“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.” Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds
This quotation comes from MacKay’s 1841 book that focuses on three speculative bubbles during the 17th and 18th centuries. Asset values getting overheated is not a new happening and the herd mentality MacKay describes is still alive and well 170 years later. We’ve seen it with internet stocks and residential housing recently, and both of those bubbles were very easy to identify – at least with the benefit of hindsight. But it is exceedingly difficult to predict the path of asset prices, as differentiating between market values that have increased based on fundamentals and market values that have lost touch with reality is growing more and more difficult. That being said, let’s consider the possible answers to the question, have farmland prices risen too far, too fast?
Asset Bubble vs. Credit Bubble
Speculative bubbles in any asset class are as much a behavioral phenomenon as they are a financial one. Rising values create a positive feedback loop where excess returns lead to more demand for the asset by new investors. When your neighbor doubles his 401(k) in six months from buying Pets.com or ThisCompanyHasNoRevenue.com, it’s hard to resist the temptation to invest. After all, who wants to be left behind? This is a positive feedback loop, and the beginning of an asset bubble. The end of an asset bubble, not surprisingly, is driven by a negative feedback loop. Investment losses lead to fear, which leads to more sellers than buyers, which leads to more investment losses and so on until asset prices fall enough for the market to clear. It’s the same sequence of greed followed by fear that has driven investor behavior since beads were traded for spices.
A related occurrence, and often a much more dangerous one, is a credit bubble. The recent subprime mortgage crisis is a prime example. The debate continues as to the primary causes of the crisis, with the leading candidates being government policies on housing, accommodative monetary policy by the Fed, and lax lending standards by banks. All three played a part in the crisis, and have played a part in pumping an excessive amount of liquidity into the housing market through mortgage loans. This credit bubble was fuel on the fire of unsustainable home price increases. And this is why a credit bubble can be so dangerous – when you add the bank’s money on top of the investor’s money all chasing the same investment, prices are bound to get way out of line. Cleaning up the mess once the bubble bursts is more difficult, as well, because the painful process of deleveraging must occur. The U.S. economy is still nursing this debt hangover three years after the last subprime loan was made.
Unlike the housing market, farmland is likely not in a credit bubble today, but investors and lenders will need to remain prudent to keep it that way. We are hearing from our Farm Credit counterparts in the Midwest (where the most significant land value increases have occurred) that many sales are on a cash basis and the financed transactions meet conservative guidelines for down payments. The lenders have looked at the long-run price of corn and soybeans, and used that to set a land value that would cash flow if commodity prices fall back to “normal” levels. If these practices continue, a credit bubble forming and pushing land values even higher is very unlikely. But, experience shows us that if a few lenders start making poor underwriting decisions and this gains them market share, it becomes increasingly difficult for other lenders to stand idly by while their loan volumes shrink. Let’s hope agricultural lenders learned a lesson from the mistakes residential lenders made leading up to the subprime crisis.
Farm Balance Sheets
On average, the financial position of farmers is as good today as ever in recent history. Producers deleveraged coming out of the 1980s farm crisis, and have maintained low to moderate debt levels since. Balance sheets are further buoyed by higher land values (the primary asset for most farmers) and strong profitability the last several years. Farmers are much better prepared for a decline in land values than they were in the early 1980s. Debt-to-equity percentages have fallen from 29% in 1985 to 13% in 2010. It can be argued that a drop in values would not cause a rush of forced selling and the negative feedback loop mentioned earlier. This is the story we’re hearing today from financial industry regulators and many Federal Reserve Bank economists. Of course, this makes an assumption that farmers are the primary buyers of farmland.
Who’s Buying the Farm?
Investors (i.e. not a farmer) are increasingly the buyers of farmland, particularly highly-productive Midwest cropland. Depending on which researcher you ask, investors make up 30-45% of recent sales. And these levels are on the rise. With opportunities for good investments harder to find these days, the “smart money” is turning to the red-hot agricultural sector. This has no doubt had some influence on the trajectory of prices in recent years. But is investor participation a bad thing for the farmland market? Not necessarily, but it could be a harbinger of bad things to come. While I’m sure that the investment groups new to agricultural investments are very intelligent folks, usually when you see a flood of relatively inexperienced participants in a market you have the beginnings of a bubble. Just think of all the stories you’ve heard of people being wiped out by tech stocks or buying multiple condos at the beach, when they really weren’t prepared to put a significant amount of their net worth toward these investments. If you’re interested in monitoring farmland values, I would recommend keeping an eye on the percentage of farmland purchases by investors. We would have been well-served to monitor this statistic in the housing market leading up to the crash as an indicator of an over-heated sector.
Cash is King
Whether you’re buying farmland as a passive investment or a way to make your living, cash flow from the investment should be the driver of value. Investors are concerned with rental rates, which have increased significantly in recent years although slower than the pace of the land itself. For instance, land rent in Iowa is up over 11% from 2010, but the ratio of rent to land value has steadily declined from 5.9% in 2001 to 3.4% in 2011. This decline is somewhat concerning, but still affords a reasonable return when inflation and a small appreciation factor are added. But, if commodity prices fall back to historical levels, farmers will not be willing or able to pay the higher rents we are seeing today. Obviously, this will have a direct impact on the value of the farmland.
As for farmers, their crop yields have steadily increased due to improved seed varieties, enhanced management practices, and more efficient use of each acre of land. Historically high commodity prices combined with these increased yields have obviously boosted farm incomes. It’s arguable whether the higher income fully supports the significant increases in prices paid for high-quality farmland, but at least there is some financial underpinning of the record value levels.
As mentioned previously, asset bubbles are very hard to predict without the benefit of hindsight, and it’s even harder to get the timing right. Many investors went broke shorting the subprime market. Right idea, wrong time. At this point, the jury is still out on whether farmland is currently in a bubble, but hopefully the four potential drivers of an overheated land market will help you decide for yourself as this chapter of the land story unfolds.
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