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Falling land values? Watch interest rates

High cash rents and low interest rates are the 2 main factors keeping farmland values in the stratosphere right now. But, there's at least one sign that a decline in values could be in the cards, one expert says.

These 2 primary factors and the 10-year Constant Maturity Treasury (CMT) rate comprise land's capitalized value, basically showing its cash flow based on current conditions. The higher the capitalized value, the more the land is being influenced by factors like low interest rates, thereby making it more susceptible to value declines when those factors change.

"Since 2009, capitalized values have been above farmland prices, suggesting that fundamentals would support higher farmland prices than currently observed in the market. The difference reached $4,537 per acre in 2012, when the capitalized value of $11,337 per acre and farmland price of $6,800," says University of Illinois Extension ag economist Gary Schnitkey. "Much of the reason for the high 2012 capitalized value is the low interest rate."

With interest rates at such low levels lately, it's widely accepted that there's one direction for them to go. And now, with the capitalized value of farmland higher than it's been in years, it means any fluctuation like this in interest rates could have a quicker and sharper effect on land values than that to which the market's become accustomed in the last 2 decades, Schnitkey says.

"While farmland prices have increased rapidly in recent years, comparison of farmland prices to capitalized values suggest that farmland prices are supported by current cash rent and interest rate levels," he says. "In the future, decreases in farmland returns or increases in interest rates could lead to farmland price decreases."

So, will that happen? Schnitkey says he doesn't expect farmland returns to decline anytime in the near future, but the same is likely not true for interest rates. So, if land values do start to slip in the future, interest rates will be the likely culprit, a circumstance that does have historical context.

"In my opinion, rising interest rates pose the largest risk that could lead to farmland price decreases in the future. Current interest rates are very low and even small interest rate increases cause large declines in capitalized values," Schnitkey says. "Moreover, the last time farmland prices decreased was in the 1980s, when interest rates were rising. It can be argued that rising interest rates had as much impact on farmland price declines during the 1980s as did decreasing farmland returns."

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