The Economcs of Asset Values and Current ncome n Farmng Robert D. Rensel and Edward. Rensel n March 1979land values n the Unted States averaged three tmes ther 1970 level. The ncreases n ths decade surpassed even those followng World Wars and. t s not surprsng that ths assocaton should once agan nqure nto both the causes of land value changes and the mplcatons of these changes for the future of agrculture. ncreasng land values are vewed by some wth elaton and by others wth concern. To some the old sayng that "farmers lve poor and de rch" has been verfed. Land owners have generally benefted from the sharp growth n ther wealth poston. But they dslke the hgher real estate taxes that follow land apprecaton. And they foresee dffculty n expandng ther farms or n transferrng ownershp to younger farmers. Some who borrowed to buy land have experenced major cash flow problems. An example mght help llustrate how such problems arse. Assume that a tract ofland whch can be boughtfor $2,000 peracre wll yeld a return of $100 above varable producton costs. f the buyer pays $400 down, hs debt carryng charges on a twenty-fve-year mortgage at 10% nterest would be about $176 or $76 more than hs frst year earnngs. However, f hs ncome were to ncrease by 5% per year he would be earnng enough ncome by the thrteenth year to servce the debt and have money avalable for other purposes. By the year of the fnal mortgage payment, hs ncome would be double hs prncpal and nterest payment. Thus, the ntal cash flow problem would have turned nto a hghly desrable cash surplus. n addton, the borrower would have benefted from substantal captal apprecaton. The queston s, how does he servce hs loan durng the frst twelve years. Secretary of Agrculture Bergland recently stated, " see the benefts of many ofour farm Robert D. Rensel and Edward. Rensel are agrcultural economsts wth the Economcs, Statstcs, and Cooperatves Servce, U.S. Department of Agrculture n Washngton, D.C. programs gong not to mprove the ncomes of rural famles needng help but contrbutng, nstead, to hgher and hgher land prces. "Hgher land prces, n tum, buld n hgh fxed producton costs whch make t very dffcult for young and new farmers to get started or for the tenant farmer to become an owner-operator" (p. 6). Besdes the mplcaton that rapdly rsng land values wll dramatcally alter the structure of the farm sector and do volence to the natonal deal ofthe famly farm, many people now feel that land s overvalued n relaton to earnngs. Values are sad to have reached unrealstc levels. Ths concern s not new. Exactly ffty years ago Gray, at a meetng of the Amercan Farm Economcs Assocaton noted, There seems to be much confuson prevalent as to the future element n land values. Some economsts would call $140 land 'overvalued.' What they mean s ether that t s valued at more than present net ncomes warrant, or at more than future ncomes wll probably justfy. Whchever they mean, they are msusng the term value. Land, beng' a fxed good, cannot escape havng ts value based on an uncertan future. That future wll create a net ncome for t whch s bound to be somethng dfferent, ether more or less than present ncome.... The value whch s based on an assumpton of rsng ncomes s therefore just as real a value as one based on the assumpton of present ncomes perpetuated." Snce Gray made hs comments n 1919, many researchers, ncludng among others, John D. Black, Ernst Weckng, Wllam Scofeld, Robert W. Herdt, Wllard Cochrane, Luther Tweeten, and James E. Martn have attempted to explan land prce behavor. A revew of ther works shows many possble explanatons for land prce changes. As early as 1927, Weckng recognzed that net farm ncome was a poor proxy for returns to land and that real estate values could not always be expected to move n unson wth
1094 December /979 Amer. J. Agr. Econ. farm ncome. However, n 1961, Scofeld observed that land prces, whch from 1912 to had moved n an almost parallel fashon wth farm ncome, were dvergng from the ncome trend. He concluded that t was paradoxcal for land values to rse wthout an accompanyng rse n ncome. n the remander of ths paper, we wll attempt to clarfy the economcs of land valuaton and explan what we beleve are the underlyng forces n the land market. We wll also brefly address what s mpled for agrcultural structure and polcy. We should say at ths pont that we accept the theory of value whch can be stated as V - -e at - ~ (l + ty' where V s the current value of an asset, a s expected value of the annual return n year t, and s the expected value ofthe dscount rate n year t. n any year, expected returns are some functon of farm commodty and nput prces, yelds, taxes, nterest rates, credt terms, nflaton rates, the potental for dsposng of the tract for some hgher and better use, and a long lst of other varables. Dscount rates are a functon of the tme preference for money, rsk, and nflaton. Thus, to explan the present value of land we must explan factors whch nfluence expectatons of net returns to land and those whch explan the formaton of expected dscount rates. Developng the formula becomes a very complex and somewhat overpowerng problem, f all these factors are taken nto account. t s temptng to smplfy the formula as many apprasers and researchers have done to V = al where (a) represents current earnngs and (a) and () are assumed constant nto perpetuty. Such a formulaton frequently has led researchers, lenders, and apprasers to beleve that land s overvalued because current returns do not explan current land values. Alternatvely, they beleve that land earnngs are below those n other potental nvestments. n realty land earnngs have not remaned constant over tme and thus V = al has msrepresented actual experence. Real estate accounts for nearly threefourths of all farm assets and returns to assets are based on farm ncome. Thus the relatonshp between returns to assets and asset values can help n understandng farm real estate ndexes of Return to Assets and Asset Value Percent of 1968 400 Return to Assets n 300------------t-+--+ 200 --------------j~ F - 100 ------..-------...;.-...--:.~---- o "'-1-----,----------,-------,------, 1970 ~ 1980 Fgure 1. ndexes of returns to assets and asset value 1968 = 100 values (fg. 1). Returns to assets are calculated as a resdual by subtractng estmated returns to labor and management from returns to labor, management, and total assets, ncludng borrowed captal and farm assets of landlords. From through the early s asset returns ncreased more rapdly than asset values. Durng the late s and early s values rose slghtly more rapdly than asset returns. From 1963 to date the general tendency has been for returns to ncrease faster than values, even though the ncrease n returns was nterrupted after the 1973 hgh. Overall snce, returns to assets have ncreased n both absolute and relatve terms. Although data on returns to assets are not avalable for 1910-40, assets ncludng land are beleved to have receved a relatvely constant share of net ncome. n that perod, land values generally rose and fell wth current net ncome from farmng. The share of net returns gong to assets rose from less than 30% n the s to more than 60% n the 1970s (fg. 2). The relatonshp between cash rents and values also provdes evdence that agrcultural rents and land values have followed parallel trends n major farm states of the Plans and
Rensel and Rensel Land Prces, nflaton, and Farm ncome 1095 Assets Share of Returns Percent 100--------------- 80--------------- 60 ----------~---.--+---- 40 --J~_J\ r_~- A F--=------- 20---------------- o ~------r-------.----------.,.-----, 1970 1980 Fgure 2. Assets share of returns -78 Cash Rent to Value Ratos of Selected States Rent per Value Rato 20 10 --a----------~~---- o ~-----.----------.----------.,.-----, 1970 1980 Fgure 3. Cash rent to value ratos, -79 selected states Com Belt (fg. 3). The rato of cash rent to value has, therefore, been nearly constant. n North Dakota and llnos, for example, the rato of gross cash rent-to-value remaned nearly stable from to 1970. Trend lnes computed for the perod show no sgnfcant slope. However, snce 1970 rent value ratos have declned rather sharply, at a rate of -.24 rato ponts per year, suggestng that earnngs expectatons have changed. Apparently, land buyers beleved that future returns wll exceed current earnngs by a substantal margn. n New Jersey, where agrcultural earnngs are a mnor component ofthe total expected return from land, agrcultural rents have declned n relaton to value snce. Ths declne may be explaned by the rapd urbanzaton of New Jersey and by the expectaton that future earnngs are more lkely to come from urban uses than from agrcultural producton. Land rents have also declned rapdly n relaton to value n Msssspp snce. However, the reason for the declne s dfferent from the New Jersey example. n Msssspp, rents n the early years were dstorted by mperfectons n the land eurchase and rental markets. Land was held n very strong hands and many tenants who had few alternatves were competng for the rght to rent land. Over tme the numbers oftenants declned sharply as nonfarm opportuntes ncreased and producton technology changed. Land became more readly avalable on both the purchase and rental markets. Apparently, a major structural change occurred whch brought rent-tovalue ratos closer to those ofmdwestagrculture. These data suggest, rather strongly, that an ndvdual buyng land at any tme durng the last forty years would have been n error f he had assumed that earnngs would reman constant n the future. Under the condtons whch prevaled durng ths perod, t s clear that the rato of current rents to current values would have represented a substantal understatement of the actual rate of return. We now ask f t s reasonable to expect land earnngs to contnue to rse n the future. What factors are lkely to determne expectatons? f earnngs and values are to ncrease, how wll t be possble for new buyers to wthstand the substantal cash flow problems that arse n the early years of land ownershp wth debt fnancng? We mght also queston how t
1096 December 1979 Amer. J. Agr. Econ. s possble for returns to assets to contnue rsng n an excess capacty ndustry. Assumng that you accept the theory that current land values are determned by expected earnngs, we wll proceed to explan those factors whch have been mportant n determnng expected earnngs and, therefore, underle the demand for land. Even n a statc economy, we would expect land earnngs to dffer among tracts, areas, and regons, because of sol, clmate, populaton densty, mneral resources, and transportaton nfrastructure. Clearly, such factors mpact on earnngs expectatons and therefore on values. Because much has been wrtten about them, we wll say no more about these crosssectonal forces. The mportant ssue s what causes expectatons of earnngs and values to vary over tme. Perhaps the most mportant factor, whch acts as a demand shfter for land, s populaton growth. Other thngs equal, an ncrease n populaton wll ncrease the quantty of land demanded at any prce. Because the aggregate quantty ofland s fxed, earnngs wll ncrease as a result of the ncreased demand for food, fber, and space. Prces must rse to reallocate land among those who currently own t and those who desre to hold t. Marketng of U.S. agrcultural products overseas has an affect smlar to a domestc populaton ncrease. nflaton also takes ts toll. When prces rse rapdly durng a general nflaton, producton of most goods can be ncreased at least partly to satsfy the demand, but new land cannot be developed despte strong demand. Thus, land values can be expected to ncrease more rapdly than the general nflaton rate. Buyers also see land as an nflaton hedge. Durng an nflatonary perod the tendency s for nomnal asset prces to ncrease as the money supply ncreases relatve to the quantty of the asset. Even f the money supply ncreases n lne wth growth n gross natonal product (GNP), the rato of money to land s ncreased and some nflaton n land values can be expected. The Unted States has had a polcy of monetary expanson. Ths polcy, we suggest, has been a factor n the ncreasng land prces. fthe terms oftrade n land are modfed by changng access to debt fnancng and nterest rates, these changes wll shft the demand for real estate to the extent that they modfy the ablty of buyers wth a gven set of earnngs expectatons to bd for land. An extenson of the repayment perod, a reducton n the downpayment or lower nterest rates wll each result n an ncrease n the number of potental buyers at any prce. Government guarantees for margnal borrowers, so that lenders are not subject to loss of prncpal should the borrower fal, have the same effect. t has often been argued that more lenent credt terms were requred to ease the entry of young people nto farmng. However, such changes n terms beneft only the earlest buyers. Cash flow and equty advantages are soon bd nto the prce ofland. Therefore, wth each relaxaton n credt terms, land prces can be expected to rse more rapdly, then resume a normal pattern ofchange wth future benefts dscounted. Tax polcy also alters the earnngs of land through taxaton of recepts from producton, taxaton of apprecaton (captal gans), and taxaton ofreal estate values. The government polcy of mnmzng taxes on captal gans has encouraged nvestment n real assets, partculady land. Not only have we taxed captal gans at rates well below those on earned ncome, but we now forgve taxes on the frst $100,000 of such gans on resdences for those over age ffty-fve. Also, we have ncreased the sze of the nhertance and estate tax exempton and developed procedures to tax estates at "agrcultural value" rather than at market value. Such tax laws encourage nvestment n land and reduce the amount offered for sale. Preferental or use value assessment of real estate has also changed land values. Dependng on how these laws are wrtten they can ether ncrease farm earnngs or result n land beng held for speculaton n nonfarm alternatves, or both. Among government actons taken to assst farmers are programs desgned to ncrease or at least stablze farm ncome. Such programs have drectly rased land earnngs by ncreasng the value of the product of land and have ndrectly ncreased earnngs by reducng the rsk nvolved n crop producton. These programs have operated through drect subsdy to dle land resources and through control of market prces. The net effect ofsuch programs s that earnngs and land values whch are a functon of earnngs are hgher than they would have been n ther absence. The mplcatons ofcontnuously rsng land values for the structure of the agrcultural sector are that current land owners wll beneft
Rensel and Rensel from wealth changes at the expense of future generatons of farmers. f nomnal earnngs and values rse faster than the general prce level, t wll become ncreasngly dffcult for prospectve farmers to acqure vable farm unts. Land ownershp and wealth wll tend to become concentrated nto fewer hands as current land owners add margnal unts to exstng operatons. Entry nto farmng wll occur manly through nhertance. Few tenants wll obtan suffcent captal to become owners. Control of land resources wll go to those wth the greatest wealth and hghest earnngs expectatons. Ths process s lkely to be aded by polces arsng from our concern for the begnnng farmer. We can expect contnued ncreases n land values. Our producton sector s lkely to dffer greatly from the Jeffersonan deal. Concludng Remarks f the land market s not allocatng land resources and wealth n a manner consstent wth economc or socal objectves we must consder mpacts of present actons and recognze potental consequences of alternatve polces. t would be possble to tax captal apprecaton at the same or a hgher rate than earned ncome. reduce the ncentve to hold land as a store of value, and slow the accumulaton of wealth. Use valuaton for real property and estate taxes could be restrcted. We could lmt borrowng aganst real estate. Ths would decrease leverage that current land owners obtan from apprecaton n real estate values. Land Prces, nflaton, and Farm ncome 1097 We could modfy the tax law so that nterest payments on real estate were no longer deductble. Commodty ncome programs could be elmnated or greatly modfed to ncrease market rsk and reduce land earnngs. All land sales could be controlled by a government agency wth redstrbuton to "worthy" farmers. Acreage lmtatons could be appled to land holdngs. t would be possble to restrct corporate control of farm land to leasng arrangements ofthrty years or less, thus placng them on plannng horzons smlar to ndvduals. Such actons would tend to lmt concentraton of ownershp, reduce competton n the land market, ncrease the rsk of farmng, and probably lmt gans n producton effcency. But whch of these polces would be economcally, socally, and poltcally acceptable as means to lmt further land prce ncreases and further concentraton of wealth? Although we may not lke t, fwe are serous n our concern over rsng land values, we wll need to consder such actons. References Bergland, Bob. Remarks before the Natonal Farmers Unon Conventon, Kansas Cty, Mo., }2 Mar. 1979. Gray, L. C. Paper presented to the Amercan Farm Economcs Assocaton, Nov. 1919. Scofeld. Wllam H. "The Land Prce Paradox." Contrbuted paper presented at Amer, Agr. Econ. AssOC. meetng, Ft. Collns, Colo., Aug. 1961. Weckng, E. H. Farm Real Estate Stuaton. USDA Bureau of Agr. ECVl., Feb. 1926.