Farm Real Estate Economy Essay Research Paper

Farm real estate values have increased continuously from 1987 to 1998, significantly improving the financial position of many farm businesses. But for the first time in over a decade farm real estate prices have begun to fall, due in part to record breaking yields for crops and extremely low commodity prices. I believe the value of farmland has increased at too fast a pace in relationship to value of farm production and is facing a major market adjustment. The farm real estate market saw it’s last major market adjustment in the mid 1980’s (see figure 1), many operations went out of business and the banking industry lost millions. In many cases the value of the note the bank was carrying was in excess of the value of the land securing that note. Although the market adjustment I anticipate will not be as drastic as the crisis of the 80’s, I do believe many lending institutions are in place to take some serious losses if the federal government suspends it’s payments to farmers.

Farmland currently accounts for slightly over 79 percent of all farm sector assets, which now exceed $900 billion. Some 52 percent of total farm sector debt, composed of either mortgages or short or intermediate term debt are secured by farmland. Consequently, the financial security of farm sector borrowers and their lenders is affected by changes in farm real estate values.

Agricultural land values are primarily determined by the income earning potential of the land, as measured by expected returns from crops and livestock. However in many areas, nonagricultural factors are playing a greater role. Where non-farm influences are involved, farmland is often drawn out of agriculture for residential, commercial, or recreational uses. Farmland values in rapidly urbanizing areas, like the outskirts of Lincoln for example or in areas popular as recreation destinations tend to be higher than would be predicted based on agricultural returns alone.

Research has found that 10 to 20 percent of the farmland in the United States is effected by population expansion. This may seem like a small percentage of the total farmland in this country but in many instances in urban areas land is valued at five times it’s production capability, or higher. This however is not taken into consideration when valuing the real estate in the farm sector as a whole. This problem is most prevalent in the Northeast United States.

Total U.S. farm debt rose from $32 billion at the start of the decade to $170 billion at the end of 1998. Who is holding this debt? The attached chart shows debt structure amongst major lenders until calendar year 1996, the trends have continued and now in 1998 commercial banks supply 45 percent of all farm debt, this up from 25 percent in the mid 1980’s.

Farm Credit Services is second holding approximately 1/3 of all farm debt.

Examination of bank farm loan portfolios should give some indication of the financial condition of farm operations. Bankers have reported that, using market prices prevailing in the late summer of 1999, current credit analysis of producers of many commodities suggests that a growing number of borrowers may have difficulty cash flowing loans in the absence of additional government assistance.

Aiming to prevent a repeat of the farm real estate disaster of the1980’s when lending institutions were holding debt that exceeded the value of the land that was securing that debt, commercial lending institutions developed a new method of appraising farming operations for credit. It no longer uses the appraised or potential sale value of the farmland, as mentioned earlier it uses a method that measures rates of return for productivity. Farm Credit Services was one of the first lenders to adopt a new credit scoring system,

Appraisal Practices of Farm Credit Services

(Omaha District)

- Used since 1988

- Estimate returns using both cash & crop share approaches

- Assume typical crop mix

- Plug in Helming prices (pessimistic)

- Income Costs

- Capitalization factor used (amortization factor of 35 year loan at 10% interest)

- PV = Est. LL. Net Income

.1036

- Production value typically 55 – 60% of market value

Commercial banks use a slightly different system to give them a valuation rate for farm real estate productivity. This rate is the annual expected per acre income return to the land owner (after property taxes and all other owner-related expenses are subtracted) divided by current average value per acre. In the vernacular of the financial world this is ROA (return on investment). In the terminology of agricultural real estate appraisal, this is referred to as the market-derived capitalization rate. Any capital gains (or losses) accruing to the real estate parcel are not included in this estimate. Survey reporters provide this estimate for the three general land classes: irrigated cropland, dryland cropland, and grassland. Estimated annual net rates of return for the current decade are presented in the following table:

Type of Land

and Year Agricultural Statistics District State Ave

Northwest North Northeast Central East Southwest South Southeast

Percent

Irrigated Land:

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999 8.3

8.7

6.8

6.6

6.9

6.6

6.7

7.2

6.7

6.0 9.3

8.0

6.5

6.0

6.5

6.8

6.3

7.0

6.7

5.9 6.9

6.8

6.6

6.5

6.3

6.5

6.9

7.0

6.0

5.9 6.8

6.5

6.6

6.1

6.3

5.9

5.8

6.0

5.8

5.3 6.7

6.4

6.0

5.7

5.6

5.3

5.2

5.3

5.0

4.6 6.3

6.4

6.5

6.5

6.2

5.9

6.5

6.7

6.6

6.1 6.3

6.2

6.0

6.5

5.7

6.0

6.2

6.3

5.7

4.9 6.0

5.9

6.1

6.0

5.7

5.0

5.4

5.7

5.4

5.0 7.1

6.9

6.4

6.2

6.2

6.0

6.1

6.4

6.0

5.5

Dryland Cropland:

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999 6.2

5.9

4.8

5.0

4.5

4.2

4.1

5.1

4.5

4.3 6.3

5.0

5.0

4.3

5.2

6.0

5.0

5.8

5.5

4.9 5.9

6.0

5.6

5.8

6.0

6.2

6.3

6.4

5.8

5.4 6.4

5.9

5.9

5.7

5.4

5.3

5.6

5.6

5.3

5.1 5.9

5.8

5.7

5.3

5.2

5.2

5.0

5.3

4.8

4.5 4.7

4.7

5.6

5.3

5.2

5.1

5.3

5.3

4.8

3.9 6.1

6.1

5.2

6.1

5.3

5.4

5.5

5.4

5.4

4.5 6.3

5.8

6.1

5.2

5.4

5.0

5.2

5.4

5.0

4.9 6.0

5.7

5.5

5.4

5.3

5.3

5.3

5.5

5.1

4.7

Grazing Land:

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999 4.0

5.5

4.0

4.3

4.7

3.7

3.8

3.6

3.4

3.1 5.8

5.9

5.3

4.6

4.5

4.7

4.3

4.3

4.2

3.5 4.6

5.4

4.9

5.0

5.1

4.9

4.9

4.9

4.6

4.4 4.9

5.0

4.6

4.6

4.4

4.0

4.3

4.5

4.1

4.2 5.0

5.3

4.4

4.3

4.3

4.2

4.0

4.0

3.9

3.6 4.5

5.8

5.1

4.6

4.7

4.5

4.3

4.0

4.2

3.2 5.4

5.5

5.0

4.5

4.1

4.2

3.8

3.6

4.0

3.6 5.0

5.5

5.0

4.6

4.5

4.0

4.1

4.2

3.8

3.9 4.9

5.4

4.8

4.6

4.5

4.3

4.2

4.1

4.0

3.7

The 1999 rates are consistently down from year-earlier levels for both irrigated and dryland cropland throughout the nation, and down as well for grazing land in most of the regions. On average, the nation-wide decline is about 8 percent, bringing current rates of return on agricultural land to the lowest levels of the decade. This trend is sure to continue with consistently poor grain prices and the bleak out look for the farm sector economy in the future.

The following is an exert from the USDA’s Agricultural Economic Outlook published 3/20/00:

Short term

Near-Term Weakness Remains in U.S. Farm Economy Markets for major commodities, particularly field crops, are very weak, as supplies remain relatively large. Despite the severity of the market downturn for many producers, an overall farm economic crisis has not materialized due in large part to built-in government support and supplemental emergency economic and disaster assistance. Positive developments in U.S. agriculture this year include higher cattle and hog prices and a fairly strong national farm balance sheet.

Longer term

Developments, including movement back to sustained global economic growth, will strengthen agricultural trade and income prospects for U.S. farmers, according to USDA’s 10-year baseline projections. Economic recovery is now underway in most of the countries affected by the global financial crisis of the late 1990’s. Economic growth, especially in developing countries, is providing a foundation for gains in global demand, agricultural trade, and U.S. agricultural exports. Incomes in many developing countries are at levels where consumers eat more meat and other higher valued food products and where consumer food demand is particularly responsive to income changes.

There is some light at the end of the tunnel according to the USDA; the question is whether the effects of the economic growth in developing countries will be felt before it is too late for many farmers in the United States.

The federal government is once again expected to give farmers billions of dollars in aid this year to help with slumping grain prices. Farmers are responding by saying this “Band-Aid approach to the farm crisis hasn’t worked”. They are lobbying Congress to rewrite the 1996 Freedom to Farm Law, adopt a more comprehensive, and more generous crop insurance law. Unless the Freedom to Farm Act is amended many farmers believe they will not be able to continue farming with prices at their current level. (An interesting statistic, a farmers share of a $3.71 box of breakfast cereal is less than a nickel.)

Over the past 10 years, land values have appreciated at rates faster than land earnings, leading to a gradual decline in net rate of return. With serious income shortfalls across production agriculture in 1998 and into 1999, this pattern of decline has only compounded. This combined with the fear of the federal government discontinuing the subsidy payments to farmers after the year 2002, when the current program expires, is beginning to make lenders nervous.

Lenders assume they have a buffer of approximately 40 percent on loan value versus land value securing that loan. If land values continue to fall and subsidies disappear, which will make real estate values decrease even faster than they already are and lower the anticipated returns per acre for farm land, lenders will see their 40 percent buffer zone shrink or in some cases may actually disappear completely.

Although commercial lending institutions are currently seeing their lowest default rates in over a decade, less than 1 percent, they are also aware of what is on the horizon and are already taking steps in anticipation of the potential market adjustment.

Commercial lenders as a whole are not in a scare by any means. They believe that lending institutions, farmers and the government are more proactive today than they were in the 1980’s. They look for potential problems ahead of time instead of reacting to problems like they have in the past. They believe this will give them the added edge that they need to make it through unscathed. Banks have also invested billions in technology, which enables them to provide better customer service and be better lenders. In the 1980’s banks’ credit analysis tool was a calculator, today they have credit analysis software and credit scoring systems.

Denny Everson, Chairman of Agricultural and Rural Banking Committee of the American Bankers Association, said, “Agriculture is in a tough situation that’s going to get tougher. What bodes well for our ability to work out of this situation is the difference in interest rates. In the early 1980’s we were dealing with 15-year high interest rates. Today they’re at 25-year lows.”

Nationally, banks are well positioned to deal with a temporary downturn in the economy, but some of the banks in rural communities that are heavily dependant on agriculture and ag related businesses are viewing the current situation as a major concern.

Another contributing factor to the increase in farmland value has been Federal farm programs. They contribute to farmland values by increasing the expected returns from land and reducing the income variability of farm operations. Research has shown that the increased net returns, from government subsidies, for owners of farmland are partially capitalized into per acre values.

Lenders are benefiting from the farm sector’s overall economic performance. Net cash farm income is estimated at $60 billion for 1998, the second highest on record. This may sound great but there is a problem. This figure and many others lenders are using are including Federal cash infusions into the farm sector in the second half of 1998 and first half of 1999. This will lesson the impact of poor commodity prices on farm loan performance. Government payments are helping farmers make their debt payments, and fund operations.

In 1996, with the Freedom to Farm legislation, 12 percent of net farm income resulted from government agricultural subsidy payments. In 1998 and 1999 this percentage increased to 22 percent and then over 40 percent, respectively. The Northern Plain states are the major beneficiaries of these payments as of late due to the distressed commodity prices.

These payments are the result of two separate pieces of legislation, Emergency Farm Relief Act of 1999 (P.L. 105-228) which was signed into law August 12, 1998, and amended the Federal Agricultural Improvement and Reform Act of 1996,and the Omnibus Consolidated and Emergency Supplemental Appropriations Act (P.L. 105-277) which was signed into law on October 21, 1998.

The question on everybody’s mind is will these subsidy payments continue if commodity prices don’t rebound. Well banks are betting on it, the economy is strong and the federal government has record surpluses of funds. The ag sector is convinced that the current legislation will be extended or revised in order to continue making payments to farmers as needed, to carry them through this current slump in prices.

It is proven that over the past 10 years, land values have appreciated at rates faster than land earnings, leading to a gradual decline in net rate of return. It is also true that land values are beginning a downward trend, down from 1998 to 1999 and from 1999 to 2000, due to several factors both domestic and international that are affecting the whole agricultural economy. Farmers are being supported by government payments that in some cases account for over 40 percent of revenue.

If the government stops payments to farmers the loan default rate on farmland will rise drastically within as little as one year, and lending institutions will be foreclosing on land that’s value is dropping and who’s rate of return for productivity just been cut by up to 40 percent.

There is no real way to calculate the likelihood of the federal government discontinuing subsidy payments, it boils down to politics, and as everyone knows politicians are very unpredictable.