Rising Interest Rates Will Test the Strength of Crop Land Values10/01/2018
Many commercial row crop farmers across the U.S. have seen their margins squeezed by lower commodity prices and relatively higher production costs, says Bryon Parman, North Dakota State University Extension agricultural finance specialist.
Rents have come down modestly in North Dakota, declining from a high of $69 per acre in 2015 to a statewide average of $65 in 2018.
Similarly, cropland values in North Dakota mostly have held their value, declining from a high of $2,123 per acre in 2015 to $1,996 per acre in 2018. However, rising interest rates will increase borrowing costs, making operating loans and new land purchases more expensive. Also, as interest rates rise, fixed-income alternative investments become more attractive, likely pushing cropland values down further.
From 1989 to 2002, cash rents held steady at just above 8 percent of the market value of farmland. Adjusted for inflation using 2012 dollars, cash rents and the market value for cropland across North Dakota modestly declined approximately $3 per acre from an inflation-adjusted $48 per acre in 1989 to $45 per acre in 2002, for an average yearly appreciation rate of minus 0.21 percent.
The market value of farmland increased slightly from an inflation-adjusted $537 per acre in 1989 to $544 per acre in 2002, for an average yearly appreciation rate of 0.04 percent. Overall, land values and rents remained fairly flat, maintaining a relatively constant rent-to-value ratio.
“A sharp decline in rent-to-value began in 2003 and culminated in 2014, where rents fell to 3 percent of the value of farmland and mostly remain there as of 2018,” Parman says. “The sharp decline in rent-to-value stemmed from a rapid rise in cropland values where cash rents increased at a much more modest pace.”
From 2003 to 2015, cropland values in North Dakota increased from an inflation-adjusted $556 per acre to $2,014 per acre. Cash rents also increased from an inflation-adjusted $44 per acre in 2003 to $66 per acre in 2015. The growth rate for land values during this period averaged 8.38 percent per year, while the average growth rate for cash rents was 2.52 percent per year.
“At these relative rates, farmland values would double in approximately 8.5 years, while rents would take nearly 28 years to double,” Parman says.
Farmland vs. T-bills
From 1990 to the early 2000s, the yield on 10-year Treasury bills (T-bills) ranged from a high of above 9 percent to around 6 percent near the end of the decade.
“In other words, the income generated from owning farmland, from a landlord’s perspective, was close to what could be achieved by buying T-bills once property taxes and other minor miscellaneous expenses were accounted for,” Parman says. “Further, as T-bills are a key factor in long-term mortgage rates, higher T-bill rates meant interest paid on new land and equipment purchases was higher than it has been in recent years.
“Other investment opportunities such as Baa corporate bonds yielded much higher returns, with yields around 10 percent in the early ’90s to 9 percent in the early 2000s, but with additional risk over T-bills.”
From 2000 to 2016, 10-year T-bills began a gradual decline from around 6.5 percent in 2000 to less than 1.5 percent in 2016.
As mortgage rates dropped, the cost of borrowing for new farmland purchases declined as well. Further, the drop in 10-year T-bills coincided with a rapid rise in commodity prices, making farmland a much more attractive investment option, relative to bonds.
“In essence, the two biggest factors in farmland values were set to facilitate growth, along with general optimism in the future of the farm economy,” Parman says.
Rising Interest Rates
However, interest rates have moved upward steadily since the summer of 2016, while net farm incomes have declined. According to the U.S. Department of Agriculture, net farm income in 2018 is projected to be about 50 percent of what it was in 2013. Meanwhile, 10-year T-bill rates have increased from less than 1.5 percent in the summer of 2016 to more than 3 percent as of September 2018, following seven interest rate increases during that period from the Federal Reserve.
Further, the Federal Reserve announced on Sept. 26 that it is raising the federal funds rate 0.25 percent, and economists anticipate that one more rate hike will occur in December 2018, three more will go into effect in 2019 and perhaps one more will happen in 2020, depending on factors such as inflation, unemployment and economic growth.
“Should yields on relatively safe fixed-income investments such as 10-year T-bills continue to move upward, farmland, from an investment perspective, will become relatively unattractive at its present 3 percent rent-to-value ratio,” Parman says.
“Also, because commercial farming margins are already thin, it is unlikely an increase in cash rents will be the solution to improving returns to landowners looking for an income stream,” he adds. “The most likely scenario is that land values will decrease, improving the projected income-to-sales price, especially given that a large share of the current value is speculative as opposed to income based.”
The key factor in a decreasing cropland value situation is the rate of decline.
“A very gradual decline will ensure large supplies of farmland are not dumped on the market in a short period when farmers may not have the wherewithal to purchase, depressing land values rapidly,” Parman says. “However, if rising rates entice potential investors or current investors away from farmland, and rates are prohibitively high for many farmers to make expansive investments in their own operations, the equity drain in agriculture could be substantial, putting farmers with what was a decent solvency ratio in jeopardy.”