Farmland prices can teach investors a lot about asset bubbles

Investors see bubbles everywhere these days from bonds to Chinese stocks to the U.S. dollar, but determining whether an asset is merely expensive versus completely disconnected from reality is no easy task.

A once red-hot market in farmland that has subsequently cooled off with few ill effects offers a case in point.

As recently as 2013, a sharp rise in U.S. farmland prices was prompting warnings. But since then, prices for prime crop-growing dirt have started to soften, but gently and with few ill effects.

First off, fears of the “next bubble” are understandable. Investors can painfully recall the collapse of two investing bubbles within a decade of each other: the tech bubble in 2001 and the housing bubble in 2007. Both had devastating effects on portfolios, while the latter also served to trigger a devastating global financial crisis.

‘Dizzying prices’

When it comes to farmland, it was Kansas City Federal Reserve Bank President Esther George who made clear in January 2012 that soaring prices were on the radar. She noted at the time that each week seemed to bring “a new tale of dizzying prices at the most recent farmland auction” and that “well-informed, concerned voices” across the region were wondering if these marked a potential bubble.

Her concern certainly seemed justified. After all, it was the collapse of a credit-fueled 1970s farmland bubble that led to the devastating farm crisis of the 1980s.

 And it is the Fed’s job to be on the lookout for such irrational exuberance.

There is no uniform definition of a market bubble. In a general sense, economists describe them as instances in which the price of an asset becomes disconnected from its underlying economic fundamentals.

In other words, euphoric investors buy an asset that is been appreciating simply because they expect it to continue appreciating. They’re confident they’ll eventually sell, say, a plot of farmland, to a higher bidder down the road. That is why people paid astronomical sums for tulip bulbs in the Netherlands in the 1630s as Charles Mackay describes in his book “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds,” or revenue-less dot-com stocks in the late 1990s or residential housing in the 2000s. But economists don’t always agree on what constitutes a bubble, with some even arguing that those 17th century Dutch tulip speculators were behaving rationally.

Responding to fundamentals

In the case of farmland, the most recent rise resulted in the average value of an acre of Iowa farmland nearly quintupling between 1999 and 2013, according to Iowa State University’s long-running annual farmland survey. Price gains accelerated sharply beginning in 2004, posting double-digit percentage gains in eight of the following nine years.

June 26, 2015 

It was a similar story elsewhere in the Corn Belt. But, as the chart above shows, the rise also accompanied a massive rally in crop prices fueled by surging demand in China and emerging markets, which in turn fueled a large jump in farm income.

Since then, however, crop prices have fallen back sharply in the wake of a pair of bumper crops of corn and soybeans. Farm income, which tends to be volatile, is projected to fall sharply in 2015.

Meanwhile, the average price for Iowa farmland fell nearly 9% in 2014 to $7,943 an acre, according to the Iowa State survey. Farmland data from regional Federal Reserve Banks also show a softening of prices across prime row-crop growing areas of the Midwest.

“The fundamentals were good. Now they’re less good and the market is behaving accordingly,” said Brent Gloy, an agricultural economist at Purdue University.

Agricultural economists have also argued that measures of the rate of return on farmland never got far out of line with those for other long-term alternative investments.

Gloy and others argue that in a bubble, land prices would have continued rising even as the underlying outlook for the stream of cash flows deteriorated.

The recent pullback in commodity prices and farm income has, so far, led to an orderly softening of farmland prices rather than the collapse that would offer the telltale, after-the-fact confirmation of a bubble.

“It is good that we’re seeing the markets react in a way that you would expect them to react. It would be probably more concerning if we saw corn prices go from $8 to $3 and there not be any correction or any adjustment in the pace of land price growth,” said Nathan Kauffman, an Omaha-based economist with the Kansas City Fed.

But Kauffman isn’t ready to sound the all-clear, either.

HSBC on the four phases of an asset bubble. 1: New discovery; 2: Early rise; 3: The pace picks up; 4: Subsequent fall

Lingering danger?

Overall demand for farmland remains relatively strong, he said, while the supply of land for sale remains limited. While a multiyear boom has left farmer balance sheets pretty healthy, falling crop prices are likely to begin taking a modest toll on operating margins. If there is an uptick in strapped farmers being forced to sell land, it isn’t clear how the market would react, Kauffman said.

Interest rates are also a wild card. While farmers didn’t leverage up to the hilt to buy farmland during the boom, it isn’t clear exactly how a rise in rates will play out, Kauffman said.

Still, “it has been encouraging the last year or two to see that markets are responding more to the changes in crop prices,” he said. “It wasn’t clear a couple of years ago whether that might happen.”

There were notable similarities and differences between the run-up in land values in the 1970s and the sharp rise seen over the past decade. Both booms were accompanied by sharp increases in commodity prices accompanied by relatively low interest rates.

But in the 1970s, farmers were quick to finance land purchases with large amounts of debt, often with the encouragement of eager lenders. The current run-up often saw buyers using cash or limited financing.

“There was credit going into this deal, don’t get me wrong, but you couldn’t go out with $10,000 and start buying farmland left and right,” Gloy said of the more recent farmland boom. “We avoided the rampant speculation…and that is a good thing.”

This farmland boom also lacked another common bubble element: euphoria. While farmers were quick to snap up property, at times paying eye-popping prices, outside speculation remained muted, economists noted. While there was demand for land among investment managers, most transactions took place between farmers or people close to the property.

Avoiding the collapse

And so far, the telltale, after-the-fact sign of a bubble—an outright price collapse—is yet to be seen.

Jim Farrell, president of Farmers National Co., an Omaha, Neb.-based land management and real-estate firm, said farmland prices are behaving like a “typical market that is gone through a substantial bull run.”

Prices more or less plateaued in the winter of 2012-13, when crop prices were at their highs in the wake of a drought.

Subsequently, there is been a transition from a torrid seller’s market to a buyer’s market, he said, with the amount of land for sale down by around 30% to 40% from where it was two years ago. Crucially, however, the number of prospective buyers has fallen by around the same amount, which has prevented the market from falling apart.

Landowners are content to hang on to land because potential returns from other assets don’t look so good, Farrell said. “The stock market looks a little choppy or toppy; interest rates are nothing to brag about. There is not a lot of motivation to move land right now except to settle estates.”

Like Kauffman, Farrell suspects that might eventually change. Operating capital is going to be an issue for some producers heading into 2016, which could motivate some farm operators to sell land to investors while they continue farming the ground to generate capital. An increase in foreclosures could also see more land put up for sale, he said.

Still, there is a sense that the farmland market will remain orderly as crop prices and farm incomes drop. So was it wrong for regulators and economists to worry?

Probably not, said Gloy.

It made sense for the Kansas City Fed, in particular, to be out front sounding the alarm.

“We have had a bubble in agriculture (in the past) and it wasn’t pretty,” he said. “From the regulator’s standpoint, I think it makes sense to say these things can get out of control [and to remind people] of the fundamentals.”