Is Farmland Still an Attractive Investment? An Update

By: Timothy Baker, Mic​hael Boehlje & Michael Langemeier

August 2015 

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*Originally published in the Purdue Agricultural Econ​omics Report, August 2015

A year ago in this publication we examined evidence that farmland values had become very high relative to underlying fundamentals.  During the past year, farmland prices declined over much of the Corn Belt.  However, farmland prices still remain substantially above historical prices.  For example, farmland prices in 2015 in West Central Indiana are 78% higher than they were in 2010 and 287% higher than they were in 2005 (for current land values see Dobbins and Cook, in this edition of PAER). Concerns are still being expressed by many that farmland prices are higher than justified by the fundamentals. One justification for this concern is that previous research has established the tendency of the farmland market to over-shoot its fundamental value.

In this article we have updated our various measures with the lower 2015 land values and have highlighted how these changes have begun a process of adjustment in the various ratios. Some of the text in this article is the same as last year’s article because we believe it is important for land owners and investors to understand these basic principles.

 

Price in Relationship to Earnings

A standard measure of value used for stocks is the price to earnings ratio (P/E).  A high P/E ratio sometimes indicates that investors think the investment has good growth opportunities, relatively safe earnings, a low capitalization rate, or a combination of these factors.  However, a high P/E ratio may also indicate that an investment is less attractive because the price has already been bid up to reflect these positive factors.   

The equivalent ratio of farmland price to cash rent ratio (P/rent) can be compared to the P/E ratio of stocks included in the S&P 500. We use land value and cash rent data for 1960 to 2015 for West Central Indiana to illustrate the P/rent ratio. Data from 1975 to 2015 were obtained from the annual Purdue Land Value and Cash Rent Survey.  For 1960 to 1974, the 1975 Purdue survey numbers were indexed backwards using the percentage change in USDA farmland value and cash rent data for the state of Indiana.

The P/rent ratio for West Central Indiana has an average value of 18.4 over the 56 year period from 1960 to 2015, with a high of 33.0 in 2014 and a low of 11.1 in 1986, which was perhaps the bottom after the price bubble of the 1970s and very early 1980s, (Figure 1).  During that bubble, the P/rent ratio rose from 14.1 in 1975 to 20.7 in 1978.  The P/rent ratio subsequently dropped to its low in 1986.  The early and mid-1980s is recognized as a difficult period of adjustment for U.S. agriculture.

Over the past year, land values fell more than cash rents decreased thus resulting in a drop in the P/rent ratio to 31.7.  While this is a slight movement back toward the historic average of 18.4 and previous high around 20, the continued extremely high level at least raises concerns that current farmland prices could be overvalued in relationship to returns.  In addition, it should be recognized that the downward adjustment of the P/rent ratio from 1978 to 1986 took eight years.  This raises the question whether the drop in the P/rent ratio over the past year is just the start of a longer adjustment process? 

 

Farmland versu​s Stock

A comparison of the P/rent ratio to the P/E ratio used for stocks provides insight into the comparative attractiveness of farmland as an investment. Figure 2 shows the P/E ratio for the S&P 500 and the P/rent ratio for farmland.  The average P/E ratio for the S&P 500 for the 1960 to 2015 period at 18.7 is relatively close to the 18.4 average for the P/rent ratio for farmland.  The P/E ratio for stocks was generally higher than the P/rent ratio for farmland from 1986 to 2004.  Since 2004, except for 2009 which exhibited a very high P/E ratio for stocks, the P/rent ratio for farmland has been higher than the stock P/E ratio.  In addition, to being relatively high, the P/rent ratio has exhibited an upward trend in the last ten years.

The current P/rent ratio of 31.7 is well above the average P/E multiple of 18.7 and the current P/E ratio of 21.2.  From an investor viewpoint, to receive $1,000 of earnings they would have to buy $31,700 of farmland compared to only $21,200 worth of stock to get the same $1,000 of annual earnings.  For 2015, these two ratios have started a process of convergence, but their continued wide gap is at least a signal that farmland prices are very high compared to alternative investments in the stock market.

 

Cyclically Adjusted P/Rent

To smooth out some of the sharp fluctuations in the P/E ratio Shiller (2005; 2014) uses a 10-year moving average for earnings in the P/E ratio, often labeled either P/E10 or cyclically adjusted P/E (CAPE).  When earnings collapse in recessions, stock prices often do not fall as much as earnings, and the P/E ratios based on the low current earnings sometimes become very large (e.g., in 2009).  Similarly, in good economic times P/E ratios can fall and stocks look cheap, simply because the very high current earnings are not expected to last, so stock prices do not increase as much as earnings.  By using a 10-year moving average of earnings in the denominator of the P/E ratio, Shiller has smoothed out the impacts of the business cycle by deflating both earnings and prices to remove the effects of inflation. Shiller also uses the P/E10 to gain insight into future rates of return.  That is, if an investor buys an asset when its P/E10 is high, do subsequent returns from that investment turn out to be low, and vice versa?     

The P/rent ratios reported thus far are the current year’s farmland price divided by current year cash rent.  Here we model our P/rent10 after Shiller’s cyclically adjusted P/E ratio. Cash rent and farmland prices are deflated, and then 10-year moving averages of real cash rent are calculated. The P/rent10 ratio is computed by dividing the real farmland price by the 10-year moving average real cash rent. A similar computation is done for 10-year owner-operator returns (P/OO-10).

Figure 3 shows all three of these ratios: P/rent10; P/OO-10, and Schiller’s P/E10.  The P/OO-10 increased from around 20 in the mid 1970’s to 28.2 in 1977, and then fell to 6.8 in 1987. The P/OO-10 then increased steadily until it reached a peak of 37.4 in 2013. The P/OO-10 ratio was 37.0 in 2014 and 33.1 in 2014.  Since 2012, the P/rent10 ratio has been substantially above the P/OO-10 ratio.   

Two important points are evident from Figure 3.  First, the P/rent10 ratio in 2013 and 2014 exceeded the peak of the S&P 500 P/E10 ratio during the dot-com stock bubble in the late-1990s and early-2000s.  The P/rent ratio in 2015 is still more than double the long-run average.  Could this be suggesting that the current farmland market is also in a bubble?  Second, the relationship between the P/rent10 ratio and the P/OO-10 ratio suggests that producers did not bid all of the increases in owner/operator returns into cash rents.  Producers may be expecting owner/operator returns to remain low, which would make it difficult to maintain high cash rents.  However, this relationship could also be explained if one expects cash rents to adjust slowly to changes in operator returns.  Historically, there have been times when cash rents were slow to adjust.

 

Buy at a High Ratio: Get a Low Future Return?

Shiller also discusses the relationship between the P/E10 ratio and the annualized rate of return from holding S&P 500 stocks for long periods. In general, his results show that the higher the P/E10 ratio at the time of purchase, the lower the resulting multiple year returns, like for the next 10 or 20 years.  The West Central Indiana farmland and cash rent data from 1960 to 2015 are used to compute 10 and 20 year annualized rates of return. Returns are the sum of the average of cash rent as a fraction of the farmland price each year, plus the annualized price appreciation over the holding period. 

The results for farmland show a negative relationship similar to that exhibited in Shiller’s stock market data.  The 10-year holding period returns for farmland show a strong negative relationship (Figure 4).  That is, if one purchased farmland when the P/rent10 ratio was very high, like now, they tended to have a low 10-year rate of return.  Alternatively, if one purchased farmland when the P/rent10 was intermediate or low, they tended to have moderate to high 10-year returns.  The 10-year returns ranged from a small negative to 20%. The 20-year holding period returns also exhibit a strong negative relationship with the P/rent10 ratio (Figure 5). The 20-year holding returns range from 6 to 14%.

The highest historical P/rent10 in our data for which a 10-year holding period return can be calculated is 30 in 1977, resulting in the only negative 10-year holding period return in our data.  The P/rent10 levels in 2011 through 2015 were above 35, which is literally “off the chart” (horizontal axis of Figure 4).  In this recent period, cash rents have increased, but farmland prices have increased much more.  Farmland prices since 2011 have been at a historically high multiple of moving average cash rent, even higher than the level seen in the late 1970s prior to the agricultural crisis of the 1980s. 

The high P/rent10 ratio in 2011-2015 could be partially explained by market participants incorporating the current high rents into future expectations faster than they are incorporated into a 10-year moving average.  Biofuel demand has been a step-up in demand that is not very likely to decline substantially.  Similarly, increased export demand, mainly soybean demand by China, could be seen as likely to hold and even expand rather than decline.  However, even if one considers the average of only the highest three years of cash rent, one still requires a combination of strong continued growth expectations and low cost of capital to justify current farmland prices and the current ratios.   


Final ​Comments

Our analysis indicates that the P/rent ratio (price per acre divided by cash rent per acre) is substantially higher than historical values, and that this ratio is also high relative to the comparable P/E ratio on stocks as measured by the S&P 500.  In order to maintain the current high farmland values, cash rents would have to remain very high, or even move higher, and interest rates would also have to remain very low.  Most agricultural economists expect crop returns to remain at current levels, putting downward pressure on cash rents, and for interest rates to move upward in coming years.

Furthermore, we demonstrated that farmland values have tended to have a cyclical component in which farmland values move too high relative to the underlying fundamentals and then over time move too low relative to fundamentals.  We use a cyclically adjusted P/rent ratio to show that a very high P/rent ratio, as we have now, tends to be associated with low subsequent returns.  Simply stated, this means that the historical relationships show that those who bought farmland when the P/rent ratio was high tended to have low subsequent returns.  On the other hand, those who bought farmland when the P/rent ratio was intermediate or low, tended to have intermediate or high subsequent returns.  The current record high P/rent ratio could be a warning to current farmland buyers that their odds of favorable returns on current purchases may be low.

Our reading from examining 56 years of history is that current farmland values have recently been extremely elevated in relationship to the underlying economic fundamentals. Secondly, the ratios we have presented have begun to adjust downward in the past one or two years. Thirdly, we observe from history that once these ratios peak and begin downward adjustments, that adjustment may continue for a number of years.

If we are correct, this means that those purchasing farmland at current prices have a high probability of experiencing “buyer’s remorse” in coming years.  As we have shown in our review of history, buying land when the price is high in relation to returns, as it continues to be now, has tended to result in low average returns in the subsequent 10 to 20 years after purchase.

While the course seems to be set for even lower land values and rents in the next few years, there remain some possible situations in which farmland values could be maintained or even increase.  These might include much higher grain and soybean prices than are now expected by futures markets; very rapid declines in prices for inputs like seed, fertilizer and chemicals; and interest rates that stay the same or decrease from current low levels.  None of these are in the current outlook, and thus we tend to favor continued downward adjustments in land values and cash rents.










Referen​ces

Baker, Timothy G., Michael D. Boehlje, and Michael R. Langemeier. 2014. Is Farmland Currently Priced as an Attractive Investment? Purdue Agricultural Economics Report. August 2014, pp. 11-14. https://ag.purdue.edu/agecon/Documents/PAER_August%202014.pdf

Dobbins, C.L. and K. Cook. 2015.  “The Bears Control the 2015 Indiana Farmland Market.”  Purdue Agricultural Economics Report, Purdue University, August 2015, pages 1-11.

Shiller, R.J.  2005.  Irrational Exuberance, Second Edition.  New York: Crown Business.

Shiller, R.J.  2014.  S&P 500 P/E Ratio.  www.multpl.com, accessed July 29, 2015.​


 For a PDF version of this article, click here​.​​

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