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Financial leverage and the farmland market

Allen Featherstone Published on 01 January 2015

Farmland has been susceptible to boom-bust cycles where a large run-up in land prices is followed by a rapid decrease in prices. Two such cycles occurred in the last century, one beginning in the 1920s and ending in the 1930s, and the other from 1973 to 1986. The end of these cycles is marked by farm financial distress due to accumulated debt and the inability of earned cash flow to make the interest and principal payments.

Research on these cycles indicates they begin because of an economic shock that is outside most farmers’ experience that justifies higher prices. This initiates a period of increasing land values as market participants attempt to determine if the economic shock is permanent or transitory.

Certainly, the increased revenue in the 2007-2010 period justified an increase in land values. However, there is concern as to whether the increases we have experienced through 2014 have gone too far with the falling commodity prices, perhaps setting the agricultural economy up for a fall in land values.

Research has indicated boom-bust cycles are exacerbated by an increased use of debt by farmers along with a herding effect. A herding effect occurs when market participants no longer focus on market fundamentals, rather on prices themselves and a concern the asset will continue to increase in price and as such, purchases need to be made immediately.

In the 1970s, it was often heard, “They are not making any more farmland.” Such sentiment has not been widely present in this cycle, suggesting a strong herding effect may not be present.

Farmland values

Kansas inflated land values

To help understand the current situation, Figure 1 examines the inflation-adjusted land values for Kansas. The basic pattern of this graph would hold for most of the Midwestern U.S. What is striking is the 2014 inflation-adjusted land values are nearly 40 percent greater than the peak land values of the previous cycle that began in 1973.

Economic conditions in 1973 provided record income to farm producers. Inflation-adjusted land values increased by 97 percent from their 1972 levels over the next eight years. From their peak in 1980, inflation-adjusted land values fell in Kansas by nearly 55 percent over the following seven years.

The current situation has seen a more precipitous increase in land values when compared to the 1973-to-1980 increase. Inflation-adjusted land values have increased by roughly 145 percent since 2004 (see Figure 1).

Given the magnitude of those increases, are farmers setting themselves up for a rapid decline in farmland values?

Farm debt

Kansas debt levels

The second factor that often leads to a boom-bust cycle is an increased use of debt leading to increased leverage. Figure 2 examines the use of debt and leverage (debt/assets) from 1973 to 1980, the boom period for inflation-adjusted land values. The debt and leverage ratio data are from the Kansas Farm Management Association.

From December of 1972, the use of debt increased from roughly $58,500 per farm to over $166,000 per farm, an increase of about $108,000 or 184 percent. The debt-to-asset ratio increased from about 23 percent to 29 percent although most of the increase in that ratio occurred from 1979 to 1980.

Kansas debt levels

The situation from December 2005 to December 2013 is different from the previous cycle (Figure 3). While the debt level has increased by roughly $150,000 per farm, the percentage increase has been a little less than 50 percent.

However, the increase in debt has been offset by a larger increase in asset value, causing the debt-to-asset ratio to decline from an average of about 34 percent to 20 percent. Thus, the use of leverage and debt during this increase in land values is relatively less than the 1973- to-1986 cycle.

The average leverage ratio is currently lower than during the previous boom cycle. The average debt-to-assets position in 2013 is the lowest since before 1973. In 1979, the debt-to-assets ratio was 24.6 percent compared to 19.6 percent in 2013.

The percentage of farms with more than 40 percent debt to assets in 1979 was 19.4 percent and was 16.9 percent in 2013. The percentage of farms with more than 70 percent debt to assets in 1979 was 1.3 percent and 3.2 percent in 2013.

A comparison of the current situation on Kansas farms with the situation in 1979 allows one to make several important conclusions. First, the leverage situation in 1979 is comparable to that in 2013, on average, although there is a higher percentage of farms with more than 70 percent debt to assets in 2013 than in 1979.

While the leverage situation is comparable to 1979, the agricultural sector may not necessarily undergo the same outcome as in the early 1980s.

While the increase in debt since 2005 has not been as large on a percentage basis compared to the last cycle, the increase in debt in Kansas for 2013 was greater than $40,000.

Of this increase, roughly 60 percent was an increase in current debt. An increase in the current liabilities section of the balance sheet could be a precursor of future financial issues due to either an inability to pay off operating lines of credit or an increase in debt used to hold inventories of crop production in an attempt to receive higher prices in 2014.

The crisis in the 1980s originated from a precipitous drop in income and an increase in interest payments that decreased the capital debt repayment capacity from 152.8 percent to 16.3 percent in two years. This initiated a decline in land values that exacerbated the crisis.

Future land values

There is a growing concern regarding the path of future land values. A recent survey completed in September 2014 by Brewer et al. found that 64 percent of agricultural lenders think land values will fall over the next two to five years, 26 percent suggest land values will be about the same and 10 percent suggest that land values will increase.

Prices received by Kansas farmers

Given the declines in crop prices that occurred during 2014, there is concern regarding future land values. Figure 4 examines the corn and soybean prices received by Kansas farmers from 2003 through 2013 and price projections from 2014 through 2017.

The price projections are based on current futures prices minus an average basis. If these expectations are realized, the current prices through 2017 are more like the 2007-to-2009 period than other periods in time.

Kansas non-irrigated corn and soybean product cost

Combining this with Kansas non-irrigated cost of production information from the Kansas Farm Management Association enterprise budgets, current costs are 15 percent to 30 percent higher than during the 2007- to-2009 period (Table 1).

Thus, at the same level of prices, incomes would be below those experienced during that period unless producers could cut production costs or increase yield.

How far could land values decline? Inflation-adjusted land values in the 2007-to-2009 period were in the $1,100 to $1,200 range. Without considering capitalization rate differences or changes in technology, these land values are roughly 40 percent to 50 percent below current values, suggesting if we have a prolonged period of output prices at current levels, a significant downward adjustment could occur in land values.

There are numerous factors that could mitigate declines of this magnitude, including higher commodity prices, improved technology and the global economy. In addition, stability in crop prices does not usually occur for three or four years in a row. Thus, we are entering a period of substantial uncertainty where current crop income is unlikely to sustain current land values.

Fortunately, the agricultural sector is probably better positioned from a debt and leverage situation to manage a decline in land values than they were in the 1980s.  FG

Allen Featherstone is a professor for the Department of Agricultural Economics at Kansas State University.

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