Extension Ag Update
November/December 2007
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Farmland Prices vs. Farmland Returns

Gary Schnitkey, Extension Specialist, Farm Management, schnitke@uiuc.edu

While farmland prices currently exceed capitalized values, likely increases in cash rents will bring farmland prices and capitalized values more closely in line with the historical average difference, according to a University of Illinois Extension study.   "Recent increases in farmland prices raise questions about whether the farmland price increases are outpacing increases in farmland returns," explained Gary Schnitkey, U of I Extension farm financial management specialist and author of the study, "Are Farmland Prices in Line with Farmland Returns?", available on Extension's farmdoc website at
 (http://www.farmdoc.uiuc.edu/manage/newsletters/fefo07_15/fefo07_15.html).

Schnitkey approached the problem by comparing farmland prices to capitalized values. He noted that the USDA's list of average prices for Illinois masks differences across the state. For example, farmland prices are much higher near Chicago. Because of those differences, price-to-return relationships vary across the state.  "Farmland prices increased from $490 per acre in 1970 up to $2,023 per acre in 1982," he said. "Then, prices decreased, reaching a low of $1,149 per acre in 1987. Since 1987, farmland prices have increased each year, with the average yearly increase 7 percent."

"Since 2003, increases have been above 7 percent. Farmland prices increased 7.4 percent between 2003 and 2004, 27.6 percent between 2004 and 2005, 14.1 percent between 2005 and 2006, and 13.9 percent between 2006 and 2007. Between 2003 and 2007, farmland prices increased by $1,900 per acre--78 percent."

Capitalized values, he explained, represent the earning potential of farmland from agriculture. A capitalized value for a given year equals cash rent divided by an interest rate and assumes that investors receive the current cash rent each year in the future and the interest rates do not change.

"Higher cash rents cause higher capitalized values," Schnitkey said. "Lower interest rates cause higher capitalized values."  In 2006 and 2007, farmland prices exceeded capitalized values--46 percent higher.  "Prior to the current period, the last time farmland prices exceeded capitalized values by a large margin was from 1977 through 1981," he said. "During the late 1970s, farmland prices increased because of strong commodity prices. In the 1980s, financial stress occurred, leading to declining farmland prices."

Will the current period of farmland prices relative to capitalized values mirror the 1977 through 1981 period? Will farmland prices decline in the future?   "While farmland prices may decline, there are two differences between the current period and 1977 through 1981," Schnitkey said.

"First, much of the decline in capitalized values between 1977 and 1981 was associated with higher interest rates. Interest rates increased from 7.42 percent in 1977 to 13.92 percent in 1981. It is doubtful that interest rates will show similar increases in future years."  Second, he added, cash rents are expected to increase over the next several years because of robust agricultural returns. Rising cash rents will increase capitalized values causing the difference between farmland prices and capitalized values to narrow.

"However, cash rents need to increase by large margins before farmland prices are only 7 percent higher than capitalized values, the relationship between 1986 through 2004," he said.  "In 2007, the Illinois farmland price is $4,330, the interest rate is 5 percent, and the cash rent is $141 per acre. Given that farmland prices and interest rates do not change, cash rents need to increase by $62 per acre to $203 per acre before farmland prices are only 7 percent higher than capitalized values."

Examining the long-term scenario, Schnitkey noted that some questions exist whether farmland prices can maintain their current levels relative to capitalized values.  "Either a new relationship between farmland prices and capitalized values exists where farmland prices exceed capitalized values by a large margin, possibly caused by more urban demand for farmland, or growth in farmland prices must slow so that capitalized values catch up with farmland prices."