A couple of weeks ago we talked about the affordability of residential housing in various countries around the world. The question arises, is the current price of farm land affordable?
There are three aspects in establishing the fair market value of farm land.
The first aspect is emotional.
You’ve probably heard the local coffee shop buzz that landlord Willy is selling his land. You have also heard the farmer Joe is offering X dollars for Willy’s piece of property. If you want the property then you will have to offer a premium over X in order to out bid farmer Joe.
It might be logical to pay a premium if you have a well established farming operation and plan to farm the land for the next several decades. The price premium you pay can be justified if you already have a healthy debt equity ratio in your existing farm operation and you don’t need to upgrade equipment to cultivate the additional acres.
If you can’t effectively farm the land yourself and afford to pay a premium for it, you will need to look to land rent and capital appreciation over time to generate a return. The return on your investment will be based on your entry price and rental income it will generate, less your land taxes and other carrying costs. In all likelihood the “investment” may produce a loss if you don’t have a well established farming operation.
Many land purchasers assume land is always a great investment because it is non-depreciable, you can touch it, you can see it, and of course the price of land never goes down, right? Sometimes feel good emotional purchases can blur reality, potentially wasting year’s worth of probable gains if a wiser investment option was chosen.
The second aspect is productive capacity.
Productive capacity is a purchaser’s yard stick used in calculating a property’s ability of paying for itself over the next 25-30 years.
The calculator (found at the end of the blog) takes anticipated operating costs along with anticipated yields and selling price to determine a breakeven point per bushel, acre, and entirety of the farm. After establishing how much cash flow you have to support a mortgage payment you can use this calculation to determine the cost this net margin would support.
For example, if the property generated $124 per acre worth of net profit over operating costs, it would support a $275,000, 25 year mortgage at 5.25% interest. In order for the property to pay for itself in the next 25 years the maximum price you could pay is $1,719 per acre.
This is a problem because a lot of land is currently trading at much higher valuations. For existing farmers to continue to expand they may need to use existing land holdings to subsidize new purchases.
The third aspect is a long term investment.
Some pension funds and large institutional investors have decided to expand their investment mix to include farm land as a long term investment allocation. An increase of their asset allocation to agricultural real estate could very well provide a large sum around $100 million to invest in land. If they anticipate the average purchase price around $3,000 per acre and purchase in approximately 30,000 acres bundles, they could create a well grounded land rental system. If the gross average rent was $70 per acre less $20 of costs, only $50 per acre per year would be available to the pension fund. The annual investment return is only 1.5%, but they would also anticipate some rate of long term capital appreciation.
Land ownership acts as a form long term inflation protection in the 50+ year time horizon. Many pension funds have large portions of their holdings in government bonds which have similar low rates of return but have absolutely no potential inflation protection.
As most of you know, real estate prices go through long-term up and down cycles. Currently, we have experienced about 25 years of rising farm land prices. By coincidence, increasing land prices seemed to have tracked interest rate’s downward trend. Some commentators have stated that declining interest rates have caused land prices to rise. Will this mean that the increasing interest rate will cause land prices to decline?
Province of Manitoba has a great interactive crop production calculator at: https://www.gov.mb.ca/agriculture/business-and-economics/financial-management/cost-of-production.html#crop