This is a good time to be an American farmer. Grain and livestock prices have been firm and although input costs are rising, farmers are still enjoying profitable margins. USDA estimates 2011 farm net income will exceed $100 billion.
When times are good, farmers need to be even more diligent in stress-testing their land purchases. I remember the late 1970s and early 1980s, when farmers were in a similar situation. Prices were good, input costs were stable and everything appeared rosy.
We all know what happened next. Short-term interest rates shot to more than 20%, the oil crisis hit again and grain prices took a tumble. Farmland prices crashed and took many years to recover.
I am not predicting the same thing will happen again. Since 2001, though, any investment with at least a 10-year history of year-over-year gains, such as farmland, usually has a correction at some point. Corrections are healthy for the marketplace, but are you ready for one?
Price Determinants. Let’s do a quick review of how the market price for farmland is determined. There are two financial components and one emotional component.
The first financial component is the investment income generated. As actual and expected cash rents increase, the price an investor is willing to pay for farmland increases. If cash rents decline or are expected to decline, the value of farmland will decrease.
The second financial component is the rate of return that the investor requires to make the investment. As this required rate of return decreases, the value of farmland will increase. Conversely, as the required rate increases, a negative adjustment to farmland will result.
Required rates of return are at an all-time low. The Internal Revenue Service publishes a monthly update of market interest rates. From about 2000 until 2008, long-term rates ranged from 4% to more than 8%. During the early 1980s, these rates substantially exceeded 15%. The latest rate just published was an all-time low of 2.67%.
These two financial components have an inverse relationship on farmland values. As income increases and the required rate of return decreases, farmland prices will go up. As income decreases and the required rate of return increases, farmland prices will decrease.
Sellers Versus Buyers. The third and final component of farmland prices is the adjustment that is made for market euphoria or despair. It is my estimate that farmland euphoria is near an all-time high. This means the number of willing sellers is decreasing while the number of willing buyers is increasing, pushing farmland prices higher.
If the market has an equal number of willing buyers and sellers, land and cash rent values are usually consistent. When despair comes into play due to an excess of sellers and a lack of buyers, land values drop.
The bottom line is that it is critical for farmers to carefully review their current and expected farmland purchases. If you assume $500 cash rent, how do $200, $250 and $300 cash rents affect your cash flow? Does a decrease in land value from $12,500 to $5,000 crimp your farm operation, your relationship with your bankers or perhaps put you out of business?
Diligence is the result of analysis and action. Make sure you properly engage in both during this time of high farmland prices.
Paul Neiffer is a tax accountant with LarsonAllen LLP and author of the blog The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at firstname.lastname@example.org.