues, I have no strong feelings one way or another about this issue. I understand that farmers would love to live in a world where returns fluctuated only minimally from one year to the next, and in a world in which they would like to have a decent income in most years. I share those values. Consumers like 30-year fixed-rate home mortgages too. The lack of volatility makes planning for the future easy. If the federal government can provide some assistance to farmers that get farmers nearer their goals, and politicians benefit from these actions, so be it.

I spent the first half of my career feeling sorry for rural people in general and farmers in particular. Gradually I have decided that I no longer feel sorry for either group. In the US, everyone has options and opportunities and this is not something conditional on where you happen to live. People unhappy with their surroundings or who feel that where they live limits their opportunities for happiness or success need to move elsewhere and do something else. Farmers are no different from anyone else in this regard. Nor are rural people in general.

Also, I no longer feel sorry for farmers if farm program payments rapidly get capitalized into farmland values. I used to think it would be nice if farmers were able to keep a higher portion of their income so that they could go out and spend it rather than have it immediately capitalized into assets. But I do not see any particular shortage of $40,000 Pickups and SUVs in rural America or in urban America. This suggests to me that most farmers do have some spendable income irrespective of complaints about low grain prices.

We might be better off if we simply thought of farmland as the farmer=s version of a 401(k) or 403(b) retirement program. The fact that the a significant share of net farm income gets capitalized into farmland prices indeed might be seen as a benefitBmuch like any long-term tax-deferred savings or retirement program, but simply employing a different class of asset from those normally contained in a 401(k) or 403(b) account. It may not be better than a conventional retirement program, but it probably isn=t inferior, either!

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