ARE ECONOMIC FUNDAMENTALS DRIVING FARMLAND VALUES

Abstract

Farmland is a critical asset in the agricultural sector, comprising 85% of the assets in production agriculture. Soaring farmland values have generated considerable national news attention and given rise to questions about the factors driving farmland values higher and whether current farmland values are reasonable. Many in the agricultural sector are worried that the farm sector is headed for a repeat of the farmland value bubble that collapsed in the 1980s. From an economic perspective, the first of the above questions has a relatively straight-forward answer. The second question regarding the “reasonableness” of land values is much more difficult to answer. To answer these questions, one must first realize that farmland is a capital asset that will produce earnings indefinitely into the future. Capital assets derive their economic value from these future earnings. For this reason, the value placed on farmland should reflect the market consensus of the present value of those future returns. Thus, to value farmland, market participants must forecast future earnings associated with farmland and what those earnings will be worth in today’s dollars. As a result, two fundamental drivers generally influence the value of any capital asset including farmland, future earnings and the expected opportunity cost of funds—the rate at which market participants discount future earnings. Expected future earnings are clearly an important driver of farmland value. Other things equal, the higher expected earnings, the more investors will pay for farmland. More subtle is the role played by opportunity costs. An opportunity cost is created because funds used to purchase farmland could be invested in other assets. Consequently, future earnings must be discounted. Factors such as expected future inflation, borrowing costs, and rates of return on alternative investments affect the expected opportunity cost of funds. Other things equal, higher discount rates will decrease farmland values. This article examines the role of expected earnings and opportunity costs on farmland values.