With a lot of recent discussion and articles on whether farmland prices are entering a "bubble" phase, I thought some analysis to see how a potential rise in interest rates might effect farmland prices would look like.
Farmland prices (as are most financial assets) is normally a function of the income generated by the farmland and the expected rate of return that an investor requires to make the investment. Currently, farm income is historically high and interest rates are historically low. With these two bullish patterns, farmland prices have enjoyed a large run up in price over the last ten years or so.
What if farm income stays high, but interest rates and the expected rate of return that an investor requires increases, how might this affect the price?
Let's assume that we have an investor who owns 160 acres of very good farmland in Iowa that is currently worth $8,000 per acre and the cash rent on this property is $300 per acre. This implies that the investor is willing to earn an approximate 3.75% rate of return. Now let's assume that the interest rates rise and the investor requires a 5% rate of return. This would reduce the value of the property from $8,000 per acre to about $6,000 or a 25% drop in price. If the required rate of return was 6%, then the price would be $5,000 or about a 37.50% drop in price.
This analysis assumes that cash rents would remain the same and other expectations would also remain constant. However, normally, when interest rates rise, expectations change and the effect on prices could even be more dramatic than what is shown here.
If you are anticipating making an investment in additional farmland, make sure that you have done this analysis to determine the effect on your farming operation if rates and expected returns do rise. Now is probably not the time to be making farmland purchases with much leverage.
Jay Christens the Disabled Cruise Liner
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