One of the consistent voices of warning on the risks in current strong farmland prices has been the Kansas City Federal Reserve Bank. We have carried the bank's warnings both here and in our LandOwner newsletter. The bank has increased its call for caution with the release of a 7-page paper titled: "What are the Risks in Today's Farmland Market?" The work by the Fed's Jason Henderson, Vice President, Omaha Branch Executive, and Brian Briggeman, economist,may seem apocryphal. It's worth reviewing to make sure you have your own operation's finances in order to ride out the set-back in land values that will eventually occur. The key question, of course, is when.
The paper points out that "current farmland values reflect high farm revenues and low capitalization rates." In other words, you toss $5 and $6 corn out there on top of low interest rates, and you get high farmland prices. No surprise there. But what happens if farm incomes fall and/or interest rates rise? That is the Fed's warning.
Here's what the paper states: "If returns on alternative investments rebound, capitalization rates could increase and cut farmland values. For example, with prices remaining constant and capitalization rates rising to their historical average of 7.5%, eastern Nebraska’s irrigated cropland values could drop by almost a third.
" Farmland values could also fall if farm revenues decline," it continues. "In response to today’s current high commodity prices, U.S. farmers are expected to expand their crop production. With larger production, crop inventories are projected to rise, placing downward pressure on crop prices. In fact, by 2013, USDA projects U.S. corn prices to fall to $4.10 per bushel with larger inventories. If these expectations are realized and corn prices fall to $4 per bushel, irrigated cropland values in eastern Nebraska could fall more than 20%, even if capitalization rates remain at today’s historically low levels.
"The worst-case scenario is a combination of higher capitalization rates and falling farm revenues," it continues. "In 1981, the spike in real interest rates pushed capitalization rates to historic highs. At the same time, high interest rates contributed to higher exchange rates, lower agricultural exports, falling commodity prices, and cuts in farm revenues. From 1981 to 1987, the combination of higher capitalization rates and falling revenues contributed to a 40% decline in real U.S. farmland values, with even larger declines in nominal farmland values. If similar events occur in today’s environment, farmland values could plummet. For example, in eastern Nebraska, if capitalization rates return to their historic average of 7.5% and corn prices fall to $4 per bushel, then irrigated cropland values could fall nearly 50% to about $2,600 per acre. Other regions face similar risks."
That's sobering. In the face of that, here's what we've been cautioning in our newsletter -- while we remain positive long term on land values, farm operators need to keep leverage low (pay down debt), build working capital (as much as 40% to 50%) and lock-in long-term interest rates in order to ride out the period negative profitability and financial stress that will eventually occur. Fortunately, it appears there is still time to get these financial goals executed.
Read the full Fed report here.
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