June 21, 2018
There are all sorts of lenders in the world, and they all approach loans a little differently. At the end of the day, all lenders look at the same things no matter what they start with. Some start with cash flow, and others start with collateral. However, they eventually look at both of them for any business because these two things are really the same thing.
In the case of lending to U.S. Farming Inc.1, the one and only asset that matters is farm land, and the question of “What is farm land worth?” should involve “What amount of income can it generate?”
According to the latest USDA estimate, an astounding 83% of the balance sheet of farming and ranching is tied to agricultural land. This represents the highest percentage since the USDA started collecting this data series. The next closest expense is machinery and vehicles at 8%. I often joke that farmers and ranchers are allergic to two things; cash and taxes. It appears that the joke is on agricultural lenders since only 3% of agricultural assets (rounded up) are cash and financial investments. That’s not much of a shock absorber for an inherently volatile commodity business.
U.S. Farming Inc.1 supposedly has $3.1 trillion dollars in assets, and it only has $0.4 trillion in debt (operating and long-term). With $2.7 trillion in equity, it should be a safe bet to lend to them even if they aren’t cash flowing well at the moment. This argument will get a good credit officer’s blood pumping even before their first cup of coffee. The credit side of the relationship wants to know why a company or sector with declining margins should be seeing stronger asset valuations.
As a junior banker has responded, “That’s a good question.” In 2012, net farm income peaked at $124 billion, and the USDA estimated farm and ranch land had an estimated $2.1 trillion in value with average borrowing rates for real estate of 4.9%. Their 2018 forecast calls for $60 billion in net farm income with average borrowing costs for real estate at 5.1%, and rising. At the same time, the USDA now estimates that farm and ranch land have $2.6 trillion in market value.
Why in the world would these assets be worth half a trillion dollars more when they’re producing half the income as before, with a higher borrowing cost? Were they grossly undervalued in 2012, and they’re just catching up to their real value now? I don’t believe that is true, but it pays to compare farm and ranch land to other assets to see if they are fairly priced. All assets are valued relative to other investment possibilities because no investment option exists in a vacuum.
Looking at U.S. Farming Inc.1 through the lens of a price to earnings (P/E) ratio doesn’t create any comfort. If we just take the value of farm and ranch ground, the 2018 forecast from the USDA calls for a P/E of 43. The 2012 P/E ratio would have been 21, which was more expensive than the S&P 500 index at that time. In fact, you have to go all the way back to the crisis of 1983 to see a more expensive P/E ratio for land values to income.
How about looking at the price of farm and ranch ground based on the sales to value ratio? These days many investors are hunting for high-growth investments before they are generating solid earnings. This investment thesis depends on growing population and rising income in the new middle class segments of growth countries to create ever rising agricultural commodity prices. Unfortunately, the price of farm and ranch ground looks even worse on this metric. Using the USDA’s 2018 estimates, U.S. Farming Inc.1 would have 7.2 multiple for land values to agricultural sales receipts. Once again, the same multiple was 5.4 in 2012, and the peak in the 1980s was 5.9. Any way you want to cut it, agricultural land remains an expensive investment relative to other options.
Is there any good news for the owners of farm and ranch land? Of course, within any market there are better and worse deals being offered. Looking at 27 years’ worth of data from the University of Minnesota Land Economics database shows the opportunity for asset discipline. The online database shows agricultural land transactions in Minnesota, and many of those transactions have an assigned value for the quality of the farm ground. This quantitative rating works as a strong, but imperfect, measure of the quality of the asset. Looking at the 27 years’ of data in a cross panel statistical analysis shows that only 30% to 40% of the asset value can be tied to its productive capacity. Flipping that around, that implies that 60% to 70% of the sales price per acre is explained by something other than its productive capacity.
Looking at the most recent data from 2017, the R-squared between land quality (measured by crop equivalency rating) and price per acre was 46. This represents one of the more disciplined years for the overall relationship between asset quality and price. However, look at the variation that occurred in what is considered a disciplined year.
Let’s compare a couple of paired transactions. In one pair, a transaction for ground with a 69 rating sold for $2,341 per acre, and another transaction with a 70 rating sold for $11,281 per acre. In the other pair, the first transaction paid $7,701 for 65 rated ground, and the second transaction paid $7,400 for 89 rated ground. Even knowing that the overall market for farm ground is overpriced, I would still be happy to participate in, or lend, to the transactions that bought average ground for way below average price, or acquired excellent quality ground for an average price. Over the course of the years, both of these transactions will add to the buyer’s economic well-being.
So both buyers and lenders should be very skeptical that agricultural land values will be stable over the next several years. Unless crop prices rise sharply, rising interest rates and declining profitability will continue to pressure overall land values lower. I personally doubt that the land market will see a sharp collapse in prices, but it will be a continuous slide towards lower prices that reflect the true economic value relative to other investment opportunities in the overall economy. However, that trend doesn’t make agricultural and ranch ground a bad investment. It is an asset that generates good income over the longer time period. The real question should be “when” and “what” to buy if someone wants to own farm and ranch ground. Are you getting a good deal? Or are you overpaying for average ground in a declining market? These are the questions that investors should really be sinking their teeth into when considering putting their capital to work.
1. Refers to the entirety of U.S. farming and ranching captured on the USDA’s P&L balance sheet
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