WE’RE HEARING despite an eye-popping, decade-long run-up in farmland values, most agricultural economists see little evidence of a bubble that could lead a repeat of the farm crisis of the 1980s that resulted in thousands of foreclosures.
Tighter underwriting standards, strong farm income and relatively low loan-to-value ratios should provide a cushion if a downturn occurs, according to the experts. Personally, I’m still a little worried about the prospects of a bubble bursting in the farm belt (more on that later).
First, let’s look at where things stand today. Nathan Kauffman, an economist with the Federal Reserve Bank of Kansas City, told me that while there are signs that agricultural real estate is richly priced, underwriting criteria are stronger than during the farm crisis of three decades ago.
Historically, farmland traded at a price to cash to rent ratio of about 15% to 18%, he said. Today, that ratio is up to 33% in the key farm states such as Iowa and Illinois, meaning investors would be willing to pay $33 for every $1 dollar of return.
Looking at those sorts of metrics, one could see why some people think things are out of whack, right?
“The concern right now is that you’ve had very strong income the last couple of years, and going into 2014 the expectation is that incomes will be quite a bit lower,” Kauffman said.
But Kauffman sees little evidence that we are on the precipice of another farm crisis. Despite all the talk about Wall Street and pension fund investors buying up agricultural land, outside investors account for less than 20% of farmland purchases in the bellwether state of Iowa.
“It’s mostly farmers that have been buying farmland in recent years,” he said.
In some cases, they may not be bothered by the high cap rate on their purchases of new land because their existing holdings are capitalized at a much lower rate, so their average cap rate isn’t that high. And after a number of years of very strong income growth, many farmers see few alternative investment options. Low interest rates mean the investment returns on bonds and deposit accounts are also very low. Economies of scale may also encourage farmers to take advantage of once-in-a lifetime opportunities to buy neighboring land.
“A lot of farmers are sitting on a lot of cash, and they have to put that money into something,” Kauffman said.
Kauffman also says that farm and ranch lenders have learned from the past and have tightened underwriting on land loans.
“Leverage is significantly less on average relative to the 1970s and 1980s,” he said. Many lenders do not allow leverage ratios above 50% to 60%, he noted. Additionally, many land purchases being made today are all-cash deals, with no financing at stake.
In an article, Ken Keegan, EVP and chief risk officer for the Farm Credit Services of America, Omaha, Neb., acknowledges that farmland price appreciation has been “the most dramatic seen in recent history,” but he also argues that the run-up in values is different from the farm crisis of the 1980s and from the recent housing bubble.
But even he sounds a cautionary tone, noting that during the last century, three “golden eras” in the agricultural economy were followed by busts.
Over the last ten years, farmland values have risen in the range of 300%, he wrote. (Last year alone, farmland values rose 20% to 30% in most Midwestern states, according to the Federal Reserve).
But Keegan says debt leverage ratios have not increased as land values have risen. The FCS of America uses caps—based on commodity prices, estimated operating costs and a 3.5% capitalization rate—to limit how much debt can be applied per acre. In most cases, the FCS would not lend more than 65% of the estimated production value of the land. But those standards could change.
“The goal is to return to more traditional loan-to-market value metrics after profit margins normalize and farmland values stabilize,” Keegan wrote.
That’s all well and good, but here’s why I’m concerned that lenders may be underestimating the risk of a bubble. Admittedly, it’s more a matter of instinct than empirical evidence.
First, I remember hearing economists in the housing boom years, and most experts discounted the risk of a bubble. Most thought the run-up in housing values would lead to a “plateau,” or at worst a modest decline. The bias among economists covering a specific industry or sector of the economy, it seems to me, tends to be to root for the home team. Economics may be called “the dismal science,” but in fact I think there’s a bias toward optimism.
Second, there’s a long list of things that can go wrong in agriculture. The farm economy can be dramatically affected by weather volatility, the value of the U.S. dollar, operating costs, overseas economies, global trends in production, etc.
(On the bright side—as Keegan notes—farmland benefits from being an income-producing asset that doesn’t materially deteriorate or depreciate from abuse or neglect. And supply is relatively constant—there’s not much fear about “overbuilding” farmland.
Like Kauffman said, it’s very difficult to spot a bubble before it springs a leak, but anytime an asset value climbs as sharply and swiftly as farm and ranch values have, I’d be cautious about buying into that market.
Ted Cornwell has covered the mortgage markets since 1990. He is a former editor of both Mortgage Servicing News and Mortgage Technology.