Rabobank: Potential for land asset bubble looms
Economists at Rabobank aren’t anticipating a collapse in agricultural land prices but caution that current and developing conditions raise concerns of a potential asset bubble in land values.
The bank’s annual report on land values focuses on the Midwest, the epicenter of steep annual growth in land values due to high corn prices, low interest rates and a scarcity of land. But there are also implications for the West, said Sterling Liddell, senior vice president of Rabobank’s food and agribusiness research and advisory division.
Land values in much of the Midwest have risen 200 percent from 2005 to 2013, substantially more than in other regions. And there are warning signs of a tipping point, raising concerns that the ratio of gross revenue produced on that land verses the cost of the land is falling, he said.
While increases in land values in the West have not matched the lofty increases in the Midwest – rising from 28 percent in California to 57 percent in Idaho -- the same influences in the Midwest will affect land values in the West. In addition, land values in the West will be affected by drought and availability of water, he said.
Corn production has expanded into the West in Idaho and Washington, and along with increased acreage in the Midwest, declining prices for the commodity will make the crop less and less viable. If corn acreage decreases in the West, it will likely be replaced with traditional crops — potatoes, wheat and barley, pressuring prices on those crops as well, he said.
“We expect to see a decrease in all commodity prices in general,” he said.
Decreased commodity prices are already throwing off the balance between revenue produced on the land and land values in the Midwest, he said.
Gross revenue produced on farmland has always been above 10 percent of the value of the land. Historically, it’s run a low of 12 percent to a high of 16 percent in the 1970s. Rapidly increasing land values in the Midwest in 2006 and 2007 were propped up by high commodity prices, which produced gross revenues of nearly 20 percent of total cost of the land, he said.
By 2013, however, the ratio decreased to gross revenue of less than 10 percent of the cost of the land, representing an imbalance of revenue and land value, he said.
“That’s the first flag we saw,” Liddell said.
Agricultural land is a physical, production asset and is only as valuable as the revenue it can generate, he said.
The current imbalance is a concern. Under current conditions, Rabobank estimates a needed 10 percent contraction in land values in the Midwest to get back to the low ratio of 12 percent revenue to land value, he said.
The second red flag is a return to “very tight” margins for corn, wheat and soybean growers. Margins tightened up substantially in 2013 and are expected to be negative in 2014, he said.
Considering a likely decline in commodity prices and a likely increase in mortgage interest rates, given signs from the Federal Reserve, the balance of gross revenue to land values would be thrown off even further, he said.
If interest rates return to 2010 levels, land values in the Midwest would have to contract 15 percent to 20 percent to stay consistent with the economic value of the land, the ability to generate profit, he said.
Break-even or negative margins are important because it affects the rental value of the land, which in a balanced environment usually reflects the value of the land. In times of tight margins, rental value is the first production cost to get squeezed, he said.
If rental value goes down, mortgage payments also need to go down, which means land value has to decrease. Rabobank expects a contraction in land value, but if that doesn’t happen, there will be a land asset bubble, he said.
If rents don’t come down, farmers renting land could go bankrupt, drop land or cut back on inputs, which would affect next’s year’s production. But the real problem is for the landowner, he said.
The farm crisis of the 1980s is a prime example. Farmers were paying substantially higher mortgage rates than the going rental rates and gave up the land, he said.
“At this point, I don’t think it’s the same situation. But we could see that same thing happen, and the concern is that we don’t get back to that point,” he said.
The biggest risk is an increase in interest rates, which will automatically increase mortgage rates. If land value doesn’t decrease, mortgage payments will increase, extending the land value beyond where a farmer can make reasonable revenue, Liddell said.
There are steps landowners can take to prevent a bad outcome, however. They can refinance at lower land values; lock in long-term, low interest rate; or take steps to retire debt earlier, he said.
Farmers make the decision to buy or rent on an annual basis. If they buy under current conditions, they need to be cautious and consider some key factors, he said.
When financing land, they need to make sure the financing is at a good economic value so the land will cash flow. That means they should use conservative commodity prices for valuation and not inflated prices, he said.
They also need to look at the long-term capability of the land to generate profit relative to the investment. In that, they need to consider yields and input costs, especially in the West where farmers are dealing with water and transportation issues, he said.
Later this year, Rabobank will perform a thorough evaluation of the land value situation in the West, given its different markets, more cash crops and resource issues, Liddell said.