The business of owning farmland

Farmers are land investors too, but are we any good at it?

Of course, farmers integrate their real estate into their production business, with land and buildings used for the growing of crops and production of livestock. Importantly, too, the asset value is used as collateral to secure financing.

As well, farm real estate is often the main retirement fund.

There is no question, too, that farmland has been an incredibly good investment in recent years. If you purchased farmland in Ontario for the average price of $3,000 per acre in 1994, that land would have been worth about $11,000 per acre by 2012, essentially quadrupling your initial investment.

With these kinds of returns to ownership of farmland, how can there be any question about the value of investing in it? But with any investment, past performance is no guarantee of future returns. Instead we need to look to the fundamentals and at what gives land its value.

Is land still a good investment?

Dr. Michael Langemeier at Purdue University urges caution: “We are already seeing weakness in the farmland market in the U.S.”

If cash rents go down because of lower commodity prices, there will be an impact on land values, Langemeier says. In fact, Langemeier believes land values will go down faster and harder than rent.

As well, land prices may be sideswiped as the economy improves and interest rates inevitably go up interest rates can hurt land prices too.

Langemeier suggests farmers calculate a Price/cash rent ratio (P/rent) on land they are considering. In the paper, “Farmland: Is It Currently Priced As An Attractive Investment?” which Langemeier co-wrote with Dr. Timothy Baker and Dr. Michael Boehlje, the researchers say P/rent over the past 50 years has averaged 18.2. This is relatively close to the average S&P 500 price/earnings ratio of 18.7 for the same time period. However, since 2004 the P/rent has been well above the average. Land prices peaked in August 2014 at 33 times rent.

historical look at farmland price to cash rent

The authors also compared a running 10-year average of the S&P 500 P/E and the P/rent and found that this ratio (i.e. P/rent10) now exceeds the peak S&P P/E10 recorded during the dot-com stock bubble in the late 1990s.

Their study concludes: “Land buyers beware… current farmland values are now extremely elevated in relationship to underlying economic fundamentals. If we are correct, this means that those purchasing farmland at current prices have a high probability of experiencing buyer’s remorse in coming years.”

Should you buy now?

For many farmers, owning land is more an emotional decision than an economic one. As long as they can make the payments, they are willing to purchase land. They justify their purchase, saying, “if I don’t buy it now, I will never get another chance.”

That may be true, but is ownership of that particular piece of property worth the risk that you will not be able to make payments if interest rates go up or commodity prices go down? Are you willing to tie up equity you already have in other owned land in order to secure an overvalued mortgage, especially since you will then not have that equity available for other needs? Are you willing to forgo the returns you are receiving on current investments which will have to be liquidated to meet the down payment for a land purchase? Can you live with the reduced cash flow?

Then there are also the “economic” arguments. We often hear that land has always gone up and it has outperformed the stock market. Lenders and those selling real estate or investments in farmland like to remind us of this, and over the long term it may be true. But like all investments, land appreciation is not smooth, constant, or guaranteed. We have seen land drop in value, as happened in the early ’80s, after which prices took a decade or more to recover.

Unlike investments such as stocks, you cannot easily liquidate overpriced land if land values begin to fall. It is much harder to sell to cut your losses on land than many other assets. You are making a long-term ownership commitment, so you better be sure you are not buying at the market peak.

With a P/rent of 40 or more, as it is right now in central Alberta, is this a wise time to purchase? Would you buy a stock with a P/E ratio of 40? Maybe you would if you felt it had good growth opportunities and had safe earnings, but can you say that about land today, given falling commodity prices, the risk of rising interest rates, and record-high land values?

Not making it anymore

Next there is the argument that “they aren’t making land anymore,” so it will always be worth more. But is that true?

U.S. farmers harvested 20 million more acres of corn and soybeans in 2014 than they did in 2005. A good portion of that land came out of the Conservation Reserve Program. We are also seeing large increases in seeded acreage in South America and Eastern Europe, and there is a large untapped potential in Africa.

But what about the two billion more people who will need to be fed by 2050? Interestingly, CNBC reported FAO estimates that while there is 0.218 ha of farmland per person today, that ratio will only decrease to 0.181 ha/person by 2050. If this is true I wonder if increased efficiency and production could easily compensate for this reduction in land per person.

Finally, potential buyers will argue that if they own the land, they do not have to pay rent. But rent is actually the return on your investment in land. You should still be paying rent to yourself on owned land, at least on paper. You are fooling yourself if you are allocating all your returns on owned land to the farm operation and paying yourself nothing for your investment in land.

This article was originally published as “Our other business” in the April 2015 issue of Country Guide

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Gerald Pilger

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