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DAVID KRUSE

By Staff | Dec 23, 2011

While the farmland market is not a classic leveraged bubble in the sense of 1980, a price acceleration as recently seen when values double in a matter of a few months, has the characteristics of a blow off top.

The sale recorded in Sioux County, last week at $20,000 an acre was an outlier. There was also a sale at auction of good land in Clay County at $10,000 per acre recently.

I think the $10,000 sale in Clay County was more indicative to where the farmland value really is, or at least at what can be supported, based on current economics. You can’t justify $20,000/acre farmland for general farm use. When prices go off the charts, they are typically in the latter stage of something.

I noted that a recent chart on land acquisition cost per acre stopped at $10,000 acre. To buy a farm today the buyer must have a lot of cash. These sales are not being heavily financed as in the 1970s, when lenders would finance 90 percent of the purchase price.

Met Life only loans $3,500/acre, so if you pay $10,000 acre you have to have $6,500 cash. Farm Credit will loan 55 percent of appraised value. Appraised value is not likely the same number as the top bids making headlines, so I think you can assume that about 50 percent about as leveraged as any of these purchases can be.

So assuming that the buyer paying $10,000 acre is borrowing, at most, $5,000/acre at 4 percent interest, the acquisition cost is $401.49/acre with a 20 year amortization. That is within reason.

If you can only borrow $5,000/acre, but pay $20,000/acre, the amortization cost would be $1,204.47/acre. Good luck with that. Whether the farm yields 220 or 240 bushels per acre corn isn’t really gonna matter much.

The owner is going to subsidize the purchase and also have to subsidize the return from revenue inadequate to accomplish the task of producing a reasonable return on investment. These buyers typically have enough other land to do that.

Everything is averaged, so the weight of the new purchase on the overall operation is diluted so that it is probably not that heavy to carry. If you own 800 acres of farmland, another 80 acres even at a high price, likely doesn’t impair the overall operational debt structure very much.

In the 1970’s, the price of farmland far exceeded the base revenue return possible from the farm, creating an asset value bubble inflated by credit on inflation extrapolation prospects. When that bubble burst, the market had to adjust not only to the excess leverage that had accumulated – not unlike what has occurred with the sub-prime home mortgage fiasco – but also to return to levels that could be supported by the underlying revenue generated from the property.

In my opinion, base revenue today can reasonably support the cost of acquisition to about $10,000 acre. What happens above that is bubble.

It is not a leveraged inflated bubble as in the 1970s, so it will not collapse in the same manner. Farm-debt-to-asset ratios got pushed way out of whack in the 1970s, as farmers overleveraged and they have recently just become about the best they have ever been as farmers in general have deleveraged during this period.

The USDA said that the farm debt-to equity ratio is currently 10.4, compared to 11.8 in 2009. Bankers remember the 1980s and they don’t push land values on financial statements like they once did.

Farmland prices are valued far below market prices on farmers’ balance sheets. That means that if the farmland market deflates, it will not be to the degree seen in the bubble-bursting 1980s, as there will be no forced sales. Farm finances can stand some deflation from recent market prices with little impact on financial statements.

I think it is safe to say that at recent stellar farmland sales, the underlying revenue will not support the acquisition cost of the purchase. When the cost of acquisition of farmland rises too far above the underlying revenue generation, to what the property can produce, then we have blown a bubble.

There will likely be a correction that brings the two back into alignment or at least closer to it.

I don’t think that the price of corn is going to $8 or $9 or $10 per bushel anytime soon to support the acquisition cost of farmland those stellar sales prices. Interest rates are a key component of farmland values offering competitive rates of return over cash sitting in a bank.

Recent farmland sales prices would appear to have bid that all away, as well as highlight the risk were interest rates to increase. Every percent increase in interest rates adds about $35 per acre to the cost of servicing the acquisition. An increase from 4 percent to 7 percent interest would add $100 acre to cost acquisition negatively impacting what farmers could pay for farmland.

The Fed meets Tuesday to make public its long term interest rate stance. I don’t think interest rates are going up any time soon, but we all know that they eventually will. History says that 3 percent is about as low as bonds should get.

If two guys have the cash and both want the same property, the farm sale that made the headlines last week shows that the sky is the limit. It made the farm sale in Clay County look like a bargain by comparison. One was a bubble the other makes economic sense.

David Kruse is president of CommStock Investments Inc., author and producer of The CommStock Report, an ag commentary and market analysis available daily by radio and by subscription on DTN/FarmDayta and the Internet.

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