Saturday, April 18, 2015

Study: Farmland in a Tech-Boom-Sized Bubble

A recent article (older, ungated version here)published in the American Journal of Agricultural Economics and co-authored by one of our contributors, Michael Langemeier, discusses long-term trends in agricultural land values nationwide. The paper draws on data from 1911 to 2012 and measures the risk, returns, as well as relationships between land values and inflation.

Much discussion in recent months (years?) has centered on the possibility of a bubble in land values. While the results of this paper suggest that ag land provides a hedge against both expected and unexpected inflation and is a relatively safe investment, the authors find that “the farmland P/rent ratio has reached historical highs and is currently at the level of the P/E ratio of the S&P 500 during the tech bubble.” The P/E ratio is the ratio of the price of a stock to its earnings or profit. A comparable ratio for ag land is the ratio of land price to cash rent (P/rent).

The P/rent ratio can be interpreted as the price market participants are willing to pay for a dollar of cash rent they will receive. A historically high P/rent ratio is justified if strong growth in cash rents is expected in the future or if interest rates are expected to be low. With the recent declines in grain and cotton prices, along with a lack of bullish expectations for the near future, broad increases in cash prices are not likely in the near future. Additionally, the CME FedWatch indicates a greater than 50% chance of an interest rate hike in December of this year. None of this provides a justification for a high P/rent ratio.

The graph below is a plot of the ratio of the U.S. average cropland prices to cash rents (P/E ratio) from 1998 to 2014 (data source: USDA-NASS). There’s a very clear run up in ag land values from 2005 to 2008 and a subsequent downward correction after the recession set in. Still, the 2009-2014 average P/rent is 26.75% higher than the 1998-2004 average, suggesting that there is potential for a further downward correction in ag land prices on the horizon. Figures 1-3 in the ungated version of the article provide a longer-run perspective.

Certainly it would be better for producers and ag landowners if prices were not driven up unsustainably in the first place. Since asset prices are inversely related to interest rates, artificially low interest rates lead to artificially high asset values. The Federal Funds rate has been at historic lows since the last quarter of 2008. This has done little to boost GDP but has certainly pumped up asset prices. A less myopic Federal Reserve policy would likely result in less risk and uncertainty in asset markets… markets that affect everyone in one way or another.

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