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The Land Value Wave Dips

From 2006 to 2013, significant increases in commodity prices, due to surging demand, signaled the need for more land to be converted to row crop production.

The subsequent steep increases in agricultural land values have pulled enough acres into row crop production to oversupply most commodities, both domestically and globally. The resulting effect has been to drive agri commodity price levels below breakeven. After two years of economic losses at the farm level—which resulted largely from the significant drop in commodity prices—the cost of renting land remains sticky and unsustainably high. In 2017/18 and moving forward, rent values need to begin dropping in order to balance with lower commodity prices over the long term. Consequently, the valuation of land will also adjust lower. If rental costs remain sticky at unsustainable levels through the 2017/18 growing period, individual land assets face the threat of much deeper devaluation, as nutrient and crop protection programs are cut and abandonment (usage changes) increases.

Key Indicators Signal Further Decline in Crop Land Values

The trend of significant increases in the value of agricultural land—which, for most row crop areas in the U.S., saw double-digit year-on-year growth in nine of the twelve years prior to 2014—has steadily declined over the past two years. Despite this decline, lower commodity prices and deteriorating economic conditions for U.S. farmers portend additional decreases in the value of agricultural land in 2016/17 and potentially into 2018.

The reduced ability of the land to generate an economic return as a result of lower commodity prices and diminished availability of investment capital are the key drivers in this trend.

Rental Rates Need to Decline

The ability of farmed land to generate rental income is often utilized as a key variable to determine what the sustainable value of the land is over time. This can be done by calculating the net margin expected to be available for rental payments after other operating costs. From 2006 through 2013, an increase in row crop commodity prices of over 100 percent drove the net margin available to make rental payments to increase at an even faster rate. This was a result of the cost of inputs growing at a slower pace than commodity prices. However, by 2015, the farm level price for agricultural commodities had dropped below the cost of inputs. (Please refer to Rabobank’s recent publication Farming the Efficient Frontier for further details regarding farm margins.)

The most significant driver in the deteriorating economics of farming is a 40 percent to 50 percent decline in commodity row crop prices and the inability for some costs—particularly land—to decline at the same rate. The lack of decline is primarily a result of ample working capital that was available following the 2006-2013 surge in profit margins. The availability of liquidity in the farm business and farmers’ desire to control land in the longer term, combined with land owners’ reluctance to accept reduced income, have led to a bidding process which kept rental values above breakeven levels. The net effect of this bidding on many farm businesses has been to drastically reduce working capital to levels below credit standards (less than 20 percent of the cost of production). The evaporation of working capital clearly indicates an end to such bidding for land at rates above breakeven.

As the primary asset in the production of row crop commodities, the cost of land must reflect substantial long-term changes in profitability. However, as of 2014, the cost of renting an acre of land has significantly detached from the returns generated from Page 1/5 | Rabobank Industry Note #565 – August 2016

The Land Value Wave Dips producing the crop. While the gap between return to land and profits has been seen before—especially in the late 1990s through 2005—the addition of payments from government programs during that period generally allowed at least breakeven margins. Current government programs, such as ARC and PLC, have supported margins to some degree over the past three years. (For example, on average, the most common program, ARC, paid ~USD 60/acre for corn and ~USD 30/acre for soybeans, compared to losses of over USD 100/acre.) Moving forward, even lower program payments, if any, are expected. Consequently, current programs are not expected to provide the same rental price support as in the past. Therefore, for production activity to remain economically viable, land rent levels must decline.

Rental Cost Reduction Can Either Be Negotiated or Rationalized

As many land leases are on a short-term basis (one to three years), rental costs can decline each year through negotiation. If this process fails to bring rental values into a range in which farming can occur at a breakeven-plus level, cuts in the cost of production inputs need to be made (cuts in nutrient application rates, crop protection, or both). The resulting depletion of nutrients or increased pest pressure from such cuts will then degrade the production value of the land for multiple years.
Alternatively, farmers will be forced to pull away from the land, as negative returns degrade credit conditions and lenders decrease total exposure to adjust for increased risk. With reduced access to capital, the probability is lower, from 2016 on, that another farmer will be able to step in and pick up the bid at above-breakeven rates. In cases where the rent price remains too high, the land owner may even be forced into taking all of the risk of farming the land through custom farming agreements.

In either of the above cases, the cost of renting land will be rationalized to more sustainable levels, and the specific land asset faces the risk of significant decline in value.

The call to action is for land owners to clearly understand the economic condition of farming and negotiate appropriate rental rates that will allow the tenant to farm effectively.

Alternative rental agreements which share risk, such as cost- and crop-sharing agreements, also help avoid long-term negative margin conditions, which result in the production value of land being degraded.

Taking into account our baseline price projections—of corn prices below USD 4.00/bushel, soybean prices below USD 10.20/bushel, and wheat prices falling in the USD 4.00/bushel to USD 5.00/bushel range—we believe that rental rates need to decline, from an expected ~USD 1.60 per expected bushel of corn produced to around USD 1.30/bushel, if the costs of seed, crop protection, and fertilizer remain relatively flat. While each rental agreement is different and should be analyzed separately, generally this means a USD 30/acre to USD 50/acre decrease. Such a move would push returns from farming back to near breakeven. (Expected bushels equal trend line yields.)

Current Conditions Will Drive Farmed Area to Contract

Regardless of a decline in rental values, acreage contraction will still likely be needed before commodity prices reach a sustainable level in the long term. As demonstrated by growth in carryover stocks over the past three years, the current acreage levels for corn and wheat can easily produce above the domestic and global demand levels. Currently, only soybean production needs to grow slightly in order to meet demand. With the price ratio strongly favoring soybeans, combined with the need to cut costs, 2017 is likely to see a significant amount of acres shift to soybean production from corn and wheat (see Figure 2). In the absence of a 2017 drought, the end result will be for soybean production to join the other crops in building unused stocks and pressuring prices down. This will likely push substantial acreage reduction out one year, to 2018, but sets up a high probability of below-break even prices for the fourth consecutive year.

The continued pressure on price will either require the cost of production to decrease or prices to increase as a result of supply reduction. To balance supply and demand at a sustainable breakeven price, we estimate that 3 million to 5 million acres (a ~2 percent decline from the five-year average) will be forced out of corn, soybean, and wheat production over the next three years.

The result of acres being forced out of row crop production will be additional downward pressure on the overall value of agricultural land. At the very least, over-availability of farmable area will create headwinds for increases in value levels. While it may take one to two years of lag time, other U.S. growing regions that depend on grain as a rotation or primary crop will likely experience similar value declines to those seen in the Midwest.

(Other regions include the Plains, the Mississippi Delta, and the Northwest.)

Lower Returns Portend Lower Inflow of Invested Capital

Return from Land Investment Drops to the Level of Alternative Investments

With the exception of a period from late 2009 through mid-2010, returns to investors in agricultural land have generally exceeded returns to alternative investments with similar low-risk profiles. For example, we have seen strong returns from agricultural land investment, compared to yields from 10-year and 30-year federal bonds.

In 2016, the returns from agricultural land investment have fallen to equal the yields from long-term government bonds. Previously, the returns on agricultural land could have been considered a better short-term yielding strategy for low-risk investments. However, the Page 3/5 | Rabobank Industry Note #565 – August 2016

The Land Value Wave Dips decline to parity with returns from alternative investments is likely to make agricultural land investment solely a long-term portfolio risk-balancing strategy. Investors will be well served to utilize a more conservative long-term return projection when making U.S. agricultural land purchasing decisions. Consequently, the incentive for investment in agricultural land by institutional organizations is expected to decline, unless returns once again strengthen relative to alternatives. This can happen as a result of increased commodity prices or a decline in land values below long-term fundamental indicators (i.e. a return to land from production activity).

Still No Asset Bubble, but Potential for One Looms

Over the past six years, we have argued against the concept of a credit bubble existing in agricultural land values. This is primarily due to the response land values have had, relative to changes in the three fundamental drivers—gross returns from crop production, low interest rates, and available liquidity. A credit bubble exists when the asset is financed at a value which is not reflective of the long-term economic value. Declines in land value over the past two years continue to support the argument that there is a low probability of a bubble in 2016. However, as the fundamental driver of gross margins generated by the land declines, land values will also need to decline, or equity requirements for the buyer will need to be increased in order to compensate for the potential increase of loan amounts relative to market value.

The relationship between rental values and mortgage payments is a key indicator of the relationship between land values and fundamental drivers. This is because mortgage payments include land price, interest rates, and required equity in the calculation. Large spreads in mortgage payments and return values, as seen in the 1980s, indicate a disconnect between the economic value of land and the financed value of the land, given current conditions such as interest rate and equity requirements.

The parameters for calculating payments utilizes Iowa State University’s Iowa Land Value Survey result for the whole state average, interest rates from the Federal Reserve Board of Chicago’s AgConditions Land Values & Credit Conditions Survey, and 50 percent equity requirement at the time of finance. With a few exceptions, mortgage payments have matched the level of rental payments, along with returns to land and profits, relatively closely through 2015.

However, the key now is whether land values will adjust enough over the next two years to allow for financing at levels that are sustainable, given the drop in farmer margins. With interest rates set to increase, a 40 percent to 50 percent equity level already required, and an increasing probability of flat to lower commodity prices, the adjustment must come largely from the price of land. If these trends continue and land values do not adjust lower Page 4/5 | Rabobank Industry Note #565 – August 2016

The Land Value Wave Dips by a total of 10 percent to 15 percent over the next two years, the case for financing land values at levels which are not economically supported can begin to be made.

Weather Volatility, Interest Rates, and an Aging Farmer Population Are Key Risks

Factors that can change the outlook for land are related, first, to the volatile weather cycle the U.S. has experienced over the past five years and, second, to global/domestic macro-economic changes. Due to potentially large yields in 2016, farmers are already facing the probability of much deeper losses than previously expected. Given the volatile pattern of recent weather cycles, subsequent years are likely to see larger swings in yield and, therefore, also prices. However, we believe the long-term outcome will be the same, with drought extending the declines by one to two years and large yields driving the declines to occur sooner.

Interest rate increases remain the most significant threat to land values. Substantial interest rate increases would drive mortgage payments higher and require values to decline more, in order to remain in balance with farming economics. This is primarily because liquidity at the farm level has decreased enough to restrict increases in equity payments to a level that would compensate for interest rate jumps. Additionally, higher-yielding long- term bonds would increase the incentive to flow invested capital away from agricultural land. While such increases are not expected, the potential impact should be monitored.

An aging farmer demographic can also impact agricultural land values. As more farmers reach retirement age (the 2012 average age for grain & oilseed farmers was 56.6 years), the prospect of declining net worth and decreased annual income from rental payments is expected to be an incentive to sell land. An increase in the supply of row crop land for sale is likely to have a negative impact on values. The emotional attachment to land makes forecasting the exact impact challenging. However, this is a factor which also needs to be monitored, especially in the event that land values surge lower.

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