Blowing the Farmland Bubble

Transcription

1 Blowing the Farmland Bubble 1 Blowing the Farmland Bubble How sustainable are U.S. land values? Contents Commodity prices driving land value increases 2 Increasing interest rates a clear and present threat 3 Limited supply of land available for sale 3 Urban development demand down 6 New environmental restrictions affecting values 6 Water increasingly important in the West 6 Outlook: land values to increase again in Conclusion 8 Steady increases in U.S. agricultural land prices over the last decade, topped off by even steeper growth over the past five years, have led many to ask if the current level of farmland values is sustainable. Specifically, the discussion has revolved around the possibility that a speculative bubble is forming in the agricultural land sector. While there are always threats that could decrease land values, any analysis needs to clarify the drivers of farmland values before projections can be made or reliable strategies developed. Critical aspects include identifying these drivers, defining factors that could precipitate a systemic crash, and determining how well-positioned land owners are to sustain incurred debt levels. Introduction For the past two decades, agricultural land in the United States (U.S.) has been one of the few investments which have consistently gained in value. Over the past five years, productive agricultural land has grown at an average rate of between 20 percent and 70 percent, depending on geography. While the increases in land value have been fairly widespread across the U.S., the most significant growth has been in regions with intensive field crops and/or livestock production, the Midwest in particular (see Figure 1). Regions with more modest value appreciation have greater diversity in types of production, production conditions, and/or they have experienced reduced demand by real estate developers for urban purposes. Though the rates of growth vary, the three major drivers of recent agricultural land value increases are high prices for agricultural output, low interest rates and a limited supply of land available for sale. Other drivers in outlying regions of the U.S. include the influence of changing demand by urban developers, new Figure 1: Percentage Change in Farm Land Value, 2005 vs 2010 percent n n 0-10 n n n n n n n No data Source: USDA Annual Land Value Survey, 2010

2 2 Rabobank Industry Note Figure 2: Observed Land Value vs. Capitalised Land Value, (f) USD/acre cre 6,000 5,000 4,000 3,000 2,000 1,000 percent Values for ground suitable for berry production and seedless, easy-to-peel citrus production in California have risen signficantly due to increased popularity of these products. Profit margins expected to tighten despite positive outlook Against the backdrop of dramatic commodity price rises over the past five years, and especially over the past 12 months, the most pronounced increase in the U.S. markets has been a 73 percent jump in the 2010 five-year average corn price compared to Much of the price jump has been driven by new inelastic demand from ethanol production and expanded global consumption n Iowa average land value n Capitalized land value n n n Average of 10-year and 30-year US Treasury yield rates (f) 0.00 As a natural response to the increases in commodity prices, farming input costs have also gone up. Despite these input cost increases, significant margins have been available, which has pushed agricultural land values higher. Source: Iowa State University, University of Illinois, USDA, Rabobank, Iowa State University; Annual Survey of Licensed Real Estate Brokers; Chicago Federal Reserve Board, Quarterly Land Value Survey, California Chapter of American Society of Farm Managers and Rural Appraisers. 2 For more detail on global trends and swing factors in commodity price drivers, see Rabobank report Looking For Delta published 12/2010. environmental restrictions and limited water availability 1. The sustainability of current land values is a key factor in weighing strategies for growing agricultural land-related business or expanding investments and risk exposure. Of particular interest is whether a speculative asset bubble might be developing in the sector, what factors may threaten to drive current values down regardless of whether or not a bubble is developing, and what capacity current agricultural land owners have to absorb decreases in land values before becoming insolvent and triggering a widespread liquidation of the asset. Commodity prices driving land value increases Commodity prices have shifted to higher levels due to increasing use of corn to produce ethanol, increasing commodity demand from highpopulation nations such as China, and more recently, the drought in the Black Sea region. Agricultural land, the primary resource for field crop production, has naturally increased in value as a result. Increased demand and higher market prices for specialty crops are driving up agricultural land values in regions other than the Midwest, although not to the same highs. While prices are strong in these regions they are not at record levels, resulting in more modest gains. Overall values for wine, raisin and table-grape vineyards have increased over the last five years, although there was some modest softening in prices for premium wine-grape vineyards in the Western U.S. during the recent recession. Increased global demand has also fueled signficant increases in the values of nut orchards, such as almond and pistachio orchards in California. The outlook for commodity prices is positive. While volatility is expected, substantial price drops are not anticipated for a number of years until global stock levels can be rebuilt. Increasing demand from China, self-sufficiency policies in large grain-supplying countries such as Russia, developing potential for grain consumption in India and increased use of corn for U.S. ethanol production are among the many factors creating an expectation for higher and more volatile grain prices over the next two to five years 2. Historically, increased profits generated by higher commodity prices are squeezed over time as production costs increase to reflect new supply/ demand dynamics and the ability of the producer to pay (see Figure 2). In the future, margins are once again expected to diminish as increases in the volume of commodity production combine with higher input costs to squeeze profit margins. The result should be a slowing in U.S. agricultural land value growth, accompanied by occasional sharp decreases from year to year. Major risks include any development which pressures commodity prices down, higher sustained costs of production, and steep increases in interest rates or a combination of all three. Examples of these risks include political action such as the U.S. government relaxing renewable fuel mandates and discontinuing tax credit support, permanent or longterm disruption in fertilizer supply capacity, an aggressive inflation control policy aimed at increasing interest rates, or disruption in global agricultural trade. Specialty crop sectors are especially vulnerable to changes in international trade policies and to foodsafety crisis. The export of various fresh fruits from the U.S. has been restricted in the past as international trade disputes are argued, and the marketing of U.S. vegetable crops has been severely

3 Blowing the Farmland Bubble 3 limited when warranted and unwarranted foodsafety problems have been publicized. Invading pests and/or the onset of significant plant disease can also limit the shipment of U.S. specialty crops to states and countries concerned about the same disease and/or pest. Such problems have limited the appreciation of regional agricultural land values. In 2011, an increase in land value 3 which is consistent with the 10-year trend increase of 10 percent would be compatible with the current average capitalized land value estimate 4 (see Figure 3). From this analysis, agricultural land values appear to be consistent with current economic conditions and commodity price levels, thus there is little sign of a land price bubble at present. Increasing interest rates a clear and present threat Historically low U.S. interest rates, stemming from the recent global recession, have helped to drive agricultural land values higher through lowering the cost of capital for financing and decreasing returns on alternative investments such as long-term government bonds. As such, agricultural land values are impacted by the interest rate policy, which is determined by national economic conditions. Consequently, the risk to agricultural land values most likely to be realized over the next three to seven years is that of increasing interest rates. An increase in interest rates can affect the value of land by increasing the competitiveness of alternative investments and increasing the cost of financing operating capital, thereby squeezing production margins on the cost side, and pressuring down the price competitiveness of U.S. commodities as the value of the U.S. dollar is stimulated. Current inflation in the U.S. is soft and the interest rate environment remains benign, suggesting that a strong upward shift in rates is unlikely in the short term. However, rates will need to increase from historic lows as the economy strengthens. Limited supply of land available for sale Farmers major buyers of agricultural land The supply of productive agricultural land for sale in the U.S. depends largely on the desire of owners to either hold the asset for a long-term period or sell after a short speculative period. Most surveys identify buyers as being either speculative long-term investors or farm operators. It is reasonable to expect more agricultural land to go on the market in the future if the balance of buyer classification becomes heavily weighted towards speculative investors. On the other hand, an increase in farmer ownership would imply less land available for sale in the future. Current trends in the U.S. are moving more heavily towards the long-term investor. In December 2010, the Realtors Land Institute released its annual Land Scan report which tracks land transaction trends Figure 3: US Agricultural Real Estate Debt vs. Debt-to-equity Ratio, e USD billion billion 2010P n Real estate debt Source: USDA, Rabobank, 2011 n Debt-to-equity ratio across the 28 Central U.S. states. The report concluded that the combination of the economic downturn and tight credit conditions had driven the speculative buyer out of the market. In addition, the report stated that agricultural land markets across the country had become very localized, with a buyer pool more familiar with local conditions and values. According to the survey, most agricultural land buyers are farmers. Iowa State University confirmed this trend, concluding that, in 2010, farmers were the buyers in 70 percent of Iowa s land transactions, compared to 25 percent for investors and 5 percent for other. These results continue a trend which began in 2004, when farmers accounted for only 56 percent of buyers, compared to investors at 38 percent and other at 6 percent of the pool. There have been increased reports of long-term investors interested in buying quality agricultural land in the Western U.S., but there is no factual data substantiating any differences from the survey results for the Midwest as found in the Land Scan report and the Iowa University survey. Farmers account for the majority of agricultural real estate purchases in the U.S.. The absence of urban development opportunities, and tighter credit availability for such investments have scared away speculators in high-growth regions throughout the U.S.. Long-term investors also find it difficult to acquire quality farm properties, as farmers in these outlying regions are more aggressive about buying such agricultural real estate. Farmers are in a historically strong financial position Currently, the U.S. agricultural industry is better positioned with regard to leverage than at any time pe percent Due to the large range of variation between land quality and uses in the U.S., a more narrow view including individual states creates a more accurate picture. Iowa was chosen based on the location and its fairly homogenous distribution of land types and uses. 4 Capitalized value = average rental rate/average of annual 10-year treasury yield and 30-year treasury yield

4 4 Rabobank Industry Note since 1960, when the USDA first began estimating farm balance sheets. Although real estate debt has increased in real terms since the 1990s, equity has continued to improve with regard to total farm debt. Real estate debt as a percentage of the U.S. farm real estate assets has averaged just over 7 percent for the past five years, compared to a 10 percent average in the 1990s and an over 13 percent average for the 1980s. It is noteworthy that this ratio exceeded 25 percent in the late 1980s before the severe downturn in agricultural real estate values. The decreasing ratio of real estate debt to real estate assets suggests that lending trends in the agricultural real estate sector have remained relatively conservative. Consequently, it would take a significant reversal in the current drivers of land values before a dramatic crash could occur. The primary risk factors which could impact the strength of the agricultural industry are financing standards. From the 1990s, lending standards in the U.S. have been sufficiently rigorous to ensure a healthy financial position in the late 2000s. However, looking ahead, financial institutions familiar and less familiar with agricultural markets need to adhere to time-proven credit policies that focus on the fundamental economics supporting farm profitability. Given current debt-to-asset conditions and the limited supply of land for sale, the erosion of lending standards would need to be widespread before any nationwide effects would be felt. Nevertheless, as agricultural markets continue to heat up, the financial sector will need to maintain solid lending practices. Investors interested, but still a small segment As the global economy has struggled through the recession, the stable returns from agricultural land investments have become more attractive. Over the past 20 years, the National Council of Real Estate Investment Fiduciaries (NCREIF) reports an average annualized total return to institutional investors of 11 percent. When compared with the average inflation rate of just over 2.7 percent for the same period, agricultural land investment has had a solid track record. In early 2011, The American Society of Farm Managers and Rural Appraisers reported that pension funds dominated agricultural land investments, followed by endowments, hedge funds and high-net-worth individuals. By a heavy majority, investors tend to be looking for a more long-term appreciating asset with consistent annual returns. In fact, NCREIF reports that 64 percent of the annualized returns generated by agricultural land investment are from the income component of operating the land.

5 Blowing the Farmland Bubble 5 While interest in agricultural land investment is picking up, the total segment owned by land investors is an insignificant USD 5 billion to USD 155 billion part of the USD 1.7 trillion asset6. Investment from institutions is expected to continue along with the investment strategy of long-term holding of the asset as part of an overall portfolio. Supply of land for sale not expected to increase substantially Large increases in sales volumes of U.S. agricultural land are not expected, given the limited supply and the fact that land is being purchased more for production and long-term returns rather than for short-term gains. However, in the 2007 census, the population of farmers over the age of 75 grew 20 percent and the average age of all farmers was estimated at just over 57 years. As a result of this ageing, a significant amount of land is expected to change hands over the next 10 to 20 years. A particular trend which has accelerated as a result of the ageing population of farmers is that of passing ownership of assets through inheritance to individuals who have no operational contact with the farming business. The usual classification of this category of land owners is absentee owner. Although the trend for absentee owners has been to hold on to land over a longer period, this fast-growing class of U.S. land ownership poses an unknown risk for the sustainability of agricultural land values in the future. Positive changes in the return to alternative investments, such as increasing interest rates, could create a natural incentive for some investorclass owners to exit the sector and thus increase the amount of land offered for sale. Currently, few metrics exist to measure the magnitude of response such investors would have to increased interest rates. In any case, a financially wellpositioned farm sector would not allow the value of land to fall far below its revenue-generating ability before entering the bidding process. Therefore, minimum land value should always be held at least near its capitalized rate. A major crash in land values unlikely Speculative bubbles are formed when an asset value dramatically diverges from its fundamental economic value. Drivers of bubbles tend to be panic-buying and selling, substantial involvement of short-term speculative interest organizations and high levels of liquidity, often provided by loose lending standards. The increasing presence of farmers on the buyer side of agricultural land, combined with a tight supply of land available for sale, provides significant evidence that there is not currently a speculator-fueled bubble 5 Source: Teachers Insurance and Annuity Association-College Retirement Equity Fund (TIAA-CREF) 6 Source: USDA

6 6 Rabobank Industry Note Figure 4: Corn Production Cost, e USD/acre 1,000 e e 2010e n Machinery n Farm inputs n Labor n Return to land and profits Source: Iowa State University, University of Illinois, USDA, Rabobank, 2011 in U.S. agricultural land markets. Furthermore, the lack of wide divergence of average values from capitalized values argues against the current existence of such a bubble. However, rapid growth in the value of any asset increases the risk associated with sustaining such high levels over the long term. For agricultural land values to crash, however, the major drivers would need to reverse course with enough weight to overwhelm the ability of land owners to generate sufficient revenue to continue servicing debt on the asset. The debt-to-equity position of land owners is also as critical as their future income generation capability. Urban development demand down Prior to the recent recession, agricultural land values near cities were appreciating signficantly as urban developers purchased such properties for residential and other urban purposes. Both farmers and speculators in such farm properties frequently sold options to developers, which were not exercised after the crash in residential construction occurred. Many farmers who had sold to developers prior to the recession frequently bought other agricultural real estate in neighboring farm regions. This increased the value of California s Central Valley farm properties, such as dairies in southern California, and farmers from Arizona migrated there in response to urban encroachment. The absence of such demand has moderated agricultural land appreciation in many areas near former urban centers of growth. This demand for agricultural land is not expected to rebound in the near term, because of the high inventory of housing yet to be sold. This lack of demand by developers has, for example, especially depressed agricultural land values in Florida. There has also been a sharp reduction in demand for small ranch and rural home properties, because of the higher cost of commuting to nearby urban centers and the reduction in purchasing power of prospective buyers of lifestyle properties. It is now unusual for grazing land or other smaller farm properties to be sold for a premium as a rural home property as they were before the recession. New environmental restrictions affecting values New restrictions on the use of agricultural land usually limit its alternative uses for either more intensive farming or urban development, which typically stimies the property s appreciation. The presence of habitat covered by the Endangered Species Act or drainage problems regulated by local state or federal water quality restrictions directly affect the value of such lands. There are also instances where water drainage considerations increase the value of other agricultural acreage. For example, farm properties near dairies in western states, where there are increasing restrictions on dairy water discharge, sold for very high values prior to the recent downturn in the expansion of dairies. The dairies needed open field land to spread their manure water to meet local water quality requirements. Such demand has vanished with the recent reduction in dairies profitability. Water increasingly important in the West The diversion of water formerly available for agricultural use in many western states has seriously limited the amount of irrigation water for particular agricultural regions. Many areas in California are

7 Blowing the Farmland Bubble 7 primarily dependent on the importation of water from other parts of the state, and higher demand for the same water for urban and environmental uses has increased the cost of irrigation and made its availability less certain. This has increased the value of properties with good water availability and depressed the values of other properties with dubious water supplies. Open ground with good soil, drainage and water supply has signficantly appreciated in California and other western states. In fact, some properties have sold primarily for their water rights and have been purchased by other farmers as well as urban agencies in need of more water. Outlook: land values to increase again in 2011, moderate adjustment down over five years Historically tight carryover stocks from 2010 in grains, vegetable oils, cotton and sugar combined with a less than ideal planting season in 2011 have led to historically high spring commodity prices. As a normal response to higher prices, farm input cost increased from USD 3.30 to USD 3.40 per bushel for the 2010 corn crop to USD 4.00 to USD 4.50 per bushel for the 2011 crop (see Figure 4). However, with the December contract well over USD 6.00 per bushel, near record net margins of USD per acre are easily within reach. Such strong margins combined with the anticipation of continued tight supply conditions for at least one more year should incentivize field crop land owners to increase rental rates and sellers to require even higher prices for the asset. Improving economic conditions in the U.S. and abroad also continue to increase the consumption of many specialty crops in 2011, sustaining the appreciation of agricultural land in most outlying regions. Water availability in California and other western states has significantly improved this year, and there is no indication that global demand for specialty crops is abating. Early indications that consumers are buying more wine is increasing interest in the purchase of vineyards in California, Oregon and Washington. Downward pressure expected over the next three to seven years While a correction in agricultural land values is unlikely in the near term, on a longer term basis of three to seven years, the accumulative probability of events with a negative impact on land values outweighs probable events on the positive side (see Figure 5). Over the five-year period, reduction of prices through inceased global production and increasing input costs are expected to reduce margins. Expectations of increasing interest rates and a stronger U.S. dollar combine with tighter margins to slightly outweigh the positive factors, creating a slightly negative outlook over time. Expected moderately increasing inflation would have a positive impact on agricultural land values. However, unknowns such as the rate of the inflation increase and the speed at which policy makers react 7 Includes cost of land and government payments Figure 5: Probability Matrix for US Land Values Impact on values Strong increase Rapid increase in US inflation Neutral Strong decrease Continuing drought conditions in key production regions Widespread unrest in the Middle East Reduced 2011 production due to lower yields and flooding At least moderate increase in US inflation Increased global production through expansion of area and technology improvements 30%+ increase in interest rates EPA relaxing biofuel mandate Meltdown in Improved weather conditions Chinese economy Strengthening U.S. dollar U.S. Congress repealing biofuels mandate Increased demand for feed and Chinese demand as livestock consolidates Increased farm input costs reducing margins Low Medium High Moderate downward pressure over 3-5 years Probability Source: Rabobank, 2011

8 8 Rabobank Industry Note to contain inflationary growth add significant uncertainty to future projections. Other factors with the ability to dramatically alter any outlook on agricultural land values include events difficult to predict, such as continuing widespread global drought, changes in U.S. biofuels policy or rapid increases in U.S. inflation on the positive side, and the repeal or relaxation of the U.S. biofuels mandates on the negative side. Increasing inflation will also play a key role over the next several years. Moderately increasing inflation should have the effect of offsetting some of the downward pressure of higher interest rates and tighter margins. Rapidly increasing inflation would catalyze another round of value growth and possibly stimulate a value asset bubble. Conclusion While evidence suggests that current agricultural land value rates are not consistent with a speculative bubble, factors combining to drive decreased land values in the future are a real risk. A modest correction in field crop values in the Midwest is a real possibility in the next three to seven years, assuming inventories of commodities are then being replenished and interest rates are rising both appear likely. Consequently, buyers need to be aware of the potential for agricultural land to generate a sustainable margin under future conditions, which may be more conducive to downward rather than upward pressure. While the near-term prospect of declining values for agricultural land in areas dominated by specialty crop plantings is unlikely, the prospect of the U.S. dollar strengthening and global demand moderating in the next three to seven years also threatens to slow the growth in demand for many expanding specialty crops. Larger crops of California pistachios and almonds, for example, are depending on increased export sales, especially to Asia. Any slowing in this demand would most likely result in fewer sales of orchards at the higher values seen in The agricultural industry must continually monitor drivers such as panic-buying and selling, loosening credit standards or divergence of average land value from fundamental prices, which could develop into a classic speculative bubble. Disclaimer: This document is issued by Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A. incorporated in the Netherlands, trading as Rabobank International ( RI ). The information and opinions contained in this document have been compiled or arrived at from sources believed to be reliable, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. This document is for information purposes only and is not, and should not be construed as, an offer or a commitment by RI or any of its affiliates to enter into a transaction, nor is it professional advice. This information is general in nature only and does not take into account an individual s personal circumstances. All opinions expressed in this document are subject to change without notice. Neither RI, nor other legal entities in the group to which it belongs, accept any liability whatsoever for any loss howsoever arising from any use of this document or its contents or otherwise arising in connection therewith. This document may not be reproduced, distributed or published, in whole or in part, for any purpose, except with the prior written consent of RI. All copyrights, including those within the meaning of the Dutch Copyright Act, are reserved. Dutch law shall apply. By accepting this document you agree to be bound by the foregoing restrictions. Rabobank International Utrecht Branch, Croeselaan 18, 3521 CB, Utrecht, The Netherlands Author: Sterling Liddell sterling.liddell@raboag.com Author: Vernon Crowder vernon.crowder@rabobank.com