Agriculture is facing Ag Bubble 2.0, reflecting “irrational exuberance,” not a “new normal.” In our opinion, this will result in a traumatic downward cycle, as discussed in our previous articles in this series.
While farmers have experienced crop price and profit cycles over the last 25 years from the mid-1980s, farmland values, as exemplified by Midwest farmland, have appreciated almost every year over the past 25-plus years.
Farmland values, which are the “poster child” for Ag Bubble 2.0, have moved beyond sustainable levels. There is a growing risk that agriculture faces a “Perfect Storm” in terms of a reversal in the key drivers of farmland values (i.e., falling crop prices, falling profits, and rising interest rates) over the next few years.
Additionally, there is also the potential risk that farmland values could be in an extended downtrend from current peak levels, or at the very least, tread water after bottoming out from an expected significant intermediate term decline from current levels.
Farmland Values: A Key Barometer
Farmers and financial investors continue to invest in farmland, especially Midwest farmland. In today’s global economic and financial environment, it would appear to be insane to bet against further appreciation in Midwest farmland, as an investment, given its track record and current Midwest ag fundamentals, especially the surge in this year’s corn profits.
In addition to the long-term up trend, Midwest farmland values have more than doubled over the past six years. Average farmland values in Iowa have increased from $2,914 per acre in 2005 to an estimated $6,250 per acre in 2011. While some recent Midwest farmland sales have reached $12,000 to $16,000-plus per acre, it has not been uncommon for sales of high productivity (180- to 200-plus bushels per acre of corn) farmland in Iowa and Illinois to continue to ring the cash register at $8,000 to $10,000 per acre.
Farmers continue to drive higher farmland values. Many farmers continue to invest in what they know best: farmland. Midwest farmers, who are flush with cash from above-average profit levels from corn and soybeans over the last four years, continue to bid up farmland prices, since they feel they have limited investment alternatives due to global financial market uncertainty, volatility, and risk. In addition, farmers are generating significant cash from mega profit levels from this year’s corn crop.
Financial investors continue to buy farmland. Almost weekly, business articles focus on financial investors continuing to invest in U.S. farmland. Continued investor interest in buying farmland reflects a number of factors: (1) the continued global rise in crop prices; (2) recognition that the financial returns from farmland have dramatically outperformed the stock market and most other investments over the last few years. Investors have benefited from stable and rising annual farmland cash rents of 3% to 4% of farmland values, plus have the benefit from the dramatic appreciation in farmland values; and (3) conventional wisdom, namely, a buy into the “feed the world” concept, driven by the rising demand for food due to population growth in developing economies, and the resultant rise in the middle class with higher incomes that will demand higher protein diets.
Against this backdrop of strengthening food demand is the general view that global arable land and water is limited. (We believe investors investing in U.S. farmland, on the basis of the “feed the world” concept, will be severely disappointed.)
Farmland values reach a strategic inflection point. We believe crop prices and profitability, as well as farmland values (focusing on Midwest agriculture, driven by corn) are at, or near a peak, and could be under significant downward pressure, not only in the short- to intermediate-term, as highlighted below, but also could have significant longer-term downside risk.
• Crop Prices — Downside risk to corn prices of $4.25 to $5.25 per bushel from current $6 to $7 levels.
• Production Costs — Continued rise in input costs and cash rents in the short term will magnify farmers’ price/cost squeeze, until farm profit pressures create a reversal in cost increases.
• Crop Profitability — Downside risk to corn profits of 30% to 50% from forecasted record levels of $660 per acre (pretax profits excluding land costs) this year.
• Farmland Values — Downside risk of at least 20% to 40% from current levels over the intermediate term.
Even if the resurgence of the well recognized La Niña weather pattern does a repeat performance in 2012, constraining yields, production, and a buildup of stocks in 2012, the peak and downward cycle will only be delayed by another year.
In addition to our corn price and profitability expectations, the greatest risk factor to current farmland values is the future direction of interest rates, the return on alternative investments. The only direction for interest rates over the intermediate term is up from current ultra-low levels. Interest rates have fallen to record lows, as evidenced by the current abnormally low 2.1% rate for the 10-year U.S. Treasury note (risk free rate), which, in part reflects U.S. Federal Reserve’s policy actions to stimulate the U.S. economy. While interest rates are expected to remain at current low levels over the next 12 to 24 months, it is only a matter of time over the next two to three years that current 10-year U.S. Treasury note rates start to move back towards more normal levels of 3.5% to 4.5%, which is in line with historical periods, such as the early to mid-1960s, when inflation remained in the 1% to 1.5% area.
Valuing farmland: the need for a strategic shift in valuation focus from today to tomorrow. In our view, the long sustained uptrend in both farmland cash rents and farmland values has lulled agriculture into a false sense of security about their future direction. The widely used valuation framework (capitalization of rents, or income) used for the valuation of farmland today, in our view, has become obsolete, given the dramatic volatility of change in key variables that affect farmland valuation, namely crop prices, crop yields, crop profitability and interest rates, which have occurred over the past five years and are expected to continue.
Farmland is a capital asset, whose value is derived from the future stream of earnings derived from planting crops, and a discount rate, or cost of capital, which are used to discount future earnings. The question for farmers or investors is how to gauge the potential upside potential and downside risk from current farmland values, given the future outlook for key macro/micro variables, such as crop prices/profitability and interest rates.
Agriculture’s pre-occupation with the capitalization rate valuation model (capitalization of rents or income, which is more complex), which focuses on how farmland is valued today, does not answer these questions. We believe there is the need for a broad strategic rethinking and shift in how mainstream agriculture values farmland, from the simple capitalization model to a net present value methodology, used by investors and corporate finance officers in valuing a company, or income producing asset.
This structural change in both farmers’ and agriculture’s mindset could be driven by an expected acceleration in farm consolidation and dramatic scale-up of farm size, both a response to farmers’ reaction to the expected profit and farmland value downturn. The most important driver could be a market-driven realization that there is a right and wrong time for farmland investment, based on under-valuation and over-valuation.
Capitalization rate valuation models have limited predictive value. From a farmer and agriculture perspective, the emphasis on the capitalization model reflects how farmland valuation grew up. Given the steady rise in farmland rents and farmland values, as well as the steady decline in interest rates since the mid-1980s, it is understandable that farmland is typically valued based on the simple capitalization of rent model, since more than 50% of farmland in the Midwest is currently rented.
The problem is that this broadly applied valuation framework focuses on a snapshot of the value of farmland today, and has no predictive value, reflecting future expectations of crop price, profit, and interest rate expectations, which will likely be dramatically different from today.
A critical component of the capitalization of rent valuation framework is interest rates. Capitalization rates are directly tied to interest rates, with the decline in capitalization rates over the last 25 years correlated to the secular decline in interest rates over the period. The average annual interest rate for the 10-year U.S. Treasury note has declined from 10.6% in 1986 to an estimated 2.8% in 2011. The capitalization rate, based on actual average farmland rents and values from Iowa, has trended down from 7% to 9% in the early-to mid-1970s and a high of 11% to 12% in the early to mid-1980s (reflecting the aftermath of the farm crises) to the current range of 3% to 4%.
The capitalization of rent valuation model simply reflects the current farmland cash rent divided by the current capitalization rate. For example, if a farmland has cash rent of $300 per acre and the current capitalization rate is 3.5%, the value of the farmland today is $300 divided by 3.5%, or $8,571 per acre.
Given our example, the value of the acre of farmland would decline by 22.2% to $6,667 per acre if the capitalization rate increases by 1% from 3.5% to 4.5% due to a rise in long-term interest rates. The only offset to sustain the value of farmland would be a dramatic rise in rents from $300 per acre to $385 per acre, which is highly unlikely if crop prices and profits are under significant downward pressure. In fact, if crop profitability deteriorates in line with our expectations, there will be significant pressure to renegotiate farm rents downwards, especially those high end rents of $300 to $450 per acre.
Potential strategic shift in how farmland is valued. We believe there could be a fundamental shift in how mainstream agriculture values farmland, from a capitalization model to more sophisticated net present value methodology. Net present value models are mainstream financial valuation tools that discount an asset’s expected stream of future earnings. Simply, in the case of farmland, a net present value model for farmland, or for simplicity, a single farmland acre, would discount forecasted after-tax earnings generated over a 5- to 10-year time frame, based on estimated crop prices, production costs, as well as a range of discount rates, or cost of capital, expected in the future. Over the next two to three years, discount rates can be expected to rise, reflecting an increase in the interest rate for the 10-year U.S. treasury note from current 2.1% to at least 3.5% to 4.5% over the intermediate term.
For example, a detailed corn profit model for the next five years for high productivity (180 to 200 bushels per acre) Iowa/Illinois farmland, excluding land costs, suggests that before-tax per acre profits could decline from an estimated $660 per acre in 2011 to $300 per acre in 2013 and then modestly increase to $325 to $425 per acre over the remaining years in this decade. Based on our forecasts and current interest rates, an acre of high productivity farmland is valued at $8,145 per acre. When interest rates rise to a more normal level of 3.5% to 4.5% over the intermediate term, the current farmland value of $8,145 per acre would be expected to decline to $4,255 to $5,235 per acre, which reflects a 35% to 45% decline.
If farm profits deteriorate in line with our forecasts over the next one to two years, we would expect farmland values to initially be sticky on the downside. Many cash-rich farmers will likely continue to bid aggressively for farmland, under the expectation that any price declines are only temporary and do not reflect a secular deterioration. However, at some point over the next two to three years, when price declines start to accelerate, even cash rich farmers will capitulate. (We believe some farmers, who realize that current farmland values reflect “irrational exuberance”, are optimizing their farmland portfolio, and starting to build financial resources, to buy farmland when falling values become undervalued.)
In our view cascading farmland price declines will be triggered by sales from two classes of “weak” holders. First, will be farmers that are forced to sell farmland due to overstretched finances as a result of significant profit declines. Second, will be investors, who are likely not prepared for capital losses in farmland values, especially if we are correct that there is a risk that farmland values could decline over an extended period from current peak levels.
Falling profits and farmland values create risks for ag dealers and the supply chain. Currently, ag dealers and the basic suppliers of inputs (ag chemicals, seed and fertilizers), machinery and services are benefitting from the mega profit levels generated in many sectors of agriculture, especially Midwest agriculture. However, based on our forecast for a dramatic decline in Midwest farm profits over the intermediate term, farm suppliers will be subject to significant downward price and competitive pressures, as well as volume declines. Downstream suppliers will also be subject to an expected growing risk of potential farm customer defaults.
Additionally, while farmers’ general debt/equity positions are favorable and debt leverage positions are not considered excessive today, a substantial decline in profits and farmland values could expose some farmers and their creditors to significant working capital and farmland loan risks.