High commodity prices and net farm income have driven U.S. farmland values to record highs. The Federal Reserve Bank of Chicago reported that farmland values rose 13% over the last twelve months. Strong demand for farmland from farmers and investors has led to some irrational prices, including a $21,900 per acre sale in Sioux County, Iowa.
What do these record prices and strong appreciation in farmland mean? Is farmland overvalued or is the increase a function of the improving fundamentals?
The short answer is we think the U.S. farmland market is fairly valued based on the current fundamentals and near-term outlook for agriculture. Futures markets are pricing in $6 corn through 2015, which makes a strong argument that farmland values are actually underpriced.
We think we are in the second-to-third inning of a long-term bull market in agriculture.
What is exciting about farmland is the agriculture thesis hasn’t even played out yet. Most agriculture investors are attracted to the sector because of the wealth creation due to the transfer to a protein based diet in emerging markets. China is expected to increase corn imports from 1 million tons in 2010 to 15 million tons by 2014. Emerging market demand for grain has not even occurred yet.
U.S. agricultural fundamentals are certainly the best in decades, if ever. The ending corn stocks to usage ratio (current inventories as a percentage of annual consumption) has declined over the last eight years from roughly 20% in 2004 to 5.6% in 2012. U.S. corn stocks are now at a 20 day supply, meaning that if corn production was halted, the U.S. would run out of corn in a little over half a month.
Tight grain supplies have resulted in record net farm income in the last few years. The USDA estimates that farm income rose 28% in 2010, 47%, in 2011, and will rise by 4% in 2012, allowing farmers to reinvest their cash flows back into farmland to expand their operations.
The long-term average cap-rate for U.S. row-crop farmland has been 5.0% and we see today’s market average at somewhere between 4.5% - 5.0%. There certainly are some buyers paying idiotic prices for farmland, but there are just as many good acquisition opportunities available.
The media is highlighting a few high dollar sales, which aren’t representative of the overall market. Taking the multiple of one $1 million dollar sale and assigning that multiple to a $2.5 trillion dollar industry isn’t fair. Amazon.com trades at roughly 100x its forward P/E multiple. No one would then assign that same multiple to the S&P 500.
The other data point that can be misleading when valuing farmland is the average cash rental rates. We estimate that U.S. farmland owners are only receiving 50% of the fair market cash rental rate. This means U.S. farmland owners are leaving roughly $30 billion of rental income on the table. The average reported cash rental rates as reported by the Federal Reseve, USDA, and Universities, are typically much lower than fair market rates. Some rental contracts are also multi-year, which causes rates to lag current fundamentals.
What helps us sleep well at night though is farmer balance sheets still remain conservative and current debt-to-asset ratios are at 40 year lows according to the USDA. Majority of farmland acquisitions we observe are 100% cash. New banking regulations have constricted the access to capital for farmland buyers and loans secured by farmland are typically limited to 50% of the purchase/appraised price.
Despite the positive story behind agriculture, we do think farmland investors have to be more cautious than ever. Patience, due diligence, and negotiation are the keys to identifying value in one of the most exciting asset classes of this decade.
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