From Big Picture Agriculture:
Two Impending Shocks to Current Farmland Prices: Falling Crop Prices or Rising Interest Rates
Note that this post is taken from a report by Jason Henderson and Brian Briggeman for the Federal Reserve Bank of Kansas City, "What are the Risks in Today’s Farmland Market?"
Capitalizing Future Revenues
If historical relationships hold true, Midwestern cropland values hinge on farm revenues, interest rates and their relationship with the capitalization rate. Assuming average Midwestern crop yields, various combinations of corn prices and capitalization rates can rationalize current cropland values. However, all of these combinations assume historically high crop prices or historically low capitalization rates, which raise the risk in land markets.
With economic models suggesting that today’s historically high farm revenues have been capitalized at historically low rates of return, agricultural real estate values could fall sharply if crop prices sag or future interest rates rise.
To illustrate the risk facing farmland values, a straight forward net present value model is used to determine the capitalized value of future crop revenues (Lamb and Henderson). Assuming constant revenues in the future and a constant capitalization rate, cropland values can be determined by:
Cropland values = Future revenues ÷ Capitalization rate. (1)
In this model, future revenues are limited to the returns that are reinvested into the land or the amount received by the landowner. While the returns to land vary with farm profitability, the portion of gross revenues allocated to land owners has remained fairly constant over time. Over the past three decades, USDA costs of production data indicate that land owners receive about 25 percent of all gross revenues generated from cropland.
Therefore, future revenues can be estimated as a quarter of expected farm revenues, based on expected crop prices and yields. As discussed earlier, capitalization rates can be proxied with historical cash rent-to land value ratios....MORE