Is farmland bubble imminent?

Is farmland bubble imminent?

BUBBLES are an economic phenomenon that are notoriously difficult to predict and exceptionally easy to recognize in hindsight after they burst.

A run-up in farmland values in recent years has some analysts questioning if a bubble is indeed forming in the agricultural real estate market.

Farmers born prior to 1985 are acutely aware of the consequences of just such a bubble. During the farmland "bubble" of the late 1970s and early 1980s, U.S. farmland prices first boomed and then fell 27% from peak to trough, with deep consequences for producers, lenders and multiple industries connected to agricultural production.

According to a recent analysis from the American Enterprise Institute (AEI), the current U.S. farmland market is showing patterns similar to the infamous farmland bubble of the late '70s. While real farmland prices have been climbing for some 17 years, it is extremely difficult to pinpoint when, or even if, the market may fall.

AEI's analysis compares the run-up and peak in farmland prices of the previous bubble (Figure 1) with the acceleration in values seen since 1995 (Figure 2) and notes that, in inflation-adjusted terms, current prices have far surpassed the 1981 bubble's peak. Real farmland prices have experienced especially rapid appreciation since 2004, coinciding with the current bull market in grains and other agricultural commodities.

At least two Federal Reserve banks -- in Chicago, Ill., and Kansas City, Mo. -- and the Federal Deposit Insurance Corp. have held conferences in the past two years to discuss the potential pitfalls and perils of the farmland market, so the comparison is not entirely new.

However, AEI's analysis compares farmland values to other available vehicles for investment -- e.g., stock prices and housing prices -- and shows that over the past decade, "farmland prices have escalated far more rapidly and have been, unlike the other two, without a severe correction."

So far, at least.

Looking back to the 1970s bubble, several factors were at play, including federal policies in general as well as specific actions that created black swan events such as the Russian grain embargo. Among the biggest factors was rampant inflation, spurred by what many experts now describe as a very loose money-printing policy.

With farmland viewed as a strong hedge against inflation, investments poured in, and prices responded, right up to the point when the bubble burst. In inflation-adjusted terms, farmland prices actually fell 38% from boom to bust, with 1987 real farmland prices reverting to levels seen in 1972.

Assuming that the current trends in farmland prices will lead to a bubble effect might not be the right call, however, based on the factors leading up to and surrounding the escalation in value.

A recent policy paper authored by Jason Henderson of the Federal Reserve Bank of Kansas City and Purdue University agricultural economists Brent Gloy and Michael Boehlje argues that while current conditions may be following the "rhythms of the past," the single biggest difference between then and now is leverage.

"With rising incomes and low interest rates, farmers are making significant capital expenditures on equipment, machinery structures and land improvements," the economists wrote. "Yet, many farmers have not used excessively high levels of debt to finance capital investments."

History shows that boom/bust cycles in agriculture are typically accompanied by high levels of farm debt. Producers were, generally speaking, overleveraged in the late '70s, and when the bubble popped in the early '80s, they simply could not cash-flow their debt service.

"The 1970s surge in farm capital spending outstripped farm income gains, and farmers continued to use debt to pay for the investment boom," the paper explained. "Historically, farm capital expenditures averaged roughly 30% of net returns to farm operators. By 1977, capital expenditures on equipment, machinery, structures and land improvements jumped to more than 80% of net returns."

When incomes and profits fell and interest rates started to climb, farm asset values and capital expenditures plummeted, hitting a bottom in 1981.

Unlike the spend-happy farmers of the 1970s, producers have been far more restrained during the current "boom" cycle. According to the policy paper, despite a 28% rise in U.S. net farm income in 2011, tractor and combine sales held steady after a 30% jump in 2010.

"As a result, the ratio of farm capital expenditures to net income remained stable, hovering near its 10-year average of 40%," the economists wrote.

Perhaps the biggest "X factor" in the current boom/bust cycle is how the Federal Reserve will continue to handle interest rates to stimulate the economy. The "cheap money" policy of the '70s was one factor that encouraged farmers to take on irresponsible amounts of debt.

With current interest rates at historically low levels, the incentive may again exist for producers to rack up debt at the exact point the bull market could be trending lower.

Volume:85 Issue:02

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