Neil A. Stevens

English

Research Papers in Economics

Rising Farmland Priees and Falling Farm
Earnings: Is Agrieniture in Trouble?
NEIL A. STEVENS
U.S. farm real estate values have risen rapidly in
recent years.tm In the five-year period from 1972 to
1977, the average price of an acre of US, farmland
increased 114 percent, or at an annual rate of 18.5
percent. This rate of gain for farmland is the most
rapid for any five-year period in this century and
compares with a 6 percent annual rate of increase
in the thirty years ending in 1972. At a time when
some alternative investments, notably many common
stocks, have performed less spectacularly, and when
assets which offer a hedge against inflation are
highly desired, farm real estate has been very at-
tractive. In fact, ownership of farmland has provided
more than simply a hedge against inflation as in-
creases in farmland values have substantially out-
paced the rate of general price inflation.
These increases in farmland values have brought
about substantial gains in the wealth of landowners
who made land purchases prior to, or in the early
stages of, the present farmland price boom. Yet,
while most landowners have become wealthier, lower
farm commodity prices and sharply higher costs of
production in recent years have substantially de-
pressed farm earnings from the level of three to four
years ago. These conditions, in turn, have led to sub-
stantial cash flow problems for those farmers \vho
financed purchases of land at the elevated prices of
recent years and who must continue to meet periodic
large interest payments as well as other fixed costs.
Such a financial “squeeze” apparently underlies the
recent farmers’ strike movement.
Determiti.cttion of Land Va.iues
Land is an asset xvhich is relatively fixed in sup-
ply. Since the quantity of land is not very responsive
Warm real estate values and farmlas~dvalues are used inter-
changeably. Farm real estate values is the more appropriate
term for the U.S. Department of Agriculture data used in this
paper since it includes the value of buildings and other per—
manent structures on the land.
to changes in its price, especially in the near term,
changes in the price of land reflect primarily changes
in the demand for the services it provides. In addi-
tion to agricultural uses, land is demanded for many
other uses including residential, industrial, commer-
cial, and recreational.
The price of most agricultural land, however, re-
HeeLs primarily the value of the agricultural prod-
ucts that it can produce. That is, the demand for
farmland is derived primarily from its role as an
input into the production process for food and fiber.
Thus, the earnings accruing to farmland are affected
by numerous supply and demand factors affecting
agricultural products Among these factors are ag-
gregate incomes in the economy, population, export
demand. prices of nonagricultural goods, prices of
non-land inputs into agricultural production, agricul-
tural technology, and government farm programs?
Farmnland is a durable asset, yielding a stream of
services, or earnings, over time. Consequently, the
price of farmland, although influenced by current
earnings, reflects the stream of earnings which are
expected over its life? Investors must, therefore, ana-
~For a summary discussion of the outlook for agriculture in
1978, see Clifton B. Luttrefl and Neil A. Stevens, “Outlook
for Food and Agriculture,” this Review (January 1978), pp.
15-22. For a discussion of the problems and eflects of Gov-
ernment price supports on agricnnlture, see Clifton B. Luttrell,
“Farm Price Supports at Cost of Prodn,ction,” this Review
(December 1977), pp. 2-7.
5
1n investment theory terminology, the stream of earnings is
discounted or capitalized in order to determine its present
value. The present value (P ) of a constant stream of earmnings
can be written asP::: + j~y~~
where E
0
is net earnings, ii sthe opportunity cost of credit,
and is is the number of periods over which the canniugs arc
expected. This formula can be written in shorthand form as
r _~h or example, eamings of $100 per year for the
un:1 (1+m )n
next ten years discounted at a5percent interest rate is worth
approximately 8772 today. When n becomes very large, the
formula reduces to the simple formula P . When a
Page 16FEDERAL RESERVE SANK OF ST. LOUIS MAY 1978
lyze the demand and supply factors which can in-
fluence the future income stream of the asset and
form some judgment as to the probable pattern of
that income stream. If, for example, population
growth is expected to increase from 2 percent a year
to 3 percent a year. investors would probably raise
their expectations of future earnings from farmland,
other things equal, and the price of farmland would
be bid up immediately to incorporate this change.4
Pa-c-ni-la-nd Values and .L’a-.rn-in-gs —
The H-isto-r-ical Record
Fannland has been a “good” investment over the
past thirty-five years in the sense that the average
value of an acre of U.S. agricultural land has increased
more rapidly than the rate of inflation. Farmland
values, deflated by the GNP implicit price deflator,
rose at an average rate of 2.8 percent per year from
1942 to 1972. Beginning in 1972 farmland values ac-
celerated sharply, rising almost 9 percent per year
faster than the general inflation rate from 1972 to 1977
(Chart I).
Farmland investments have also performed well
when compared with most common stock invest-
ments. In the past ten years, farm real estate values
in nominal terms have advanced at an 11 percent an-
nual rate while common stock prices, as measured by
the Standard and Poor’s 500 Index, have remained
about unchanged.5 In the previous twenty years coin-
mon stock prices rose at a 9.4 percent rate, compared
with a 5.2 percent rate for farmland prices. Such a
divergent pattern for these t\vo types of investments
is symbolic of a snbstantial shift in investors’ expee-
stream of returns is expected to increase g percent per year,
t ,‘ 0
the formula can be rewritten as 1 h,,( 1+g) - When a
nrl (1+m~
becomes very large and ii s greater than g, the formula he-
comes Po =
4
For studies which have attempted to determine which factors
underlie real estate movements, see !vlarvin Duncan, “Farm
Real Estate Values — Some Important Determinants,” Federal
Reserve Bank of Kansas City Alonthly Review (March 1977),
pp. 3~l2~ Luther G. Tweeten and Ted R. Nelson, “Sources
and Repercussions of Changing U,S, Farm Real Estate
Values,” Technical Bulletin T-120, Oklahoma State University
(April 1966); Robert W. Herdt and Willard W. Cochrane,
“Farmland Prices and Farm Technological Advance,” Journal
of Farm Economics (May 1966), pp. 243-63.
5
While different growth rates were observed for the two assets,
the rates of return on investments are not necessarily differ-
ent. In fact, over the longer term, rates of return for assets
tend to epmalize when differences in risks are taken into ac-
count. If, for example, the rate of return of a particular asset
is substantially above that of other investments, iuvestors will
tend to switch into the higher-yielding assets, thereby bidding
up the price of the asset relative to that of other assets.
U.S. Farm Real Estate Values (Per Acre)
Ratio Smol, Rain s’aI’
1967=100 “0 19670n00
- 1400
7501 -- 1750
200 --- 300
250 /--- 250
200 200
iso
15,,,s,,Fk,,,,,,I ,‘t,,,,,k,,,,,d,f1,,45
5
,s, 0NPi”pr,d,,,d,,,i~lI,,,,.
100
90
80
70
60
50
4°
30
20
15
tations about the future earnings of these two
investments.
Historical data on earnings from farmland as a sep-
arate factor of production are not readily available.
1-Iowever, a measure of earnings on total fann assets
is computed by the U.S. Department of Agriculture
and can be used here as a proxy measure for farm-
land earnings.0 As shown in Chart II, these earnings
on farm production assets (in nominal terms) have
treuded npward since 1950. Especially noticeable is
the sharp rise in earnings in the early 1970s when
earnings from farm assets rose 200 percent from 1971
to 1973, then subsequently fell. Earnings adjusted
for changes in the general price level also increased
sharply in the 1971-73 period, hut by 1977 real earn-
ings were only 15 percent above the 1971 level.
‘In Anau:’s-js of P-rice (i-rid La-c-n-ui-os
The ratio of the value of farm production assets
to earnings on these assets is a useful tool for analyz-
ing the behavior of farm earnings and farm real
estate values. This ratio, similar to the price-earnings
ratio used in stock market analysis, is a measure of
0
Farm meal estate comprised approximately 80 percesst of ali
fanu production assets irs 1977. Earnings on faros assets are
total net income of farm operators from farming plus net rent
to nonfarm landlords and irsterest on farm debt, less adjust—
nnents for farm operators’ labor arid management.
lOll itli 1924 1q20 936 1942 I94i 1954 1960 966 977 197i
:-,,,,,- coos
Page 17FEDERAL RESERVE BANK OF ST. LOUIS
Oh,,’ 6
Farm Earnings and Asset Values
ii A,,~,,&=,,,n,=
T
]950-54p,H,,d 6 6&4
0 A’,,,d ~ 165004 ,,d4d ;, 004
MAY 1978
however, the ratio has continued to misc and by 1977
the value of farm assets was estimated to be 31
times current earnings, well above the average ratio
of the 1950s and 1980s.
One interpretation of this most recent rise in the
P/E ratio is that investors revised upward their ex-
pectations concerning long-rnn prospects for future
earnings on farm assets following the surge in earn-
ings in 1972 and 1973. An acceleration in real estate
prices would accompany such an upward revision in
earnings as these expectations are capitalized into cur-
rent land prices. In this case, the recent shortfall in
farm earnings would appear to reflect an investor
view that such low earnings were a temporamy
ph enomena
The fact that farmland prices relative to other
Ruti, prices have grown at an accelerated rate beginning
—~ in 1972 strongly suggests that investors’ expectations
of earnings, indeed, have increased in real terms.
20
Because of higher earnings expectations, investors
0 have bid up the price of farmland. This has meant
1950 952 1954 1956 1958 960 1962 1964 1966 968 1970 1972 974 976 I substantial ~vealth gains to landowners, but the rate
0-6- D’p,,n,o
of return to new farmland owners depends upon the
~- correctness of these expectations of higher earnings
the confidence that investors have in the future earn- which have been incorporated into land values. Should
ings of one investment relative to another. For cx- these expectations be revised downward in the market,
ample, the higher the price-earnings ratio (P/E), thus leading to a general decline in farmland values,
the greater is the expected growth rate of earnings Il either have to sell their land at a
new owners xvi
from the current level and the more certain investors loss or continue to fann the land at a lower rate of are that a given stream of earnings will be realized.7 return than was anticipated when they made their
As shown in Chart II, earnings on farm production original investment.
assets and the value of these assets generally treaded Cash flow problems can develop when asset values
upward together in the 1950s aisd l960s. Fluctuations are bid up considerably above that level which is
in the P/E ratio occurred, but the price of farm assets consistent with current earnings. When purchases are
averaged 26 times earnings from 1950 to 1971. The heavily financed, as is usually the case for most farm-
P/E ratio fell sharply in 1972 and 1973, but has risen land purchases, large interest payments, as well as
significantly since then, other fixed costs, must be covered by current earn-
These recent movements in the P/E ratio reflect ings, unless other sources of income are available.
the unusual pattern of earnings in this period. The Farmers who borrowed heavily to purchase land or
sharp rise in earnings in 1972 and 1973 was not im- who have borrowed on the increased market value
mediately and completely incorporated into future of their land and who do not have other sources of
expectations. Thus the P/E ratio fell to an abnonnally income xvill experience financial trouble when realized
loxv level when compared with historical values, Earn- earnings are considerably below the level anticipated
at the time of purchase.
ings subsequently began falling and the P/E ratio
began rising. Instead of reestablishing a value at The higher expectations for farm earnings reflected
around the average ratio of the 1950s and 1960s, in the recent upsurge in land prices may he traced
— back to the 1972-73 period when farm commodity
7
The greater the degree of certainty the less is the return me- prices and farm asset earnings rose dramatically, The
qoned to compensate for risk. The investors’ perception of risk
may be based, for example, on the variability of earnings, sharp rise in earnings in this period reflected changed
To compare P/F: ratios among alternative investnsents, the supply and demand conditions for agricultural prod-
useful life of the investmesst nsust he similar since assets with nets. Unexpected sales of wheat and feed grains to
a longer life span will have higher P/E ratios than shorter—
lived investments, the Soviet Union in mid-1972 served to reduce domes-
RtOi, Scat, -‘too
40
Roth Ratio of form Assets to Earnings tO
i~20
Page 18FEDERAL RESERVE BANK OF ST. LOUIS MAY 1978
tic stocks and increase prices. A sharp decline in the
production of Pernvian fish meal led to a shortfall
in world protein supplies and an unanticipated in-
crease in export demand for soybean meal. The un-
expected decline in world crop production in 1972
and a realignment of world currencies led to large
increases in export demand for U.S. crops. U.S. farm
exports rose from about 15 percent of farm commod-
ity sales in 1971 to 25 percent in 1975. In addition
to sharply increasing export demand, domestic de-
mand for food in the early l970s \vas boosted by
increases in government food assistance programs
such as the food stamp program. Also, a number of
factors adversely affected U.S. agricultural production
in the early l970s, such as wage-price controls, envi-
ronmental regulations, sharp increases in energy prices,
and a drought-induced shortfall in U.S. crop produc-
tion in 1974.
-----------
Price Trends
Roth’ Scat, 8 aIim Scat,
1967=100 19676100
240 ——— ANNUAL — — — 100651010 240
-DATA- — -—
120 ---- -
200 --
tao I
160
40- 40
020 ——
too ttI~t0m~0t~m;~ - inn
80
1964 1965 1966 0967 968 0969 1970 9970 1972 1977 1974 0975 1976 9977 0978
U6. D,SL,16,,l {6,6,, ~,,‘I 0-5-
form
Consumer Price loden
(Altttnm~
.(Th—J’~’
‘rodoct Pri
E’
~&
0/
~7
/1/
// r
~7t\
Jr
/
—A
~,
~---
food assistance programs has levelled off and many of
the factors, such as mandatory xvage-price controls,
svhich had disruptive effects on agricultural produc-
tion in the early 1970s have disappeared in recent
years.
If the bulge in earnings in the early -l970s xvas
mostly temporary, then current earnings may not he
too far out of line with longer-run supply and de-
mand forces. To the extent this bulge was the basis
for the upward revision in investors’ expectations
about farmland earnings, then farm assets, and farm-
land in particular, have become overvalued on the
basis of fundamental supply and demand conditions
in the market for agricnltural products.8
fr-nj-~d
The farmers’ strike movement has brought consider-
able attention to the current “low” earnings in agri-
culture. One might infer from this movement that
U.S. agriculture is in trouble and is near widespread
bankruptcy. However, the fu damental factors affect-
ing U.S. agriculture appear relatively sound. The
health of U.S. agriculture is heavily dependent on
its ability to compete effectively in world markets,
U.S. agriculture is very efficient and enjoys a corn-
°° parative advantage in trade with most countries of
the world.
All of these factors contributed to a sudden, large
increase in agricultural earnings. Most of the factors
behind this bulge in earnings were temporary as is
indicated by the decline in earnings and fanu com-
modity prices in recent years. As shown in Chart III,
farm commodity prices rose munch faster than con-
sumer prices from 1971 to 1973, hut have since come
back in line with the general price level in the
economy. World grain production, aided by more
favorable weather, has increased 14 percent since
1972-73, and oilseed and meal production across the
world has risen 38 percent. U.S. crop production also
snapped back from the 1974 disaster as weather con-
ditions normalized. In addition, funding for domestic
While the long-rnn prospects appear sound for
U.S. agriculture, “hard times” may be experienced by
some farmers who possibly made incorrect decisions
020 based, perhaps, on misinterpretation of the bulge in
earnings in the early l970s. Cash flow problems have
already developed for some farmers. Should earnings
not rise in accordance with the expected earnings now
built into land values, then agricultural land values
80 will decline. Continued “low” earnings, if maintained,
would eventually prompt a change in expectations by
investors since farmland must compete svith other in-
vestments. If farmers and other investors in farmland
begin to doubt the future prospects for earnings
growth, they will lower their bid prices for farnmland
coming into the market or attempt to sell land in order
to take advantage of higher-yielding investment oppor-
tunities elsewhere. Farmland values would then de-
cline until the return on farmland has risen to a com-
parable level with returns on alternative investments.9
8
Based on 1977 data, either a 20 percent rise in earnings or
a 17 percent fall in the value of fann assets, or some com-
hination, wmdd be necessary to reestablish the average ratio
between farni assets and earnings which prevailed in the
period from 1950 to 1971.
9
The rate of increase for nominal farm real estate values has
shown a tendency to slow in the past year. From February
22°
Page 19If land values do decline, owners of farmland will
experience losses in wealth. For most, this would
simply reduce some of the gains experienced as prices
rose. But those farmers who bought at the higher
prices of the past few years will realize a lower rate
of return on their initial investment than they ex-
pected, and some who are highly leveraged may be
forced to leave agricnlture, and the rate of bank-
ruptcy might increase for a tUne.
Yet, equity in agriculture is large. In fact, the
ratio of farm real estate debt to the value of farm
real estate has actually fallen in recent years, from
about 14 percent in 1971 to about 11 percent in 1977.
It xvould appear that most farmers would be able to
weather some decline in land values withont incur-
ring bankruptcy. In recent years over one-half of all
farmland transfers have been to existing owner-oper-
ators of farms, where equity is often substantial in
existing acreages, so cash flow problems are not as
severe for these farmers.
In the final analysis, the health of the agricultural
industry reflects its efficiency in producing food and
fiber products and the level of demand for these
products. While investors’ expectations determine the
value of farm real estate as well as other investments,
these expectations cannot stay out of line with the
fundamental supply and demand conditions for these
investments for very long.
1977 to February 1978, the average price of farmland rose
about 9 percent compared with a 16.5 percent increase per
year in the previous five years.

Rising farmland prices and falling farm earnings: is agriculture in trouble?

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Rising farmland prices and falling farm earnings: is agriculture in trouble?

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