June 28, 2018

DrKohl_color The Ag Globe Trotter

Dr. Dave M. Kohl

Welcome to the weekly edition of The Ag Globe Trotter by Dr. Dave Kohl.

One of the major questions posed during conferences and schools in recent years is why land values have not crashed, similar to what was experienced in the 1980s. What is different this time? Is farmland and ranchland still a good investment? These topics will be discussed from a national perspective; however, remember that farm real estate is influenced by local and regional dynamics. Caution must be taken when viewing land values because the situation could be different in your specific area or region.

100-Year Perspective
If you examine farmland and ranchland values over the past 107 years, it is obvious that this asset is a good investment. Over this duration, these land values have been flat or appreciated 79 percent of the time. When the Great Depression years are eliminated, this figure jumps to 88 percent. Analysis of data from 1910 to the beginning of World War II shows that farmland and ranchland values appreciated only 57 percent of the time. One can see how and why the Great Depression farmers and ranchers were debt averse, particularly when it was an investment in farm real estate. One would have to surmise that changes with the Farm Credit Act and, to some extent, the banking industry during that era led to more stability of one of the largest assets on the farm balance sheet after World War II. The ability to make long-term loans through funding sources such as the Federal Land Banks and having a source of short-term credit through Production Credit Associations (PCAs) were also a boost to stability of land values in the post-World War II era.

Fast-forward to the late 1970s when the perfect vortex was set up for the 1980s farm crisis in which farmland values crashed. The stage was set with record profits from the 1970s Russian wheat deal and the opening of international markets, along with inflation of 10 to 12 percent during a period of interest rates at 6 percent. Youthful, baby-boomer farmers purchased farms and ranches from Great Depression-era farmers. They borrowed money for land investment as a hedge against inflation under the premise that strong international markets would continue forever.

Paul Volcker, chairman of the Federal Reserve, and the Federal Open Market Committee (FOMC) rapidly raised interest rates to slay the dragon of inflation. The sharp uptick in interest rates combined with softening international markets created a combustible mix for financially leveraged farms. This led to farmers who were unable to service their debt and resulted in many farm foreclosures.

The tough years of the 1980s set in motion declines in land values up to 50 percent. Those producers resilient enough to adjust their business practices with government supports started a slow process of farm asset appreciation during the 1990s. This was a period characterized by conservative lending supplemented by government support programs.

International farm markets became stronger at the turn of the 20th century. Baby-boomer farmers reached the age in which their balance sheets were stronger.

Super Cycle
The perfect convergence of events set in place the longest, strongest commodity super cycle since 1910. Ethanol and strong demand from emerging nations for commodities increased demand for farm products. An urban real-estate crisis resulted in quantitative easing and low interest rates, which in turn reduced the value of the dollar. This made U.S. farm products an attractive buy for international customers. These factors combined to create the golden years of profits for agriculture. In fact, many producers indicated that they made more profit in this six-year period than the previous 40 years. This economic windfall created tremendous farmland and ranchland appreciation. This appreciation attracted willing investors who, without comparable alternatives, made farmland their investment of choice.

No Bust
The great commodity super cycle ended around 2013. Over half a decade has passed and farmland and ranchland values have been resilient, representing $2.8 trillion of the $3.5 trillion U.S. farm balance sheet, or 81 percent of the asset base. Why is this major asset not going bust? In the 1970s and 1980s era, farmland and ranchland were in a credit bubble. This bubble existed with highly financially leveraged farms. Credit bubbles tend to burst. As a case in point, in 2009 the real-estate crisis in urban and suburban areas created a housing bubble. The conditions in agriculture today are more like an asset bubble. This time, strong profits, working capital and asset appreciation from the super cycle are providing a bridge for farmers and ranchers to have time to make adjustments. Reactive managers are on their second or third round of refinance or debt restructure over this six-year economic reset. This is resulting in a slow decline in land values in certain areas.

Next, resources under the ground such as minerals, water and oil are attractive investments for hedge funds and other wealthy individuals or institutions. Approximately 80 percent of farmland is owned by passive investors, some who have inherited the land with little or no financial leverage. This has been a platform for little change in land base despite the struggling agriculture economy.

Of the 911 million acres of farmland in the U.S., it is estimated that 93 million acres will change hands in the next two years. Much of it will be transferred within families: 62 percent by wills, trusts and gifts; 14 percent by sale to relatives; and 23 percent by sale to non-relatives. This dynamic in itself creates a floor on this important asset on the farm balance sheet. Other factors such as farmland for development, entrepreneurial or value-added activities, and land that is adaptable to technology and bioengineering all work to create a dynamic different from what we experienced during the 1980s farm crisis.

Perfect Storm
What are the dynamics that could create the perfect storm for a major land-value correction? First, international trade disruptions have already been set in motion. Over 20 percent of net farm income is generated on the global markets. Small changes can have a large impact on specific commodities in specific regions. American agriculture is in only the first and second innings regarding how trade may impact land values.

Next, an increase in interest rates could disrupt land values. An increase of 100 to 200 basis points could have a major influence on values. Higher interest rates would strengthen the dollar, which would work to curb exports. This would squeeze already tight margins and increase interest costs, specifically for those who have financed debt using variable interest rate loans.

Investors divesting their interest in farmland could put downward pressure on farmland values. Other segments of the economy are showing attractive alternative returns. These opportunity investments must be closely watched for the future direction of farmland markets. Of course, a crash in the debt-oriented U.S. and global economies could quickly change credit underwriting dynamics.

One variable that will have to be closely watched will be the refinancing cycle. How, when and how much will regulators and lending institutions restrict the practice of capitalizing operating losses to term debt? When this occurs, the land supply and demand could be out of balance. This would create too much land on the market in a given area for the number of buyers.

In summary, the next few years will be interesting in the farmland markets. Will renters and lessors continue to incur losses just to maintain the ground? Will the non-farm children or grandchildren cash in their inherited farmland? What will happen on the international markets? Will the refinancing cycle continue? Only time will tell.