Midwest land values poised to move higher
As fall begins and the bustle of farmland auctions grip the Midwest, the farmland market seems to have moved toward an advantage for sellers. The year of 2020 depicts many similarities to the combination of economic factors observed in 2012 after experiencing several years of diminishing commodity prices. Strong grain prices, increased farmer participation in land purchases, and suppressed interest rates collectively contributed to the strength in land values which peaked in 2013-14.
While commodity prices currently do not compare to the elevated values experience from 2011 through 2013, the abundance of “cheap” capital seeking a stable return is unprecedented. Simply stated, a 3% cash yield generated from owning farmland has never been more financially attractive. In the current market, the surplus of interested money exceeds available land for sale creating many interesting economic scenarios.
The farmland market has, and is expected to remain, steadfast throughout the downturn in commodity prices primarily due to stifled return expectations otherwise known as the capitalization rate or cap-rate compression. Table 1 depicts the inverse relationship between cap-rates and property values.
The following assumptions were used in the creation of this model: (1) one-third of farm gross revenue is paid as rent to the landowner, and (2) an average Iowa farm yield of 198 bushels of corn per acre. To use the matrix, one needs to simply select a return expectation and target corn price to determine the value one is willing to pay for a farm.
While the matrix is not comprehensive, it demonstrates the connection between commodity prices and return expectations. When using the matrix to calculate the land value for $6 corn with a 4% cap-rate the model implies a value of $9,899 per acre, and interestingly, the matrix also indicates a price of $9,899 per acre for $3 corn at a 2% cap-rate.
Therein lies the solution to the puzzle of farmland prices that seems to be noted in the popular press these days.
Table 2 illustrates how changes in rental income and cap rate adjustments interact. As the table indicates, a $50-per-acre rent reduction coupled with a 50-basis point decrease in return expectation establishes a farm value that is only 3% from the peak price. The two previous examples have illustrated the offset that cap-rate compression has created in respect to declines in rental rates and suppressed commodity prices.
In addition to reduced return expectations, the land market is also realizing the immense power of discounted money. The impact of financing the purchase of farmland just one year ago at 5.5% interest compared with 3.55% today is shown in table 3 below. While holding payment and amortization constant, the 200-basis point interest rate decline allows a buyer to pay an additional $1,380 per acre for the same farm year over year.
Perhaps more impactful than interest rates and commodity prices is rising farmer participation in the land market. Farmers tend to make purchasing decisions based on the long-term, and therefore are more aggressive than pure financial investors.
When the already declining farm liquidity was forecasted to get as low as .08 on a working capital to gross revenue ratio, according to USDA ERS Whole Farm Sector Ratios, farmers started to become timid and were less of a driving force in land price discovery. A working capital to gross revenue ratio of .08 means for every $1,000,000 generated in farm revenue only $80,000 is available in current farm liquidity hampering the ability to continue farm operations.
On average farmers are typically responsible for approximately 70% of all farmland purchases in Iowa shown in figure 1. A greater downtrend in working capital and therefore farmer market participation will adversely affect land values. However, recent commodity price rallies coupled with federal aid programs seem to be igniting optimism for profitable farm operations in the future.
These economic factors have converged to form another perfect storm for land value appreciation; the difference lies in the current cap-rate compression. Reduced cap-rate expectations combined with inflated rents create a scenario that results in land prices approaching the peak values observed in 2013-2014.
The fate of the farmland market relies on farmers’ confidence in commodity markets and federal aid payments. Despite the results of fall market surveys, significant strength is anticipated for farmland values through the end of 2020, which should be reflected in favorable spring survey outcomes.