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Kub's Den
By Elaine Kub
Thursday, May 21, 2020 1:37PM CDT

Question: "What will this COVID-19 lockdown recession do to land prices?"

Answer: Probably nothing. Even an 18-month or 24-month scenario is basically a blip in comparison to a 50-year or longer investment horizon.

Q: "Should we be worried about inflation or deflation right now?"

A: In theory -- long-term -- inflation. In reality -- right now -- consumer prices are obviously more likely to be deflating.

Q: "What's the best trade to make in this environment?"

A: Refinance the mortgage on your house.

These are real, complex questions I've been asked lately, followed by my glib, oversimplified answers. Upon reflection, I realized that each of these topics are tied to interest rates or the outlook for interest rates through the next year or two. Even though the Federal Open Market Committee (the Federal Reserve's interest-rate setting body) isn't scheduled to have another meeting until June, and they're broadly expected to leave their benchmark interest rate -- already at zero -- unchanged for the foreseeable future, it's useful to think about how interest rates affect asset prices in the agriculture industry and how participants can use that knowledge to position themselves in the market.

The FOMC carries out its twin mandates to maximize employment and stabilize prices for goods and services by setting a target rate for federal funds to be lent out overnight amongst banks. In an emergency meeting on March 15, the FOMC dropped its target by a full percentage point from 1.00% to 0.00% (technically the "target" is now 0.00% to 0.25%). Most other interest rates agreed upon between lenders and borrowers are benchmarked off that target rate in one way or another, with the "prime rate" currently at 3.25%. Let's say a typical farm operating loan these days will have fallen after that March rate cut from 5.25% to 4.25%. Mortgage interest rates have fallen to record lows like 3.125% (for a 30-year mortgage from some lenders to some qualified borrowers). Compared to the world back in 1979-80 when the target rate was 20%, today it's almost like free money!

For most agricultural goods that a farmer sells, the prevailing interest rates have a negligible effect on prices. Maybe there are some market moments when financial investors get worried about inflation and start buying up commodity futures contracts as a "hedge against inflation," and while that appears to be happening in the gold market now, there isn't much volume of that activity in the grains or livestock futures to really affect prices. Interest rates also matter, technically, when calculating the costs of carrying stored grain and deferring cash income from one month to the next. But when interest rates are close to zero, the opportunity costs of losing interest income on that cash also dwindle toward zero.

In contrast, for the agricultural goods that a farmer needs to buy, interest rates matter quite a lot. Lower interest rates tend to mean higher prices for assets. Perhaps this is the simplest way to think about it: When a farmer sees smaller borrowing costs to worry about when buying a tractor, she can bid more for that tractor.

The biggest input for agricultural production, of course, is land, and land costs can be extremely sensitive to interest rates -- more sensitive to this factor, in my opinion, than to any short-term shudder of recession fears. The COVID-19 pandemic isn't stopping land auctions; like everything else, they've just moved online.

To find a rational price for land, a buyer can think about the present value of all the income streams from the asset. For a farmer, this could be the profit he expects to earn on each acre for as many years as he and his heirs own the property (effectively forever, probably). However, estimating the profitability of farming is tricky from one year to the next, let alone for the next 50 years. Instead, let's think about the math from the perspective of an investor who will receive a pretty reliable rent check every year -- these days an average of about $220 per acre for good quality Iowa farmland in the center of the North American Corn Belt. Some would say the calculation should also include the present value of the "salvage" value that the investor will earn back someday when it eventually sells the property, but that value is just going to be calculated from the same year-after-year cash rent income stream, so we might as well treat this present value exercise as a perpetuity. The present value of a perpetuity equals the cash flow divided by the discount rate, so: $220/0.03 ... or whatever discount rate you think accurately represents the time value of money over the next 50, 100 or 1,000 years.

That's where the math becomes extremely sensitive to any changes in that discount rate. If we anticipate a world where interest rates are going to be extremely low for a long period of time, then there will be fewer opportunities to earn better returns from other assets and we should adjust the discount rate in our calculation a little lower. Even adjusting it down by 0.25% can make an acre of land suddenly look like it's worth an extra $667 ($220/0.03 = $7,333, but $220/0.0275 = $8,000). When the Fed dropped interest rates by a full percentage point to its record-low of zero, that didn't mean the long-term discount rate necessarily dropped by a full percentage point over this full investment horizon, but it definitely suggested that prices should be bumped up for this type of asset.

On that point, we should take a moment to think about the theoretical possibility of negative interest rates. During the financial crisis, Japan, Sweden and Switzerland all dabbled with negative interest rates, so yes, it can be done. In 2020, Jerome Powell and many others at the Federal Reserve swear they aren't willing to set a negative target Fed Funds rate, but some investors are busy hedging against the possibility, just in case. If you had a bunch of cash, and you started to worry that the banks were going to effectively charge you money to hold that cash for you instead of paying you interest for your savings, wouldn't you rather take that cash out and use it to buy some real, income-producing asset, like land? Look at what happens to the perpetuity math when we use a 0% discount rate: $220/0.00 = infinity.

Ultimately, prices for any asset aren't determined by a math equation -- they're determined by what the market is willing to pay. Farmland price trends are hard to assess because there are rarely, if ever, any apples-to-apples comparisons to make between tracts of different quality in different locations sold at different times. One recent example of several hundred acres of farmland sold in northwest Iowa last month at $9,450 per acre suggests that, compared to last year, prices remain "stable," says Shane Brant of Midwest Land Management, who was involved in that sale.

"The ag population expects land prices to drop, looking at the way the economy has been in recent months, but that may be just wishful thinking," Brant told me. "Investors, they see all this instability in the stock market and turn to land instead. People like tangible assets in times of uncertainty."

Elaine Kub is the author of "Mastering the Grain Markets: How Profits Are Really Made" and can be reached at masteringthegrainmarkets@gmail.com or on Twitter @elainekub.


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