Recent declines in commodity prices combined with the potential for rising interest rates could trigger a decline in agricultural land prices in coming months. Two of the most important crops in Texas, corn and cotton, have recently suffered dramatic price declines. While corn seems to have leveled off, substantial downside price risk remains for cotton due to high production abroad and a continued protectionist policies in China.
Low interest rates have provided support to growing land prices over the past 20 years. Farmland rents in Texas have not kept pace with rising land prices largely because a falling interest rate environment provides little justification for high returns. However, the low interest rate environment is likely to change. Other commentators have made similar arguments about the Corn Belt and many have suggested that a bubble in land is beginning to burst.
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The Federal Reserve (America’s central bank) is scheduled to end its bond buying program known as quantitative easing in October of this year. While many Federal Reserve economists expect rate hikes in mid-2015, recent statements by Fed Chairwoman Janet Yellen have muddied the waters a bit. Still, whether the Fed pushes rates higher on their own or price inflation down the road puts a premium on current rates, it’s likely that rates landowners pay to finance land purchases and producers use to finance their operations will climb at some point. Due to the low commodity price environment, producers may be forced to roll over operating loan debt to the following year, making rising rates a more serious issue. A rising rate environment will cause either farmland rents to increase or farmland prices to fall.
The equation below describes the relationship between land prices, rent, and interest rates.
Land Price = Cash Rent / Capitalization Rate
This is a simple present-value calculation where the land price is the capitalized value of cash rents. If interest rates climb, the capitalization rate will rise and put downward pressure on land prices unless cash rents increase proportionally. As rates rise, returns on other “safe” investments like bonds also rise. This creates an incentive for landowners to sell land and buy other assets with similar risks and higher returns.
Bearish commodity prices
While a rise in cash rents would mitigate this factor, increasing the return to land (cash rent) will likely be more difficult due to a bearish commodity price outlook. Additionally, increased interest rates also strengthen the dollar relative to other currencies, which puts downward pressure on exports. This would also be bearish for commodity prices since demand from exports is an important component of the Texas marketing chain. The implication is that farmland prices will likely fall as rates begin to rise.
Figure 1 shows the capitalization rates (approximated by the ratio of cash rent to land price) for irrigated and dry land in Texas, and the 10 year Treasury bond rate from 1997 to 2013. Over the period, capitalization rates fell 22.8 percent and 41.1 percent for irrigated and dry land, respectively; while the 10 year Treasury bond rate fell 63 percent. The declines in capitalization rates are due to an explosion in land prices in general over the period and were supported by low interest rates.
Figure 1. Texas Rural Land Capitalization Rates and the 10 year Treasury Bond Rate
Cap rates dropped
While capitalization rates have dropped dramatically since 1997, both irrigated and dry land capitalization rates have ticked up in recent years. In the case of irrigated land, the uptick is due to increases in land rents over the last few years, likely due to higher grain prices. However, in the case of dry land, land prices fell from 2012 to 2013 while rents continued to rise. This may be a response to an uptick in bond rates in 2013 and is likely an illustration of what may be on the horizon for land prices as we move into next year.
A common objection is that, due to the development of oil resources in recent decades, Texas represents a special case. Land prices, it is held, are highly unlikely to fall due to the dramatic rise in the non-agricultural value of rural land. While it’s true that development of the mineral resources of rural land as well as urban sprawl contribute to higher land prices, those activities are themselves dependent on low interest rates. Housing developers and oil companies have had access to cheap credit in recent years, which has lowered the cost of investment in long-term projects. If rates rise, costs associated with investment in suburban housing and drilling equipment will rise. That doesn’t bode well for farmland prices.
The Texas Real Estate Center has some interesting data on farmland prices. Their research indicates that current inflation-adjusted land prices from 2004-2013 were, on average, 31 percent higher than they were during the last major land bubble (1973-1985). Though productivity has increased since that time, historically low interest rates and record high grain prices have certainly contributed to a bubble in land.
While it’s inevitable that interest rates rise at some point, and it’s likely that they will start to rise next year, producers who own large shares of the land they operate can protect their operations by ensuring that they have adequate operating capital. Those with lower total debt-to-asset ratios will likely be in a better position to maintain creditworthiness as land prices begin to decline. It will be increasingly important to keep an eye on measures of liquidity like the current ratio and working capital to value of farm production. Managing liquidity while maintaining a strong balance sheet can help producers transition into a higher interest rate and lower land price environment.