Farm Real Estate, Rights, Trends, Values, Methods of Sale, Finances, Appraisal, Investments (1996)

Farm Real Estate RIGHTS

• TRENDS • VALUES • METHODS OF SALE • FINANCES • APPRAISAL • INVESTMENTS

North Central Regional Extension Publication No. 51 1

In cooperation with NCR Educational Materials Project Urbana, Illinois

August 1990 (rev.) 8M—75930—TNM

Issued in furtherance of Cooperative Extension Work, Acts of May 8 and June 20, 1914, in cooperation with the U.S. Department of Agriculture. Dennis Campion, Interim Director, Cooperative Extension Service, University of Illinois at Urbana-Champaign. Programs and activities of the Cooperative Extension Service are available to all potential clientele without regard to race, color, sex, national origin, or handicap.

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Farm Real Estate RIGHTS

• TRENDS • VALUES • METHODS OF SALE • FINANCES • APPRAISAL • INVESTMENTS

Coordinators Duane E. Erickson and John T. Scott, Jr. Contributors J. H. Atkinson, Phillip Eberle, Thomas L. Frey, William McD. Herr, Fred E. Justus, Arnold W. Oltmans, John E. Reynolds, John T. Scott, Jr., Donald G. Smith, and Donald L. Uchtmann Representative of the U. S. Department of Agriculture Buel Lanpher, Extension Service Representatives of the Farm Foundation R.J. Hildreth, Managing Director Walter J. Armbruster, Associate Managing Director Administrative Advisor Don Pretzer, Kansas State University

North Central Farm Management Extension Committee Norlin A. Hein, University of Missouri, Chairman Richard P. Kesler, University of Illinois William Edwards, Iowa State University John R. Schlender, Kansas State University Richard Trimble, University of Kentucky Ralph E. Hepp, Michigan State University Richard O. Hawkins, University of Minnesota Larry L. Bitney, University of Nebraska Harlan Hughes, North Dakota State University Bernie Erven, Ohio State University Ross Love, Oklahoma State University George Patrick, Purdue University Burton Pflueger, South Dakota State University Bruce Jones, University of Wisconsin

North Central Regional Extension Publication No. 51 Special Publication No. 45 • Cooperative Extension Service • College of Agriculture University of Illinois at Urbana-Champaign Agricultural Extension Services of Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, Wisconsin, and the U. S. Department of Agriculture cooperating. Also cooperating were Kentucky, Oklahoma, and Southern Illinois University at Carbondale.

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Preface The purpose of this publication is to provide information related to farm real estate values, trends, rights and obligations, methods of sale, appraisal, and investment. The authors discuss the topics in detail in the nine chapters. Particular reference is made to the North Central region of the United States. The principles discussed in the various chapters are applicable in all areas of the country. Changes that have occurred in land values, the pressures on land use for nonfarm uses, the need to use land for farm business expansion, and interest in the purchase of land have all combined to provide the need for the information in this publication.

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Contents

1 2

Farm Real Estate Principles ........................................................................................... 1 Fred E. Justus, Professor of Agricultural Economics, University of Kentucky at Lexington

3

Importance of Various Factors in the Land Market ................................................... 13 William McD. Herr, Professor of Agricultural Industries, and Phillip Eberle, Assistant Professor of Agricultural Industries, Southern Illinois University at Carbondale

4 5

Trends in Returns to Farm Real Estate ....................................................................... 21 John T. Scott, Jr., Professor of Agricultural Economics, University of Illinois at Urbana-Champaign

6 7 8 9

Land Sale Methods ........................................................................................................ 43 Donald L. Uchtmann, Professor of Agricultural Law, University of Illinois at Urbana-Champaign

Trends in Farm Real Estate Values in the North Central States: 1912 to 1989 ..................................................................................................................... 7 William McD. Herr, Professor of Agricultural Industries, and Phillip Eberle, Assistant Professor of Agricultural Industries, Southern Illinois University at Carbondale

Financing Land: Methods and Characteristics ........................................................... 29 Thomas L. Frey, Professor of Agricultural Economics, University of Illinois at Urbana-Champaign; and Arnold W. Oltmans, North Carolina State University

Estimating the Value of Farm Real Estate ................................................................... 47 Donald G. Smith, Professor of Agricultural Economics Emeritus, University of Illinois at Urbana-Champaign Buildings as Value Components .................................................................................. 55 Donald G. Smith, Professor of Agricultural Economics Emeritus, University of Illinois at Urbana-Champaign Investment in Farm Real Estate ................................................................................... 59 J. H. Atkinson, Professor of Agricultural Economics, Purdue University, West Lafayette, Indiana, and John E. Reynolds, Professor of Food and Resource Economics, University of Florida, Gainesville, Florida

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1

Farm Real Estate Principles Fred E. Justus University of Kentucky at Lexington

Since 1980, farmers and others involved in the farm real estate market have learned— the hard way—a basic economic truth. After four decades of almost continuously increasing land values, land values have dropped— in some areas dramatically. With the unprecedented rise in land values in the 1970s, and predictions for even greater increases in the 1980s, this sudden reversal of the trend seems almost incomprehensible. But it happened; and people have suddenly begun to recognize that to sustain the value of a productive asset such as land, net returns from the asset use must provide enough cash for operational expenses and financing. Land values exceeded “use” net returns in the late 1970s, and a number of economic forces from beyond the farm gate (resulting in unprecedented high interest rates and unfavorable farm commodity prices) triggered the collapse in land values. Throughout history, land has been the only tangible commodity to challenge gold as the “most sought” commodity. Even in biblical times, land was of primary importance. The only nonhuman tangible item that the Lord promised Abraham was land (Genesis 12:7). It has meant wealth and security for its possessors. In many ways, the relationship between man and land has been much more fundamental than between man and gold, silver, or other precious items. Land has provided food, clothing, and many other definable and undefinable personal benefits. Strictly speaking, land is needed for all economic and social activities. For many activities, land merely contributes a site where buildings and facilities can be constructed. The land is an inert resource with location as a primary consideration. In farming, however, land supplies much more than site; it supplies the support for liv-

ing plants, the environment in which plant roots obtain water and air. The soil supplies at least part of the needed nutrients. Land is not inert. It contains living organisms and is continually changing via chemical processes. Thus, soil characteristics that affect plant growth are of primary importance to farmers. Among these are texture, structure, depth, topography, and fertility. The United States has been blessed with an abundant, but not unlimited, supply of productive land. American farmers have combined technology and know-how with land so efficiently that most Americans take their food supply completely for granted. The need for food has not driven Americans to seek land for producing their own food (fewer than 3 million farmers feed our population of over 240 million and produce large quantities of commodities for export). Yet, Americans have a strong desire to own “a piece” of land. Moreover, there is a continually expanding demand for land for nonagricultural purposes.

Rights and Obligations That Accompany Land Ownership To understand the rights and obligations of land ownership and their implications for the farm real estate market, one must comprehend the complex and unique nature of land. Thus, a brief discussion of relevant definitions and concepts precedes the discussion of rights.

Land Defined Land can be defined in purely physical terms as “the solid portion of the earth’s surface.” Perhaps for economic and legal consideration, however, land is best defined as “that portion of the earth’s surface over 1

which ownership rights might be exercised.” This definition is most relevant because in our modern, non-nomadic world, ownership and use of land is guided and restricted by legal rights. In most areas of the country, few transfers of land ownership involve only land. The term “real estate” must be introduced in any discussion of land markets, value, and use. Real estate is generally defined as land and all improvements usually transferred with the title. Real estate is a complex of resources including land, buildings, fences, water management structures, mineral deposits, woods, and soil improvements. Moreover, each tract of real estate presents a different complex. A common synonym of real estate is real property.

Land Concepts Economists strive to understand man’s relationship to land, its use, and its value and have developed classification schemes, or ways of looking at land characteristics. For classical economists, there are two types of land: physical land and economic land. Physical land is generally defined as the spatial, locational, and physical characteristics of land in its natural state. These economists considered physical land as a gift of nature and as having only production potential. Economic land is created when labor, capital, and management are applied to physical land, thus developing its production potential and giving land its value. Economic land can be created or destroyed for certain uses. Draining a swamp for agricultural production or irrigating arid land are examples of creating economic land. Permitting excessive erosion or strip mining without reclamation are examples of destroying economic land for agricultural purposes. Most land is suited for a variety of economic uses. Different composites and quantities of labor, capital, and management are needed for various uses, and different economic rewards are attained. Thus, land values are justified by the various uses. The “highest or best use” is generally defined as that use which maximizes returns to the owner and/or society. In a dynamic and nonrestricted society, land will move, but imperfectly, into the use that yields the highest economic returns. Therefore, land use will change when eco2

nomic conditions enable higher returns from a different use. This change may be temporary and reversible, or permanent. For example, land in the semiarid West can move from pasture to small grains if the price of grain is high enough to make this use more profitable. Should grain prices drop, the land will revert to pasture. On the other hand, farmland around metropolitan centers that moves into subdivision use (because of higher rewards to developers) or becomes inundated by water impoundments (higher rewards to society) is not likely to be used for agriculture again. The U.S. farm real estate market is relatively unrestricted. Some zoning restricts private use, and the subordination of private use to public uses has prevented some land from moving to, or remaining in, the highest economic use, as far as the private owner is concerned. The movement of land to highest economic use is also restrained by (1) imperfect knowledge about returns from various uses, (2) noneconomic personal values (for example, wishing to keep the home farm in the family), and (3) the conflict between land as property and land as a factor of production (for example, selling a farm for a big profit, but thereby losing land for production and annual farm income). In distinguishing between physical land and economic land, some basic attributes of land help explain forces in the farm real estate market. These include thinking of land as (1) a consumption good, (2) property, (3) capital, and (4) a factor of production. While people don’t usually think of land as a consumption good similar to food, clothing, and automobiles, land is purchased and held to satisfy human wants, not economic production. Purchases for subdivision development, rural residences, and summer homes are clearly consumption purchases. So are purchases for parks and recreational areas. The idea of land as property recognizes that in the United States, land can be owned and leased by private citizens and organizations. This concept deals with the rights of individuals in regard to land. Closely associated with that notion, yet distinct, is the concept of land as capital. In our society, land must be purchased or leased the same as other capital goods. Thus, land is an investment opportunity—an alternative to stocks, bonds, and the like. Moreover, because it is tangible, land has long been

sought by speculators and people seeking long-term gain and a secure investment. Nonfarm people wanting to invest in farm real estate are part of the rural estate market, especially near cities. Land can be a factor of production. Combined with labor, capital, and management, land will result in economic production. In agriculture, this production consists of food and fiber. For farmland particularly, it is important to differentiate between land as capital or property and land as a factor of production. Associated with each concept is a source of income (or potential income) from land. As capital, land can appreciate and depreciate in value. Appreciation is an important source of income, collected by the owner only when the land is sold. Some or all of appreciation can be lost prior to the land sale. As a factor of production, land contributes to income from the business conducted on the land. This flow-type income received for the use of the land must be adequate to make interest and principal payments on the real estate mortgage, provide for family living expenses, and provide operating capital, unless there is nonfarm income or the land was purchased using previously accumulated wealth. Factors affecting current farmland prices will be discussed in a later chapter of this publication, but the role of these two sources of income needs to be mentioned here. In the 1970s, farmers purchasing land, particularly for expansion, often failed to consider land as a factor of production in the prices they paid. They and their creditors counted heavily on continuing appreciation. Thus, the relationship between land prices and “land-use” income became unbalanced, setting the stage for the drop in land values since 1980. As noted, land owners learned that land value appreciation can be lost. Note that (1) farm business income depends on how efficiently the farm business is managed (as well as on uncontrollable forces such as weather, disease, and commodity prices) and (2) the other factors of production—labor, other capital, and management—contribute business income and should be allocated their share of net returns.

Individual Property Rights Land is physical, as are buildings, fences, and other parts of the complex called real estate. But land ownership includes legal rights regarding that real estate. This bundle of ownership rights is determined and protected by law. No body of real estate law applies to all states, since the laws related to tenancy, deeds, and mortgages vary from state to state. However, the fundamental principles and concepts are applicable in practically all states (6,7). The fundamental rights can be summarized as follows: The right to enter and use. Owners are guaranteed the right of peaceful access to their property. Moreover, owners can use this property (land and improvements) as they see fit so long as this use is legal and does not violate the rights of other persons and the public. Zoning ordinances, while not common in rural areas, can limit this. Provisions on deed can also affect use. For example, a written farm operating lease in effect at the time of purchase can prevent the new owner from using that land until the lease terminates. Similarly, mineral rights under farmland are frequently leased or sold and are excluded from the resource complex transferred with a farm sale. The right to mortgage real estate. Few farm real estate purchasers have enough cash for the entire purchase, so most typically use borrowed money. The legal right to pledge real estate as security for farm debts is the cornerstone of financing land purchases, building construction, and other farm business investments. The right to lease real estate. Owners can lease the use or occupancy of part or all of their real estate, usually for remuneration. The terms of lease are subject to mutual agreement. State laws specify ways and times to terminate leases if such are not stated in a written lease. The right to sell real estate. Owners have the right to sell all or part of their real estate whenever they wish and receive compensation for the real estate. Not all rights must be transferred with the title. For example, the owner may sell part interest in the property, maintain a life interest in part (or all) of the property, or retain use of the farmland for a specified period. The right of reversion. Reversion is the owner’s right to regain possession of real estate (1) at the termination of a lease, (2) if a 3

lessee defaults on any provisions of the lease, or (3) if a buyer defaults on any provisions of the sale contract. The right to give away real estate. Owners have the right to give to family members, nonrelated persons, or institutions all or part interest in their real estate. The owner may retain certain rights (for example, life possession of a farm dwelling) when the gift is granted. The right to will real estate. Owners have the right to bequeath their rights in real estate, so that they will be transferred at their death to designated heirs. The legal instrument used is a will. Should an owner die without a will (intestate), real estate ownership will be transferred to legal heirs according to state inheritance laws.1 The right to do none of these. Owners do not have to use land or take any other overt action implied by the other individual rights. Ownership can be maintained as long as the owner complies with the rights of the government (public). These individual rights are a portion of the basic rights guaranteed citizens by the United States Constitution. It is important to recognize that rights to surface, air, and underground control and use can be separated. Moreover, specific rights acquired with ownership of real estate can be no greater than those that are enjoyed by the previous owner.

Public Rights Legal title or fee simple title of real estate is not absolute. Our government, or the general public, retains certain rights in all real estate. Decisions involving ownership and use of farm real estate must be made within the framework of public rights. The following briefly describes these rights. Taxation. Real estate has long been a source of money for various levels of government in the United States. In early years, farmland taxes were the primary source of funds for public services. Although new sources of revenue and more elaborate taxation systems have been developed, property taxes—particularly real property—are still a major cost of owning farmland. Near some metropolitan areas, high land values and the consequent heavy property taxes have helped move land from farm to nonfarm uses. Eminent domain. This is the right of government to take private real estate for 4

public use. Many federal, state, and local agencies now have the right (or power) of eminent domain. In recent decades, we have seen a broader interpretation of this power and of the concept of public benefits. Owners of real estate taken for public benefit must, however, receive just compensation for the property (1). This is guaranteed under provisions of the Fifth Amendment to the Constitution for federal government acquisitions, and under the “due process” clause of the Fourteenth Amendment for state and local acquisition. Owners of farmland have been affected appreciably by the right of eminent domain in taking land for water impoundments and the interstate highway system. Police power. Our government is responsible for performing those functions necessary for public safety and well-being that individuals cannot perform independently. Police power gives government the right to regulate the use and development of property to promote the public’s safety, health, morals, and general welfare. All levels of government are involved in activities that discharge this right and responsibility. Zoning, building codes, sanitation requirements, traffic regulations, and environmental protection regulations are examples of police powers that affect owners and users of real estate. Escheat. Land is actually a national resource, even though individual ownership is permitted in our nation. The federal government still owns vast tracts, usually nonproductive desert, mountain, or swamp land, or land in national parks and national forests. States and counties own land in parks, forest preserves, and the like. The right of escheat reverts ownership of land to government if taxes on the property are not paid, or if the owner dies without a will or known heirs.

Responsibilities Economists have long recognized the fixed quantity of land available for human use and what this means to an increasing world population. Only recently, however, has widespread concern about conserving this irreplacable resource and using it wisely been evident. Early settlers cleared or broke the land, farmed it until the loss of natural fertility or erosion caused poor crop yields, and then moved on. A few Americans recognized the folly of exploiting our land, but not until the drought

and dust bowls of the 1930s was there enough concern to bring about an active conservation program. In 1935, the Soil Conservation Service was established as a permanent agency of the U.S. Department of Agriculture. Thus began the first organized national effort to help farmers adopt practices that would maintain land productivity for future generations (3). During World War II and the postwar period, new concerns about our limited land resources developed. Improved technology resulted in huge earth-moving shovels and strip mining. “Raping” farmland to get at this valuable source of energy brought forth cries of indignation at the loss of land and attempts to create zoning that would prevent strip mining. Suddenly, urban areas, the interstate highway system, water impoundments (to provide water, electricity, and flood protection), and other nonfarming activities sprawled over farmland. The term “farm real estate” came to be replaced by “rural real estate.” Taking farmland for nonfarm uses continues, and in some areas may be expanding. Unfortunately, the land taken is often highly productive agricultural land, not tracts with marginal productivity. To slow the movement of farmland to nonfarm uses, or at least to reduce the role that high property taxes play in that process, 45 states have passed legislation to reduce property taxes for farmers near metropolitan areas. The general form of tax relief is through differential tax assessments, that is, basing assessed valuation of land actually used for agricultural purposes on some “agricultural value” concept. To make up some of the lost tax revenue, the legislation includes provisions that allow taxing bodies to recover the tax differential for the last few years in which the land is in agricultural production if it moves into a nonfarm use. Zoning has been used to prevent or direct the movement of land from farm to nonfarm uses. If used wisely, zoning is a potent regulatory tool available to state and local governments. Programs tried on a limited scale or as alternate ways of preserving farmland include agricultural districts (New York), purchasing development rights (New York), and fee simple purchase and leaseback (New Jersey) (4). In the late 1960s and early 1970s, Americans were introduced to three words important in man’s relationship with land—pollu-

tion, ecology, and environment. Air and water pollution became common targets of crusaders. Industrial plants, automobiles, and municipalities were identified as the main culprits, but farmers were not overlooked. Nitrates and agricultural chemicals in water runoff received considerable publicity. Livestock producers, particularly those with large confinement operations, found out how vulnerable they were to complaints about odors (even if plaintiffs moved into the area after the livestock operation was established). Intermixing farm operations and rural residences makes these land-use problems particularly acute in the “rural-urban fringe.” In the mid-1970s, there was a clamor for federal and state comprehensive land-use planning.2 Generally, such legislation would guide development and use of our limited land resources to maximize public benefits, limit short-sighted exploitation of land resources, eliminate ill-conceived developments, protect the rights of land owners, and protect the environment. For such legislation to have any effect, however, those zoning and restrictive regulations must be enforced, and enforcing them impinges on individual ownership rights. Without enforced land-use regulations, farmland will move to uses that give higher monetary rewards, even if those uses are undesirable from the public’s standpoint, and even if that land is needed to feed future generations. Except for restrictions that protect the rights of others, which the courts will enforce, proposed legislation to control the use of land will meet vehement resistance on the grounds that it violates individual rights granted by the United States Constitution. The current farm real estate market includes purchasing farmland for nonfarm uses and by nonfarmers (for rural residences, investment, speculation, financial security, hobby, and the like). This is likely to remain so. High interest rates, high unemployment, high federal budget deficits, and associated economic woes are current public concerns. In agriculture, concern is centered on low farm incomes, farm foreclosures, and farmland values. The need for land-use planning and soil conservation legislation has been put, at least temporarily, on the back burner. The public is beginning to recognize that because it is limited and irreplaceable, land should not be considered as a commodity, but as an extremely valuable natural resource that belongs to the public. As such, all land-

5

owners have more than a legal responsibility to develop and use land wisely and protect it for future generations. Perhaps the best way to summarize that commitment is to quote a Wisconsin court case: “The land belongs to the people . . . a little of it to those dead . . . some to those living . . . but most of it to those yet to be born.”3

Notes 1.

2.

3.

There are two basic forms of ownership when property is owned by a husband and wife together—joint tenancy and tenancy in common. Form of ownership affects in particular rights of survivorship, and inheritance and state taxes. State laws are not consistent on these provisions and implications, so a buyer of farm real estate should investigate this matter in the state where the tract is located. Land use bills were introduced and discussed in both houses of the Congress in 1975: Representative Morris Udall introduced HR 3510, “Land Use and Resources Conservation Act of 1975,” and Senator Henry Jackson introduced the “Land Resources Planning Assistance Act of 1975.” Just v. Marinette, 56 Wis. 2d 7.

References 1.

2. 3. 4.

5.

6.

7.

6

American Society of Farm Managers and Rural Appraisers. Professional Rural Appraisal Manual. 6th edition. Denver, Colo.: The Society, 1986. Barlowe, Raleigh. Land Resource Economics. Englewood Cliffs, N.J.: Prentice-Hall, 1958. Bennett, Hugh H. Soil Conservation. New York: McGraw-Hill, 1939. Bryant, William R. Farmland Preservation Alternatives in Semi-Suburban Areas. A.E. Ext. 75-5. Dept. of Agricultural Economics, Cornell University, 1975. Murray, William G. Farm Appraisal and Valuation. 5th edition. Ames, Ia.: Iowa State University Press, 1969. Semenow, Robert W. Questions and Answers on Real Estate. 4th edition. Englewood Cliffs, N.J.: Prentice-Hall, 1963. Suter, Robert C. The Appraisal of Farm Real Estate. 2nd edition. Danville, Ill.: Interstate Press, 1980.

2

Trends in Farm Real Estate Values in the North Central States: 1912 to 1989 William McD. Herr and Phillip Eberle Southern Illinois University at Carbondale

Figure 1 Comparison of nominal and real value of United States farm real estate values per acre.

Dollars

ward pressure occurred in the 1920s and For nearly 50 years, between the Depression continued into the Depression era. Land valof the 1930s and 1981, U.S. farm real estate ues increased from 1950 until 1981, then devalues tended to rise. There were a few clined sharply. The following sections reyears of little or no change and modest deview these trends and related factors. clines, but the trend was clearly increasing value. In this environment, the focus was on the past, to find clues on changes in the rate The Early Period, 1912-1950 of increase. From 1912 until 1920, U.S. farm real esHowever, in the early 1980s, farm real estate values increased at an annual rate of 7.5 tate values declined, especially in the North percent. This was followed by 13 years durCentral states of Illinois, Indiana, Iowa, Kaning which farm real estate values declined sas, Kentucky, Michigan, Minnesota, Mis6.8 percent annually (Table 1). Farm real essouri, Nebraska, North Dakota, Ohio, Oklatate values in the 14 North Central states rose homa, South Dakota, and Wisconsin. Beand fell by about the same annual rate. tween 1981 and 1987, the national rate of The early increases were stimulated by a decline was equivalent to an annual rate of about 8 percent, whereas in the North Censtrong economy and high farm exports, tral states, the annual rate of decline was which resulted in favorable prices and net nearly 11 percent. The duration and magnifarm income. As European agriculture tude of this decline was surpassed only in the years 1920 1200 to 1933 (Figure 1). Nominal Annual indexes Real* of farm real estate 1000 values since 1912 are available. This 800 review is divided into two periods: 1912-50 and 1950600 present. The early period was one of 400 considerable vari1950 = 100 ability. Strong upward pressures 200 on farmland values occurred in both war and early post0 war periods (19121910 1920 1930 1940 1950 1960 1970 1980 1990 20 and 1941-49). *Deflated by consumer price index Substantial down-

7

decline. This in turn caused a downturn in land values in most states. Three North Central states—Michigan, Ohio, and Illinois— registered gains, while 11 states showed declines ranging from about 1 (Indiana and Oklahoma) to more than 6 percent (Wisconsin). From 1954 to 1971, land values increased nearly 5 percent annually. The economic climate of the period was one of modest inflation. In many years, major crop prices were at or near their price support levels, and the Commodity Credit Corporation accumulated stocks. The major dynamic force in this period was the persistent gain in farm productivity associated with mechanization, growing use of chemicals, farm specialization, and increased farm size. Fairly stable prices encouraged the adoption of these and other technologies to reduce per unit costs. Thus, the gain in productivity, along with price supports, probably provided most of the impetus for the rise in farmland values. From 1971 to 1981, the annual rate of increase in farmland values accelerated to nearly 15 percent in the North Central states (Table 2). Not only did farm productivity continue upward, but commodity prices and

farm incomes surged as surpluses turned to shortages brought on by increasing demand, largely from overseas. High inflation and relatively low real interest rates contributed substantially to investor interest in farmland. Although the trend was decidedly upward, the rate of increase varied substantially during the decade. After 1981, farmland values turned down. The average rate of decline in the North Central states was about 11 percent annually, compared with an average annual decline of 7.8 percent for the United States. In Ohio, Indiana, Illinois, Iowa, and Nebraska, the decline approached 13 percent per year. Again, a key factor was a downturn in farm exports, but high interest rates contributed to the downturn. Widespread financial distress among farm operators limited the number of buyers relative to the volume of land on the market, and this pushed values down. Including the 1988-89 recovery, land values registered an average annual gain of 6.0 percent nationally and 5.4 percent in the North Central region for the entire period 1950-89. Despite the weakness at the end of this period, average gains outstripped the

1950-53 1950-53 1953-54 1953-54 1954-71 1954-71 1971-81 1971-81 1981-87 1981-87 1950-89 1950-89 - - - - - - - - - - - - - - - - - - - - - - - - - percent

Michigan Wisconsin Minnesota Lake states average

change - - - - - - - - - - - - - - - - - - -

8.3 6.5 8.2

1.0 -6.1 -5.6

4.7 5.0 4.6

13.3 15.5 18.5

-7.0 -9.7 -14.7

5.4 5.3 5.4

7.7

-3.6

4.8

15.8

-10.5

5.4

Ohio Indiana Illinois Iowa Missouri Kentucky Corn Belt average

9.9 10.3 9.1 6.2 9.4 6.8

1.9 -1.2 2.6 -1.4 -5.6 -2.6

4.7 4.6 3.9 4.2 6.1 5.2

16.1 16.9 16.8 17.9 13.7 13.3

-10.5 -12.2 -11.7 -15.1 -9.3 -4.8b

5.8 5.5 5.4 5.3 5.7 5.8

8.6

-1.0

4.8

15.8

-10.6

5.6

North Dakota South Dakota Nebraska Kansas Oklahoma Plains states average

9.4 6.7 10.1 7.8 7.2

-2.0 -2.9 -5.0 -2.2 -1.2

5.3 4.0 4.2 3.8 6.2

15.2 14.2 14.7 12.8 12.7

-9.1a -12.6a -14.4a -11.4a -8.7ab

6.2 4.8 5.0 4.5 6.0

8.2

-2.7

4.7

13.9

-11.2

5.3

The 14 N.C. states 8.3 United States (48) 8.9

-2.2 -1.1

4.8 5.3

15.1 13.8

-10.8 -7.8a

5.4 6.0

Table 2 Average annual rates of change in farm real estate values for North Central states and the United States in selected periods, 1950-1989.

a

From 1982 peak; bto 1988 low

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Table 1 Average annual rate of change in farm real estate values for North Central states and the United States in selected periods, 1912-1950.

1912-20 1912-20 1920-33 1920-33 1933-41 1933-41 1941-49 1941-49 1949-50 1949-50 1912-50 1912-50 - - - - - - - - - - - - - - - - - - - - - - - - - percent

Michigan Wisconsin Minnesota Lake states average

5.9 7.3 10.6

-4.9 -5.7 -7.4

1.8 0.3 1.2

10.2 8.0 8.4

-1.2 -4.1 3.2

1.9 1.1 1.6

7.9

-6.0

1.1

8.9

-0.7

1.5

Ohio Indiana Illinois Iowa Missouri Kentucky Corn Belt average

6.3 6.7 6.4 10.4 7.0 9.4

-7.3 -8.3 -7.9 -9.5 -8.3 -6.8

4.0 5.0 4.3 3.2 1.2 4.6

10.1 10.9 9.6 9.5 9.5 11.9

-3.9 -0.8 2.6 1.7 0.7 -3.1

1.4 1.6 1.4 1.3 0.7 2.8

7.7

-8.0

3.7

10.2

-0.5

1.5

5.1 8.3 7.9 5.1 6.9

-5.9 -8.7 -7.0 -5.7 -5.9

-3.0 -3.9 -3.1 0.2 3.0

10.9 11.6 12.6 11.6 10.1

-3.4 0.6 -6.2 -1.7 -2.8

0.4 0.0 0.8 1.3 1.9

6.7

-6.6

-1.4

11.4

-2.7

0.9

The 14 N.C. states 7.4 United States (48) 7.5

-7.1 -6.8

1.3 2.0

10.4 10.0

-1.3 -2.1

1.3 1.5

North Dakota South Dakota Nebraska Kansas Oklahoma Plains states average

recovered after World War I, foreign demand decreased and farm prices and land values declined. Following that collapse, the farm economy’s performance for most of the 1920s was less favorable than that of the nonfarm economy, and land values languished. As the nonfarm economy retreated and international trade declined even more, economic conditions in the farm sector deteriorated, and the downturn in land values deepened. After 1933, U.S. farm real estate values increased modestly until 1941. Most of the gain occurred early; and by 1938, values had reached a post-Depression high in most states. For the rest of the decade, until the beginning of World War II, change, if any, was modest. From 1933 to 1941, U.S. farm real estate values rose an average of 2 percent annually. Corn Belt states generally gained more, while a number of Plains states continued their slide (Table 1). Strong gains occurred during the war and through 1949. The average annual increase in the United States was about 10 percent. Gains in the Plains states were above average, while those in the Lake states were below average. In 1950, fewer farm exports, 8

change - - - - - - - - - - - - - - - - - - - - -

resulting from the recovery of European agriculture, once again contributed to a decline in farm income and halted the rise in farm real estate values. The magnitude of the change, however, varied among the North Central states. For example, in five states, land values did not decline, and declines in the other states ranged from less than 1 percent to more than 6 percent. Major swings in farm real estate values from 1912 to 1950 averaged out to an annual compound gain of slightly more than 1 percent. This slight upward tilt in nominal values was less than the average increase in the consumer price index. Hence, by 1950, the real value of farmland was more than 25 percent lower than in 1912 (Figure 1).

The Later Period, 1950-1989 The period began with a sharp increase in land values from 1950 to 1953, when the Korean War and related events stimulated the demand for farm products. The annual rate of increase in U.S. farmland values averaged 8.9 percent (Table 2). The end of hostilities and a decrease in foreign demand caused farm prices and net farm income to

consumer price index, and the real value of farm real estate in 1989 was nearly 60 percent above the 1950 level (Figure 1).

Comparing the Downtrend in Land Values in the 1980s with the 1920s The downtrend of the 1980s may have stemmed from declining foreign demand. This also was an important factor in the decline in farmland values after 1920. Also, both downturns occurred after periods of agricultural prosperity when land values increased at faster rates than long-term trends. In both periods the nonfarm economy was stronger than the farm sector, and the farm sector was wracked by financial problems. These and other similarities merit comparing the 1980s downturn with the earlier period. The decline that followed 1920 lasted 13 years. The recent decline was about one-half as long, but it was at a sharper rate. For example, by early 1987, after 6 years, average U.S. values were down nearly 35 percent from their 1981 peak. A similar decline took 10 years to occur following 1920 (Figure 2). The steepness of the recent decline was even more evident in the North Central region. There, land values fell nearly 50 percent from their 1981 peak. A similar decline following 1920 took more than 11 years. The Figure 2 Comparison of major periods of decline in farm real estate values.

last 2 years (1932 and 1933) registered the two largest annual declines recorded in the 75 years covered by the data. Those severe declines were associated with economic depression that was unlike the 1980s. The historical record may provide clues about the future trend in land values, but a more likely scenario is that future trends will be different from those of the past. This is because the economic environment is different and the relative importance of factors affecting farm real estate values will likely change.

A Perspective Concerning Farm Real Estate Value Trends This chronicle of farm real estate values in the United States and North Central states illustrates two lessons. First is the homogeneity in the long-term trend of farmland values among the North Central states, and second is the importance of foreign demand in determining farm prices, incomes, and, hence, land values.

Different Markets but Homogeneity in Trends The farmland market appears to differ by region or state. For example, the natural productivity of land differs, types of farming

100

80

60

United States, 1920–33*

40

United States,1981–89** 14 North Central states, 1920–33*

20

14 North Central states, 1981–89** 0 0

1

2

3

4

5

6

*1920 = 100 for 13-year period, 1920–33 **1981 = 100 for 8-year period, 1981–89

10

7

8

9

10

11

12

13

Ratio of of gross gross cash cash Ratio rent for cropland rent for cropland to to value value per per acre, acre, 1981 1981 Greater than 6.0 5.0 to 6.0 Less than 5.0

Number Number ofof states states 2 5 7

differ, and the effect of nonfarm demands for farmland also differs. Despite these differences, the similarity of the annual compound rates for change for the 14 North Central states for selected periods between 1912 and 1986 is striking. With few exceptions, turning points occurred in the same years, and increases and decreases were similar. For example, between 1912 and 1950, the average annual increase among the 14 North Central states was 1.3 percent. All states registered an increase, and only two states (South Dakota and Kentucky) had an average gain outside the range of + 1 percent, about the average rate. Between 1950 and 1986, the average gain for the 14 states was 5.2 percent, and no state fell outside a range of + 1 percent from the average rate. For shorter periods of time, however, differences in annual rates of change were larger. Factors that account for the similarity in compound rates of change include the competitive nature of farm product and real estate markets, as well as general economic factors that affect farm real estate values regardless of location. In the North Central region, one crop or enterprise can be substituted for another. Thus, for example, poor prices and incomes among wheat producers may result in a decline of land values in wheat-producing areas. This encourages some wheat producers to shift land out of wheat into other crops to minimize their decline in income. But these actions expand feed grain and soybean production, and net returns to these enterprises tend to fall, causing land values in other areas to fall. Favorable returns to one crop tend to stimulate acreage increases in that crop and reductions in other crops, with the result that favorable conditions are transmitted in time to other parts of the region. Potential farm real estate investors may also help farmland values move in the same direction and by similar amounts in each state. Investors seek out the “good buys”

Average Average rent rent to tovalue value 6.1 5.5 4.5

Average annual annual change change Average in farm real estate in farm real estatevalue, value, 1981-871981-87

Table 3 Effect of rent to value ratio on subsequent changes in farm real estate values in the North Central states.

-9.2 -10.7 -11.1

(low-value areas) and shy away from highvalue areas, even selling holdings in such areas. Thus, the competitive action of commodity producers and participants in the land market tends to unify the market, resulting in broadly similar trends in values, especially in the grain states of the North Central region. Differences in rates of change tend to occur within short periods of time. In some areas, changes are due to imperfect knowledge, the ease of shifting resources among enterprises, and differences in the demand for land for nonfarm uses. Another indication that the farm real estate market works in this way is shown by examining the ratio of gross cash rent to value of land in the North Central states. In 1981, this ratio varied between 3.7 and 6.1 percent among the 14 states. Other things being equal, market participants tend to increase farmland values relatively more in states where this ratio is high during periods of rising farmland values. Likewise, market participants cause farmland values to decrease more where the ratio is low during periods of falling land values. Subsequent changes in land value from 1981 to 1987 followed this latter pattern—in this instance, declining more in states where the ratio was low than where the ratio was high (Table 3). Economic factors independent of geographic boundaries also enhance conformity in rates of change. Thus, inflation—and the accompanying demand for land as a hedge against inflation—tends to pervade all areas, states, and regions. Changes in interest rates and the availability of credit tend to be nonspecific with regard to location and, therefore, result in broadly similar trends across states. These strong forces help unify the farmland market in the North Central states.

Farm Exports and Land Value Trends Virtually every turning point in the record of farmland values was associated with 11

foreign markets. The strong upward trend after 1971 was fueled by foreign demand. Likewise, the lack of foreign demand pushed values downward after 1981. Change in foreign demand for farm products is likely to continue to play a major role in determining farm prices, net income, and, hence, land values. Farm production trends in foreign countries, economic growth, the value of the dollar, and changes in agricultural programs and trade policies may provide clues for future levels of U.S. farm exports, prices, net income, and land values.

Summary and Conclusions The record indicates that average annual changes in farmland values have been similar in the 14 North Central states. This similarity can be traced to the competitive nature of markets for farm products and farm real estate in the region. A major factor affecting turning points and trends has been changing foreign demand. This factor continued to be important in the 1970s, in the downturn after 1981, and the improvement in 1988-89. While land values nearly doubled between 1912 and 1950, inflation outpaced these gains, and the real value of land was lower in 1950 than in 1912. Between 1950 and 1986, farmland values increased nearly tenfold, much faster than inflation. As a result, the real value of farm real estate increased by about 50 percent. During the latter period, farmland was at or near the top of investor lists of “hedges against inflation.” However, that image was tarnished after 1981. History may provide clues about future trends in land values, but trends in the future will likely be different from past trends. For example, if farm price support programs remain more market-oriented and technology continues to increase productivity in the United States and abroad, land price trends would not likely be the same as in the years 1954 to 1971, when these factors resulted in a persistent increase. Moreover, the future will hold a different set of farm credit institutions that will use different lending procedures. Also, government fiscal and monetary policies that affect inflation, interest rates, and foreign demand for U.S. products make it very unlikely that the outcome will mirror the trend of the 1970s. 12

As noted, the historical trend among states has been fairly homogeneous; however, in the future, other factors affecting land values may change the nature of farming and, hence, the homogeneity in trends. For example, environmental concerns could play a key role. Irrigation may expand in some areas and decline in others, such as the High Plains, where aquifers are being depleted. Soil conservation efforts are likely to have a differential effect on the way land is used and, hence, on farm real estate values. Concern about the long-term effects of intensive chemical use may also cause some areas to lose their comparative advantage as others gain. Finally, changes in consumer demand for food, especially meat, may affect feed grains and, in turn, land values. The record shows variability, and the future will no doubt hold considerable change.

3

Importance of Various Factors in the Land Market William McD. Herr and Phillip Eberle Southern Illinois University at Carbondale

Economists have long been interested in explaining changes in land values. John Locke (1632-1704) developed a theory of capitalization, but puzzled over an empirical test and doubted his theory. Researchers faced a similar conundrum 300 years later as land values increased in the 1950s and 1960s, even while farm sector income changed little. In the 1980s, many economists examined changes in net farm returns and other variables for clues to the length and depth of the decline in farm real estate values. A variety of factors influences the farmland market. Two unique characteristics of land—its location and permanency—contribute to the variety and complexity of the market forces affecting it. The value of any tract may be influenced by factors unique to that location, for example, a neighbor who desires to expand his or her farm, a nonfarm use, or a specific physical characteristic of the tract that affects productivity. Permanency suggests that since knowledge about the future is imperfect, land values are subject to a great range of expectations concerning technological, economic, political, and social conditions. As a result, the auction price for a tract of land will differ, depending on, for example, the views of bidders about the world food situation. Bidders could support Malthusian ideas, or they could believe the world is approaching zero population growth and that continued technological improvement will lead to a surplus of food. Differing beliefs result in differing bids. Studies that attempt to explain farm real estate values through time (time-series studies) must somehow capture buyer and seller expectations regarding net earnings on land, price changes, interest rates, technology, and other long-run dynamic elements. None of these factors are completely understood, nor are they easily incorporated into economic

models. Studies designed to explain the variation among tracts at a point in time (cross-sectional studies) must include features specific to those tracts—soil productivity, distance to markets, improvements, size of parcel, and potential nonfarm uses. A review of the literature is likely to provide a lengthy list of factors affecting farmland values, and ascribing relative importance or rank to each factor is difficult. Despite these problems, a useful factor to examine is net earnings realized from the use of land as expressed by the capitalization concept. Another factor often examined separately from net earnings is the demand of farm operators for land to enlarge their operations. Most observers believe that farmland values are also influenced by phenomena outside the farm sector. The demand for land for nonfarm uses and owning land as an investment are influences from outside the farm sector. Finally, values may be influenced by fiscal and monetary policies that affect inflation, after-tax returns, and terms and availability of farm mortgage credit. These categories, or factors, have helped change farm real estate values and are discussed in the following five sections.

The Capitalization Concept The value of an asset, such as land, is based on its earnings. This concept is expressed as V = I / r, where: V I r

= the present value of land = expected annual net returns to land = the discount or capitalization rate

Expected annual net earnings summed for all years in the future equals the present value of land. For example, a prospective buyer estimates that a specific tract will earn $75 per acre. The $75 net return reflects the 13

buyer’s estimate of long-term crop yields, market prices for the products to be sold, and deduction for all costs of production including noncash outlays for depreciation, labor, and management. If this buyer assumes the opportunity use of capital to be 6 percent, the capitalization formula indicates a value of $1,250 per acre. If this buyer could purchase the tract for $1,250 and receive $75 annual net return, the earnings would be 6 percent on this asset each year. Higher net earnings of $90 per acre, for example, would increase the land’s value to $1,500 per acre. On the other hand, an increase in the capitalization rate would reduce the land’s value. This mathematical simplicity, however, conceals the complexity of the capitalization concept. The earnings to be capitalized represent expected net earnings to real estate for many years in the future. Estimating the numerator is, therefore, very difficult. Determining the denominator is no less perplexing. It should represent the time preference rate of market participants, but there is no satisfactory way to determine this rate. Several studies in the 1960s inferred that the link between net farm income and land values had been greatly weakened in the decade or so after World War II, when farm real estate values continued to increase but sector net income stagnated. This led to questions regarding the usefulness of the capitalization concept for explaining changes in farmland values. While researchers still accepted the reasoning in the concept, some searched for additional factors to help explain the almost uninterrupted rise in farm real estate values after the early 1950s. Melichar demonstrated that changes in the income produced by farm assets were similar, if not parallel, to changes in farm asset values. At the same time, alternative expectation and behavioral models were being developed and used. When these two ideas were merged, the central role played by the capitalization concept in determining land values was reestablished. Not only has the capitalization concept proven useful in econometric models (Castle and Hoch, Espel and Robison, Hauschen and Herr), it is a convenient way to show how a number of factors affect net returns to land, the capitalization rate, and, hence, the value of farmland.

14

Net Earnings from Land With a constant capitalization rate, any item causing a change in the expected net return to land will alter land values in the same direction. The major items causing net earnings to change in recent years have been the prices of farm commodities, changes in farm productivity, federal farm programs, and input costs. Commodity Prices Increasing or high commodity prices have a positive effect on net income, which tends to strengthen farmland values. The reverse is also true. Decreasing or low commodity prices have a negative effect on net income, which tends to decrease farmland values. Major changes in farm commodity prices have been associated with changing foreign demand. Thus, farm prices and land values rose in the war-affected periods of 1914-20, 1940-49, and 1950-53, then reversed in the year or so immediately after. Strong foreign demand in many years of the 1970s contributed to strong commodity prices and record annual gains in farmland values. When foreign demand eased after 1981, farm prices declined and midwestern land values registered their largest decrease in over 50 years. This relationship does not always hold because higher product prices may be associated with higher input prices, leaving net income the same or lower. Commodity prices may vary more in the future than they have in the past. The increased variability may stem from (1) the farm sector’s greater susceptibility to fluctuations in foreign demand, (2) the sector’s increasing ability to vary purchased inputs, thus making output more variable, and (3) the large federal deficit, which may reduce government involvement in determining farm prices. If farm prices vary more, farm real estate values may become more difficult to chart. Changes in Farm Productivity Expectations of farm productivity may also affect farmland values. From the early 1950s and for the 15 years after, the farm sector was in a cost-price squeeze. Many farmers partially offset this adverse pressure by adopting new technology and expanding farm size, which permitted operational economies. This improvement in farm productivity, and the expectation that it would continue, helped maintain an expectation of

stable-to-rising net earnings, which, in turn, had a positive influence on land values. Individual farm firms and buyers may view technological gains as reducing their per unit costs and improving their net returns, but this may not occur when many firms adopt the new technology. When more commodities are supplied and demand is inelastic, prices and total returns decline. The aggregate effect of new technology on net returns and hence on land values depends on which declines the most: total costs or total returns. Studies by Chryst and by Herdt and Cochrane indicate that the combination of farm price-support programs, which limited price and income declines, and technological change, which expanded output, were major factors influencing the upward trend in farmland values in the 1950s and 1960s. In 1973, Reinsel concluded that the effect of technological change was closely tied to farm commodity programs and to the demand for land for farm enlargement. It is difficult to project future productivity changes in agriculture. Growing concerns about the environment and the healthfulness of food may limit the use of certain chemicals and growth additives. On the other hand, advances in biotechnology and improved information processing may lead to even more rapid gains in productivity. These and other considerations suggest that whatever role technological change played in the past, its effect could be different in the future. Farm Programs As indicated above, government farm programs affect net earnings and hence land values. In general, these programs curtail supplies through acreage allotments and diversion programs, provide minimum prices, and, in many years, direct payments. Schultz summarizes the view generally held regarding the effect of government programs on farmland values: Indeed, at the limit, a subsidy attached to land eventually ends up granting no benefits to farmers. To the extent that the value of the subsidy is capitalized into land prices, the higher carrying costs soak up the annual subsidy, as land gradually changes hands over the years. But since subsidy values are frozen into the price of land, any

attempt to reduce or remove them would leave recent purchasers of land with incomes below what they would have been before the subsidy program started and confront them with a capital loss. Paradoxically, therefore, after a number of years have passed, such programs end up transferring little net income to the second generation of recipients, but at the same time become so frozen into asset values that their removal would bring substantial hardship. (p. 3) Studies by Aines and by Reinsel and Krenz suggested that program benefits were capitalized into land values, especially in tobacco, peanut, cotton, and wheat areas. In 1973, however, Reinsel suggested that the effect of government programs on the values of land may in fact be less than Schultz and others imply. Reinsel says that although the capitalized value of program benefits on an opportunity-cost basis is large—8 percent of the total value of real estate—the actual investment of land owners in program rights seems small. The large government deficit in the early 1980s provides a rationale for reducing government aid to the farm sector. If federal deficits continue to be a dominant factor in the economic environment, many government programs, including farm price and income programs, could have less of an effect on land values than in past years. To the extent that price and income supports are reduced, net earnings of land would likely fall and become more unstable. This, in turn, would tend to cause land values to fall and become more unstable. Lower net earnings and increased risk tend to reduce land values. To compensate for greater variability in earnings, owners would likely desire a higher rate of return (discount rate). Price and income support programs also affect specific classes of land since some programs are designed for and affect specific subsectors, for example, the dairy buyout and conservation reserve programs. Input Costs Prices of many key inputs were relatively stable from 1950 to 1970. This tended to focus attention on product prices and crop and livestock production as the major causes for changes in net farm incomes and land values. However, the surge of inflation in the 1970s 15

and the decline in the mid-1980s associated with the energy situation proved that net farm returns can be affected substantially by input costs. Changes in input use and prices are likely to be more important factors in future changes in net farm returns than they were in the past. Two input costs attracting attention are real estate taxes and interest costs on operating and working capital. Both are frequently viewed as costs over which the manager has little control. High debt and high interest rates, especially in the early 1980s, helped check net returns and contributed to the decline in land values in that period. High interest rates reduce net earnings from land and create financing problems. Highly leveraged farms were particularly vulnerable to record-high real interest rates. Some were forced to pare debt by selling farm real estate. Pasour has shown that high and increasing property taxes also depress land values. This negative effect may diminish as school enrollments stabilize or decline, other forms of taxation (especially income tax) increase in importance, and property tax schemes shift more to a use basis that usually gives tax preference to agricultural land. Even though the burden of the property tax could moderate, improving assessment practices will remain a high priority.

Discount or Capitalization Rate Change in the discount rate, although probably more difficult to quantify than net farm returns, can also cause farmland values to fluctuate. Relatively small variations in the discount rate can produce large absolute changes in land values. For example, a decrease in the capitalization rate from 6 to 5 percent with net earnings at $75 per acre can increase land values from $1,250 to $1,500 per acre. Capitalization rates are likely to be affected by changes in market interest rates, changes in the perceived variability of future earnings, and expectations of future earnings that result in capital gains, especially in areas where nonfarm landlords are a sizeable portion of market participants. Many landlords are familiar with returns on investments having similar liquidity, risk, and capital-gain potential. When returns on these alternative investments rise or fall, landlords are likely to expect that returns to land should change 16

in the same direction. Thus, the decline in land values following 1981 was not just the result of lower net returns to farmland but also related to higher interest rates. Interest Rates A major factor causing interest rates to change is inflationary expectations. Some believe that with no inflation, rates might average near 3 to 4 percent, reflecting relative stability in productivity gains and time preference of consumers. In this view, current high real rates are an indication of inflationary expectations. Associated with these expectations are continued large government deficits and the high growth rate of the money supply. Whenever inflationary expectations differ from actual rates of inflation, real rates of interest change, which may cause fluctuations in the real price of farmland. Others believe that current high real rates of return to capital are due to an increased worldwide demand for capital for development and to deregulation of the finance industry. Even though deregulation may improve efficiency and reduce the cost of funds, initially it has tended to reward savers and increase the cost to borrowers. Risk Another component of the capitalization rate is the relative risk of future earnings. Should net earnings from farmland become more unstable because of price variability, reduction of government programs, or other factors, market participants will require a risk premium, or a higher rate of return than received on less-risky investments. If farmland earnings stabilize, the risk premium or required rate of return will be less. Real Growth in Earnings or Capital Gains The capitalization rate may be adjusted to reflect expected increases in earnings or expected appreciation in land prices. Buyers or owners will accept lower current rates of return if earnings are expected to increase or land values appreciate. If land is expected to lose value, buyers and owners will require higher rates of return. These views suggest land values could become more variable because the capitalization rate and net returns are likely to be more variable. The capitalization formula, however, indicates that at times these independent forces could cancel out. Thus, sharply rising (or falling) net incomes and

capitalization rates could result in little change in land values. However, opposite movements in these variables—for example, rising net farm income and falling capitalization rates (or the reverse)—could cause sharply higher or lower land values. These are distinct possibilities since change in net returns and change in the capitalization rate can be caused by quite different factors.

Land for Farm Enlargement A persistent trend in the U.S. farm sector is growth in farm size. The trend reflects economies of size and the fact that many units are below optimum size. Thus, an important demand for land is for add-on acreage. Because this demand is related to technological change and improved net earnings prospects, it is difficult to separate the effects of demand for add-on acreages from those of capitalizing net returns. In recent years, probably more than half of all land transfers added acreage for another unit. The U.S. Department of Agriculture reports that in the Northern Plains and the Corn Belt, about 60 percent of all transactions involved land to be farmed as part of another unit. This characteristic of the land market is so important that the market could be characterized as one for parcels of land rather than for complete farms. To accommodate this demand, sellers often divide tracts into smaller parcels. The strength of the demand for add-on acreage is reflected in the widespread observation that smaller units of farmland command a premium price, compared with larger tracts. Farmers often purchase neighboring parcels to assure the continued growth and the economic viability of their present unit. Therefore, farmers may bid vigorously for neighboring parcels. Small parcels also bring comparatively high prices because more buyers are willing and able to invest in a 40- or 60-acre tract than in one of 160 or 200 acres. Probably of greater importance, and closely related to the capitalization concept, is the likelihood that residual returns (net rents) for add-on acreages can be substantially greater than those from larger tracts. Add-on acreages can often be farmed without additional outlay for machinery, buildings, or hired labor. Since the projected net returns from such add-on acreages are high, so are the prices paid per acre.

This demand has not run its course in most areas. Many farm units are still below the optimum economic size, and new technology seems to push the optimum farm size even larger. This demand may be expected to vary as technology alters economies of size among various types of farming areas and enterprises.

Land as an Investment Farm real estate owners can accrue (1) annual rent or net earnings, (2) noneconomic returns, such as those associated with recreational use or desirable living environment, and (3) capital appreciation. The focus here is on appreciation. Comparing appreciation to annual net returns prior to the recent decline in land values illustrates its importance to a farm real estate investor. Because equity in land is such a large part of the total equity of the farm sector, the 1950-1980 average annual return to farm sector equities of 2.7 percent is assumed to approximate the annual returns to real estate. However, when this return is added to the average annual appreciation of about 7 percent, the total annual return to land ownership during this period was almost 10 percent. That surpassed the return received from many other types of investment. The appreciation component exceeded the rate of inflation as measured by the consumer price index in most years between 1950 and 1980. Two important reasons that land appreciates are the expectation of a change in land use (for example, to nonfarm use), which increases value, and the knowledge that farmland provides a good hedge against inflation, which creates a demand for land that may “feed on itself,” resulting in further appreciation. Therefore, some buyers, especially investors from the nonfarm sector, may consider farmland to be an excellent investment regardless of annual earnings. Farm operators can seldom look on a land purchase from these viewpoints. Yet, no doubt, many are cognizant of this return when contemplating a purchase. Example 1 illustrates appreciation. Assume that expected annual net returns will be $75 per acre, the buyer expects to purchase land for $1,500 an acre and sell it after 25 years, land is expected to appreciate at 4 percent per year in real terms, and the capitalization rate for the buyer is 5 percent.

17

Example 1. Estimated Per Acre Value of Land $75 × 14.0941 = $1,057

1. Present value of the net rent for 25 years

2. Value of land in 25 years compounded at 4 percent per year $1,500 × 2.6662 = $4,000 3. Present value of $4,000 received 25 years hence 4. Present value of land (1) + (3)

$4,000 × .2953 = $1,180 $1,057 + $1,180 = $2,237

1

Present value of a uniform series for 25 years at 5 percent Future value of $1 in 25 years at 4 percent 3 Present value of $1 received 25 years hence at 5 percent 2

18

In this example, the expectation of capital appreciation accounts for about half of the estimated total this buyer could afford to pay for the land. It may be difficult to measure the importance of this factor in the purchase price for a specific tract, but potential capital appreciation may be present in virtually all transactions. While the above example excludes the effect of taxes, these benefits may be large for those who could benefit from capital gains. Because the 1985 Tax Reform Act curbed tax shelters and reduced the value of capital gains, farmland investment decisions in the future are expected to become more dependent on the annual earnings of land. Appreciation is assumed to exist because it always has. Economic events indicate this assumption can be dangerous. The appreciation rate may change drastically, along with the cash flow necessary to finance the purchase. High interest rates in the early 1980s increased the cost of carrying debt and reduced cash flows. The result was considerable financial distress, particularly among highly leveraged owners. Farm real estate buyers and creditors are paying considerably more attention to prospective cash flows. An important support for farmland is expected annual earnings from land, used to pay projected annual finance charges (principal plus interest). In the mid-1980s, a few transactions were based upon current net return and credit costs. This indicates little or no premium for expected land appreciation, but does not mean land value declines have halted. Farm real estate values will bottom out only if interest rates are not expected to increase and/or net earnings from land are not expected to fall further.

Nonfarm Demand for Farmland Each year as much as 2 million acres, or a fraction of 1 percent of the land in farms, is converted to nonfarm uses. The size and effect of the conversions depend on many factors, including nonfarm housing activity; the type of land converted; how much land is needed for public uses such as parks, highways, and airports; and the amount of land reclaimed for farm uses. For example, state indexes of farmland values since 1977 show larger gains in the Northeast than in the Midwest or the Plains, supporting the view that nonfarm demands probably are greater in more urban regions. Data show that farmed land with a probable subdivision or commercial use within five years often sells for several hundred dollars more per acre than tracts that will continue to be farmed. Potential nonfarm demand is often large in the rural-urban fringe. In such areas, appreciation is affected by many of the factors affecting farmland values (such as net returns, technology, and product prices) and by the expected change to a more intensive land use. The effect of this factor on the value of a specific tract depends on its “nearness” in time and location to a conversion use. Thus, growth characteristics of the rural-urban fringe in which the tract is located become crucial. While demand for farmland for nonfarm uses will always be present in certain locations, Plattner has suggested that zero population growth could radically alter this demand. Such a condition would drastically affect the demand for land for nonfarm uses—housing, shopping centers, commer-

cial development, highways, and the like. Land would be required only for replacement, not expansion. This situation may be far in the future, but knowledge of the possibility could affect the farmland market. Virtually all observers note that farmland values are influenced by nonfarm uses. However, most studies have not clearly indicated the importance of these nonfarm factors, perhaps because the effect is localized and is difficult to capture in studies of large market areas.

Effect of Government Fiscal, Monetary, and Tax Policies The influence of fiscal, monetary, and tax policies on farmland values is complex and varied. The blend and interaction of those policies contribute substantially to changing rates of inflation and interest rates; and through tax laws, these policies serve as incentives or disincentives for investing in land. Feldstein argues that inflation and tax laws interact to raise the return on land, which was a major factor causing the price of land to rise relative to general prices in the 1970s. Espel and Robison show how higher inflation rates lasting for some years and variable rate farm mortgage loans such as provided by the Federal Land Bank (the largest institutional lender for farmland) can lead to a number of years of land value gains greater than increases in the general price level. Alston and Burt conclude that inflation has no effect on real land prices. The influence of credit terms on farm real estate values is debated. Atkinson and Francl suggest that readily available credit and liberal terms frequently cause higher land values. They argue that as the availability of funds expands, the demand for land increases. The pressure of growing demand against a relatively fixed supply on the market helps create rising land prices. Others maintain that conditions in the credit market have little or no effect on farm real estate values. They argue that farmers do not expand because they can obtain loans; they expand to increase income, and value is determined by prospective earnings. Credit money converts this potential demand for land into effective demand; but according to Van Vuuren, it seems doubtful that this money has an additional influence independent of any market force.

A study by Herr examined the hypothesis that the terms of farm mortgage loans provided by the Land Bank affect land values; however, the results did not support the hypothesis. This study concluded that the explanation for the tremendous surge in farmland values since 1971 seems to be improved farm income prospects rather than a liberalization of financing terms. However, the study did not directly consider the effect of the availability of funds on values. Thus, the author concluded that finance terms, rather than price paid, may determine who buys, especially in good farm areas where the market has depth and breadth. That conclusion might not hold if financing by the seller is considered. Seller financing permits a trade-off of credit terms —interest rate, loan maturity, and down payment—against the price of the property. Reinsel’s analysis in 1972 indicates that in the aggregate, land prices may have been 2 to 5 percent higher in 1970 than they would have been if seller financing had remained at the 1965 level. Although sellers will probably continue to finance a substantial portion of all transfers, the importance of seller financing is likely to change as the terms of mortgages from institutions are altered and as tax laws on capital gains are modified.

Summary and Conclusions Many factors influence farmland values. Most of these—commodity prices, input costs, real estate taxes, government farm programs, and technology—can be viewed as operating through the capitalization concept. The demand for land for enlarging farms is frequently treated separately. However, the premium frequently associated with tracts purchased as add-on acreages could also be explained by the capitalization concept. High values are the result of expected higher net returns from land purchased as add-on acreage. These factors represent influences that originate largely within the farm sector. Another group of factors affecting farmland values largely originates in the nonfarm sector. These include nonfarm demands for land—a factor important in urban-industrial areas, but especially important in the eastern United States. The changing demand for land as an investment may also be an important factor affecting land values. It seems less likely that credit terms exert separate and important influences on land values.

19

It is difficult to make precise conclusions about factors affecting farmland values because land is not a homogeneous commodity transferred in a national market. Instead, land prices are determined in many micromarkets, imperfectly linked with another. Cross-sectional studies frequently leave a relatively large portion of the total variation in average tract values per acre unexplained. This unexplained portion may represent inadequate data or a failure to specify all factors affecting land values. The unexplained portion could represent imperfections in the market such as those associated with institutional factors (taxes and zoning) and lack of knowledge. The latter could cause wide differences in income expectations by market participants and, hence, variation that cannot be explained easily by the most logically constructed models. The farm and nonfarm factors presented in this chapter seem likely to continue interacting in a way that affects the land market. Farmland values will probably continue to be influenced by government programs and policies. However, this influence may be increasingly exerted through land-use regulations, property taxes, and environmental regulations, rather than through price and income programs. Changes in the average value of farm real estate in the United States may be viewed as associated with broad factors reflecting the population’s need and ability to buy food, fiber, and space. This changing demand interacts with a relatively inelastic supply of land. Although these conditions affect the prices of farmland, buyers and sellers make their decisions in local markets where a unique set of factors, each of differing relative importance, influences land values.

References Aines, R.O. “Farmland Valuation and Farm Programs.” Journal of Farm Economics 46 (1964): 1,2531,259. Alston, J.M. “An Analysis of Growth of U.S. Farmland Prices, 1962-82.” American Journal of Agricultural Economics 68 (1986): 1-9. Atkinson, J.H. “Land Prices—How Much Higher?” Journal of American Farm Managers and Rural Appraisers 38 (1974): 13-16. Burt, O.R. “Econometric Modeling of the Capitalization Formula for Farmland Prices.” American Journal of Agricultural Economics 68 (1986): 10-26. Castle, E.N., and I. Hoch. “Farm Real Estate Price Components, 1920-78.” American Journal of Agricultural Economics 64 (1982): 8-18.

20

Chryst, W.E. “Land Values and Agricultural Income: A Paradox?” Journal of Farm Economics 47 (1962): 1,265-1,273. Espel, T.K., and L.J. Robison. A Conversation Between Buyers and Sellers of Land or A Market Equilibrium Approach for Estimating Land Values. Agricultural Economics Report No. 403. Department of Agricultural Economics, Michigan State University, December 1981. Feldstein, Martin. “Inflation Portfolio Choice, and the Prices of Land and Corporate Stock.” American Journal of Agricultural Economics 62 (1980): 910-916. Francl, T. “District Farmland Values Soar.” Business Conditions. Federal Reserve Bank of Chicago, April 1974, pp. 8-12. Hauschen, L.D., and W. McD. Herr. “A New Look at the Relationship Between Farm Real Estate Prices and Expected Returns to Land.” Paper presented at the American Agricultural Economics Association meeting, Urbana, Illinois, 1980. Herdt, R.W., and W.W. Cochrane. “Farmland Prices and Technological Advances.” Journal of Farm Economics 48 (1966): 234-263. Herr, W. McD. “The Influence of Farm Mortgage Loan Terms on Farm Real Estate Values.” Paper presented at the Southern Agricultural Economics Association meeting, New Orleans, 1975. Melichar, Emanual. “Capital Gains versus Current Income in the Farming Sector.” American Journal of Agricultural Economics 61 (1979): 1,085-1,092. Pasour, E.C., Jr. “Real Property Taxes and Farm Real Estate Values: Incidence and Implications.” American Journal of Agricultural Economics 55 (1973): 549-556. Plattner, R.H. “What Fewer People Will Mean for Real Estate.” The Appraisal Journal 42 (1974): 602607. Reinsel, R.D. “The Aggregate Real Estate Market.” Ph.D. thesis, Michigan State University, 1973. Reinsel, R.D. “Effect of Seller Financing on Land Prices.” Agricultural Finance Review. U.S. Department of Agriculture, ERS. Vol. 33 (1972): 32-35. Reinsel, R.D., and R.D. Krenz. “Capitalization of Farm Program Benefits into Land Values.” U.S. Department of Agriculture, ERS, 506, 1972. Schultz, C.L. The Distribution of Farm Subsidies: Who Gets the Benefits? Washington, D.C.: The Brookings Institution, 1971. U.S. Department of Agriculture. “Farm Real Estate Market Developments.” ERS, CD-86, August 1981. Van Vuuren, W. “Agricultural Land Prices and Returns in an Advanced and Urban Industrial Economy.” Ph.D. thesis, University of California at Berkeley, 1968.

4

Trends in Returns to Farm Real Estate John T. Scott, Jr. University of Illinois at Urbana-Champaign

Farm real estate values are a function of, and a response to, income attributable to the land factor, at least in the long run. This relationship is inherent in the capitalization approach to value. The simple capitalization formula, V = I / r, assumes that “I” is the annual net income expected from the land and that “r,” the capitalization rate, is the rate of return investors are willing to accept. Thus, if a tract of land will produce a net income of $80 per acre for the owner and if the owner is willing to accept a 5 percent return, the owner can pay $1,600 an acre for the property (80 ÷ .05 = $1,600). In the formula, “I” and “r” are independent variables. It is not always clear that “r” is an independent variable. Buyer behavior suggests that in some cases, the price may have been determined by an ability to pay, and “r” was viewed as a result, rather than as a factor determining value. In other cases, there were marked differences in how “I” was defined and determined. When an appraiser reviews rate of return derived from the sale price and the estimated income from comparable sales, the rate of return generally varies significantly. Thus, not all investors expect the same return, nor do they view the same property as equal in risk or with equal expectations about the eventual earnings or future value of similar properties. Economists still argue about how to treat income taxes in the capitalization formula, and whether the cap rate should have a defined relationship with the current rate or the “real” rate of interest. An elaboration of the perpetuity formula above results in:

which allows for variation in income among the holding periods and indicates that no one investor holds any property into perpetuity. It must be sold or evaluated finally in the investor’s estate. The subscript on the rate of return indicates that the rate of return expected may vary. A formulation for income taxes clearly adds to the variation and complexity because of changing tax legislation and the variation in how taxes affect individuals. If erosion and fertility are managed, most people consider land to be a permanent resource; so the perpetuity formula for land capitalization is generally acceptable for our purposes.

Residual Income In theory, the return to land is residual, that is, the income remaining after paying all other factors of production at returns that will hold them in the specified use. In practice, the theory holds only in the aggregate and over time. Individual parcels may rent for more than economic residual if a farmer is willing to subsidize the rent. The subsidization may come from less than economic rent on other parcels farmed or from the return of owned parcels or outside income. Farmers subsidize to gain control of more land or to force nearby competitors out of business with the anticipation of reducing future rent or income rising to cover the rent. The maximum net income that can accrue to a parcel of land is determined by the principle of diminishing returns. Under this principle, employing additional units of factors other than land per unit of land will yield an increasing residual (net) income to land, until maximum income per additional unit of investment (point D, Figure 1) is reached. Diminishing returns set in until the last unit of input yields only enough income

21

to pay for that unit with no additional return to land (points A and B, Figure 1). Under this condition, total net income to land is maximized. The cost for each additional input unit (OC, Figure 1) is assumed to remain constant because the supply is large in relation to the quantity required by the individual farm firm. The residual returns to land in Figure 1 would be represented by the total area above the cost line (CEF) and under the production curves (GE and HF). In practice, points E and F (or A and B) are hard to determine. Some farmers will stop adding inputs before reaching the point where MC = MR, thus sacrificing some income but reducing their risk of losses. Figure 1 shows how commodity prices affect the residual return to an acre of land. This occurred from 1972 through 1975. Farm incomes went up, inputs continued to rise, and the agricultural industry sought to produce more in response to the increased demand for farm products. Returns to land began to shrink after the very high levels reached in 1980. The returns to land in Figure 1 are clearly a residual—or what remains of gross farm income after paying all nonland costs, including risk-bearing and management. Farm

owner-operators may estimate a return on owned land this way. However, when determining what they can pay for an additional 80 acres, they may use different nonland costs. They may already have enough labor and equipment to farm the additional land and may limit the added nonland costs to direct inputs of seed, fertilizer, tractor fuel, and chemicals. This thinking pushed some farmers into high-priced land purchases and financial difficulty. The residual return a farmer attributes to land would be higher than that actually earned because it is partly the product of a temporary, subjective situation. Residual returns must be approached with caution. Costs imputed to the operator’s labor and management must be high enough to be attractive and keep a required number of qualified operators employed in farming. Any error or bias in estimating gross returns or input costs will be carried into the residual returns to land. The technique is useful, but it lacks objectivity. On the other hand, there is nothing illegitimate about capitalizing nonland returns into higher land values, as long as the user is aware of what this action involves.

Figure 1 Residual returns to an acre of land at two product price levels.

MVP under two price levels

$

Output

H G

Returns to land

E

C

F

Returns to labor, capital, and management

O

D Units of labor and capital input

22

A

B

MC per input unit

Figure 2 Productivity basis for differential rent shares to the landowner on Corn Belt farms rented on shared leases.

Dollars per tillable acre

Gross value of crop production

1/2

Landlord’s share

2/5 1/3

1/2

100

90

Tenant’s share

80

3/5

70

2/3

60

50

40

Index of soil productivity

Rental Income Illinois and most parts of the Corn Belt have a well-developed rental market for farmland. The rental price of land is usually a 1/2, 2/5, or 1/3 share of the crop (see Figure2). This is a gross return, from which net return must be calculated. Net return can be calculated by budgeting typical cost-sharing arrangements or by taking the landlord’s costs from financial data on rented land. The landlord’s nonland costs are a matter of record, reflecting the terms of the lease and landlord shares in operating costs (such as seed, fertilizer, and pesticides) and in certain harvesting and building costs. Net rents derived from these data are residuals in some sense, but they avoid most of the costimputation problems involved in working with total farm data, where the analyst must place a value on the operator’s labor and management as well as a rental value on interest returns on the value of machinery. Illinois has the highest tenancy rate in the Corn Belt (55 to 58 percent of all farmland on an acre basis); this includes farmers who rent all the land they farm and part-owner farmers who own and rent. Also, the largest number of farm financial records are for rented land. Therefore, we shall draw heavily on this information. Table 1 contains 27

years of net rents received by crop-share landlords by soil categories. Unfortunately, these data are not completely comparable.1 However, deviations due to changes in how the soil-rating categories were determined are probably not significant. The data in Table 1 show that rates earned tend to be low, relative to mortgage interest rates, except during periods of rapidly rising net returns when there was an obvious lag in capitalizing the higher returns into land prices. Also, the 1974-75 land market was unusually responsive to changes in net income, which seems to contradict the first observation. Despite a three- or fourfold increase in net rents, land values rose gradually, while net returns were generally stable. The rates earned worked downward slowly, indicating a long-term strength in the land market and response to income stability on grain farms. In addition, nonfarm demand for farmland was expanding. Urban expansion, interstate highway construction, airports, reservoirs, and other requirements for land created additional purchasing power for farmland. Southern Illinois farmland showed greater variability in net returns from year to year than did central and northern Illinois land. This led to slightly higher rates of return—a rational market response to greater risk and

23

uncertainty. Thus, capitalization rates appear to be the lowest when net returns to land are stable. In western and southern Illinois, and in Iowa and Indiana, net returns tend to be capitalized into land values at rates 1 to 1.5 points higher than in the cash grain area of east-central Illinois. These higher rates reflect a greater variation in net rents from year to year, making these farms a more risky investment. The trend toward lower rates of return observed in the 1960s characterized the farmland market for the following 5 to 10 years for several reasons, including higher land

Table 1 Net rent for landowners on crop-share leases, farm business farm management records.

prices and stabilization of higher farm income. High demand for land at some price will probably continue because land will be used (1) for enlarging farms, (2) as an investment by farmers, (3) for nonagricultural uses, and (4) as an inflation hedge (despite recent experience). As shown in Figure 3, debt service for the full price of land was higher than net rent from 1960 to 1972. Farmers have always been willing to buy land when the rent would make the payment on a loan for 50 percent or more of the total land price. When rents rose rapidly from 1972 through 1975, land

Central and Northern Illinoisa Net per acre

Land values

1960 61 62 63 64 65 66 67 68 69

21 23 26 29 27 30 33 29 24 30

$522 507 522 551 573 647 724 770 801 840

4.0% 4.5 5.0 5.3 4.7 4.6 4.6 3.8 3.0 3.6

4.41% 4.35 4.33 4.26 4.40 4.49 5.13 5.51 6.18 7.03

.91 1.03 1.15 1.24 1.07 1.02 0.89 0.68 0.48 0.51

9 14 11 17 11 16 16 18 16 16

$242 242 248 263 273 294 329 350 364 382

3.7 5.6 4.4 6.5 4.0 5.4 4.9 5.1 4.4 4.2

0.84 1.29 1.02 1.53 0.91 1.20 0.96 0.93 0.71 0.60

1970 71 72 73 74 75 76 77 78 79

33 34 48 85 107 80 103 89 95 110

787 794 853 949 1,272 1,713 2,131 3,197 2,839 3,400

4.2 4.3 5.6 8.9 8.4 4.7 4.8 3.1 3.0 3.2

8.04 7.39 7.24 7.67 9.01 9.17 8.46 8.12 8.90 9.92

0.52 0.58 0.77 1.16 0.93 0.51 0.56 0.38 0.33 0.32

14 23 24 49 62 42 55 45 45 78

374 378 406 452 606 732 910 1,263 1,366 1,509

3.7 6.1 5.9 10.8 10.2 5.7 6.0 3.6 3.3 5.2

0.46 0.83 0.81 1.41 1.13 0.62 0.71 0.44 0.37 0.52

1980 81 82 83 84 85 86 87

108 93 90 102 91 110 79 90

3,500 3,605 3,280 3,215 2,630 2,200 1,885 1,746

3.1 2.6 2.7 3.2 3.5 5.0 2.6 5.2

12.68 15.65 14.95 13.50 12.50 12.50 12.00 11.50

0.24 0.16 0.18 0.23 0.28 0.40 0.21 0.45

86 76 76 64 52 54 51 57

1,720 1,817 1,669 1,492 1,467 1,069 928 1,135

5.0 4.2 4.6 4.3 3.5 5.0 5.5 5.0

0.39 0.27 0.31 0.31 0.28 0.40 0.46 0.43

a

Rate earned

Mortgage rate

Southern Illinoisb Opportunity Net cost ratioc per acre

Soil productivity rating range from 86 to 100, with 100 the best. Soil productivity rating range from 36 to 85. c Rate earned divided by the mortgage rate for Central and Northern Illinois. b

24

Land values

Rate Opportunity earned cost ratio

540

Debt service required to amortize the full land price per acre Net rent per acre

Dollars per acre

450

360

270

180

90

0 1960

1965

1970

values rapidly caught up, and speculation, along with expectations of inflation, caused land prices to continue to rise through 1980. The debt service required for full amortization rose even faster than land prices because of the increasing mortgage rates. By 1980, the rate of return on farmland reached the lowest point in modern times, relative to opportunity returns in alternative investments. This is shown under “Opportunity Cost Ratio” in Table 1. Land prices began to fall for lack of investors interested in an asset producing such a low relative return. From 1980 through 1986, land prices and alternative rates of return declined until the relationship between the rate of return on land and the rate of return on bonds reversed on some selected properties. The low point on land values occurred in mid-October 1986; and land prices have since rebounded and are still improving. A clear change in the market since 1985 is the decline in use of borrowed funds to buy land. In absolute terms, we would expect this to happen with lower land price levels, but leverage has sharply decreased. A high proportion of farms recently purchased has had no mortgage financing. Thus, farmland is now in stronger financial hands than it has been for about 10 years. Rent declined relative to the mortgage payments on loans based on the value of assets rather than cash flow. From 1978 to 1980, this decline spelled financial disaster in the farm sector. Most farm investors will keep leverage low,

1975

1980

at least until they perceive a clear signal to the contrary. The relationship between Illinois land values and net returns has been experienced nationally. Although the realized net incomes of farm operators are not synonymous with net rent of landlords, correlations allow similar inferences when net rent data is lacking. For example, rates of return in the mid1970s were not as high, relative to income and land values, as they were in the period following World War II.

1985

Figure 3 Net return on land with basic soil productivity rating 85 –100, all tillable, and amortization of full land price.

Land Prices in Commodity Terms Farmland values may be analyzed in deflated terms, or in dollars of constant purchasing power. Any price or value series can be deflated by dividing by an appropriate index of the general price level. In agriculture, dividing land values by major commodity prices gives an expression in physical quantities equivalent in value to an acre of land. Table 2 shows bushels of corn and liveweight of hogs equal to the prevailing value of an acre of land. From 1968 to 1972, Illinois farmland was priced high relative to the price of corn—an average 753 bushels of corn were required to equal the per acre price of land, compared with 619 bushels for 1960-1975. Values of farmland and buildings are as of March 1, and the average of the prices received by Illinois farmers for

25

Table 2 Estimated values of highquality Central Illinois land compared with commodity prices.

Year

26

Land Land value valueper per acre acre

Average Averageprices prices rec’d received bybyIllinois Illinoisfarmers farmers for for Corn Corn

Hogs Hogs

Land Land value valuesinin bushelsof bushels bushel s ofcorn corn

Land Land value valuesinin 100 100 lb. lb liveweight liveweight of of hogs hogs

1940 45

$160 232

$0.37 1.04

$ 5.15 14.15

432 223

31.10 16.40

1950 55

336 456

1.18 1.42

16.00 16.60

285 321

21.00 27.50

1960 61 62 63 64 65 66 67 68 69

552 507 522 551 573 647 724 770 801 840

1.04 1.02 1.05 1.04 1.19 1.10 1.22 1.30 1.06 1.08

12.60 17.20 16.55 15.10 14.20 15.95 27.35 18.95 18.50 19.40

531 497 549 530 521 544 593 592 756 778

43.80 32.11 31.54 36.49 40.35 40.50 26.33 42.33 43.29 43.29

1970 71 72 73 74 75 76 77 78 79

787 794 853 949 1,272 1,713 2,131 2,839 3,197 3,400

1.16 1.48 1.09 1.42 2.80 3.00 2.51 2.07 2.13 2.44

27.05 17.25 24.30 32.35 40.10 38.25 47.85 41.85 49.80 37.51

678 536 783 668 454 571 842 1,371 1,501 1,393

29.09 46.02 35.10 29.23 31.72 44.78 44.53 67.83 64.19 90.64

1980 81 82 83 84 85 86 87 88

3,500 3,605 3,280 3,215 2,630 2,200 1,885 1,746 1,885

2.80 2.98 2.43 3.06 3.12 2.54 2.01 1.61 2.32

38.80 40.79 57.43 42.70 47.25 43.91 49.10 51.70 43.52

1,250 1,210 1,350 1,051 843 866 938 1,084 812

92.10 88.38 57.11 75.29 55.66 50.10 38.39 33.77 43.31

corn are for January and February of the same year. Thus, land is valued in light of current commodity prices. Hog prices may move in the opposite direction to land or corn. Hence, land prices in terms of 100pound units of live hogs are more erratic than corn prices, and mostly opposite. Why was land, priced in bushels of corn, so high in 1968-1972, relative to the early 1960s and the two decades prior to 1960? The relative costs of producing a bushel of

corn have declined since 1940. Improved varieties, more fertilizer, better weed control, and more timely planting all contributed to higher yields during 1968-1972, and hence to lower prices. Thus, as land became more productive, more bushels were required to equal the value of land. As technology increases, technical inputs become a substitute for land. In addition, the market’s tendency to respond to stable prices with lower capitalization rates also contributed to higher

land prices in terms of bushels of corn for equivalent value. Relating gross product in price and physical terms to the price of land has many shortcomings. It is a gross measure rather than a net, and often costs and returns for farmers move in opposite directions in inflationary and deflationary periods, givin wider fluctuation in the net. Thus, gross physical relationships, while they are indicative, can be misleading.

What Does the Future Hold? Is there an equilibrium commodity price that will prevail? How might this be related to land? Our volatile economy requires caution in predicting either equilibrium prices or price trends in commodities or land values. Over the past 10 years, national policies on fiscal actions, the trade balances, and exchange rates are very important exogenous variables, which are little influenced by agriculture and difficult for agricultural economists to predict. The physical relationships of producing ever-higher yields are always in doubt. It is a biological process that, logically, does have a limit; but with new technological developments such as gene splicing and hormone controls, we do not see yields leveling off or declining in the near future. Past trends indicate that it would be foolhardy, at least in the short run, to bet against the ingenuity of man to develop new technologies to increase output. The demand side is also important. Production of food is rising faster in the lessdeveloped countries than population. Domestic demand, except for some shifts among products such as from red meats to poultry and fish, will not likely grow faster than population. Demand factors, along with increasing production, make it very unlikely that land values will increase more than the general rate of inflation, as they did from 1972 through 1980. It is more likely that land prices will increase, but at average rates somewhat less than the general rate of infla-

tion. This will be particularly true after the current price rebound has run its course. The elasticity of food production is said to be determined by the elasticity of the stomach. Judging by the number of diet ads and exhortations about what and how much to eat, the stomach’s limits of elasticity have been reached in this country.

Note 1.

A new set of soil-productivity ratings was adopted in 1971. The classification of the farms was also changed to obtain approximately the same groupings as were included before 1971 in the soil-rating categories of 100-76, 75-56, 55-36, and 35-5. Changes due to new soil-productivity categories have not been measured. In 1971, these categories were 100-90, 89-75, 74-60, and under 60; but they were modified in 1972 to the categories now in use, which are 100-93, 92-80, 79-65, and under 65. Since 1971 the data has been for soils rated 86 to 100 and soils rated 36 to 55.

27

28

5

Financing Land: Methods and Characteristics Thomas L. Frey, University of Illinois at UrbanaChampaign; and Arnold W. Oltmans, North Carolina State University

The balance sheet of the U.S. farming sector as of January 1, 1989, showed real estate assets worth $592.2 billion—69 percent of total assets in the farming sector. Substantial amounts of this farm real estate change hands each year. Buyers have three basic alternatives when purchasing farm real estate: 1. Paying in cash, using their own funds. (With the large sum of money usually involved, this is seldom possible.) 2. Using a down payment as part of the purchase price, with the balance financed by a creditor and secured by a real estate mortgage from the buyer. 3. Contracting with the seller, where the down payment and installment terms are specified by the contract. A mortgage is a legal document, transferring a conditional interest in property to the lender as security for the payment of a debt. The mortgage may cover only land being purchased or additional land to allow the lender to make a larger loan. For example, a farmer purchasing 80 acres with an additional 80 acres free and clear may offer a mortgage on 160 acres, which may be enough for a nearly 100 percent loan on the 80 acres being purchased. Where the mortgage agreement is with a third-party lender, the seller receives the full purchase price and in turn transfers title to the purchaser. Where the mortgage is with the seller, the seller receives a substantial down payment, then gives the buyer a deed and accepts a purchase-money mortgage to secure the balance. A land contract, as opposed to a mortgage, is only a conditional sale of property. The seller transfers possesMany of the terms and concepts used in real estate financing are defined and discussed at the end of this chapter.

sion rights to the buyer at the time of the down payment, but does not transfer title and ownership rights until terms of the contract agreement are met. The seller retains legal title to secure the payment of remaining installments and to assure compliance with the terms of the contract. The down payment in a mortgage or contract land purchase is usually cash that the buyer has available. A buyer may borrow part of the down payment from a short-term lender, such as a commercial bank or farm credit association. The buyer usually offers non-real estate property as security, and the loan for the down payment is usually for a relatively short period of time—possibly one to five years. A borrower must have strong repayment ability to borrow money for a down payment.

Importance of Debt in Transferring Farm Real Estate Over the past 40 years, more and more farm real estate transfers have involved debt financing. The percentage of farm real estate transfers involving debt ranged from 44 percent in 1945 to 66 percent in 1989 (Table 1). This percentage peaked in 1980 and has decreased every year since, reaching its lowest level in nearly 30 years in 1989. This trend in the use of real estate debt closely follows land values, which peaked in 198182, declined steadily in the years following, and have begun to increase again in the late 1980s. The farm depression of the mid1980s and the financial difficulties that resulted have also contributed to the lower level of debt involved in real estate transfers.

29

Table 1 Debt related to purchase price and credit-financed farmland transfers, 48 states, selected years, 1945-1989.

Ratio of debt to purchase price 1945 1950 1955 1960 1965 1970 1975 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

Proportion of farm real estate transfers on which debt was incurred

57% 57 59 65 72 73 76 78 78 77 76 77 76 77 77 72 73

44% 58 64 67 73 78 88 91 90 89 84 84 82 76 73 70 66

Source: Agricultural Resources: Agricultural Land Values and Markets. U.S. Department of Agriculture, Economic Research Service, AR-6, July 1987, and AR-14, June 1989.

Table 2 Selected average interest rates on farm real estate loans, 1960-1988.

Federal Federal Land Banks Land Banks 1960 1965 1970 1975 1980 1981 1982 1983 1984 1985 1986 1987 1988

6.0 5.6 8.7 8.7 10.4 11.3 12.3 11.6 11.8 12.2 11.6 11.1 10.1

insurance LifeLife insurance companies companies

Farmers Farmers Home Home Administration Administration

5.0 5.5 9.3 10.0 13.2 15.4 15.5 12.5 13.5 11.7 11.9 10.7 NA

5.0 5.0 5.0 5.0 11.0 13.0 12.9 10.8 10.8 10.8 9.1 8.8 9.5

Source: Agricultural Finance: Outlook and Situation Report. U.S. Department of Agriculture, Economic Research Service, AFO-32, February 1989.

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Interest Rates on Farm Real Estate Loans In the past 25 years, interest rates charged on farm real estate loans by institutional lenders have changed substantially (Table 2). The stable 5 to 6 percent rates of the 1960s increased to higher but relatively stable rates of the 1970s. With the high inflation years of the late 1970s and early 1980s, and a change in U.S. monetary policy, interest rates skyrocketed in the 1980s. Interest rates at Federal Land Banks (FLBs) and insurance company rates peaked in 1982, with yearly average rates of 12.3 and 15.5 percent, respectively. Even the usually low-cost government funds from Farmers Home Administration (FmHA) were at a high of 13 percent in 1981. Interest rates on farm real estate loans have steadily declined since 1982, parallel to interest rates in the general economy. The high and volatile rates of the early 1980s may be an abnormality not likely to be repeated, or this volatility may be an indication of future interest rate behavior.

Sources of Credit for Financing Land Purchases Volume of Debt Outstanding During the 20-year period ending January 1, 1989, farm real estate debt outstanding expanded greatly, reaching more than $l04 billion in 1984 at its peak (Table 3). In addition to individuals and others, four major institutional lenders provide this debt capital for agriculture. In the late 1960s and early 1970s, the FLBs and life insurance companies had nearly equal shares of the total debt. Table 3, however, reveals a dramatic shift. Insurance companies steadily reduced their proportion of the debt outstanding—from 19.7 percent in 1970 to 11.6 percent in 1989. Simultaneously, the FLBs increased their share from 22.9 percent in 1970 to 36.0 percent in 1989. Since 1980, the FLBs have been the largest holder of farm real estate debt. Historically, individuals and others, primarily through land contracts, were the largest holder of real estate debt, but their share declined from 37.5 percent in 1970 to 22.1 percent in 1989. (Note, however, that the largest holder of total real estate debt outstanding is not always the largest source of new credit for farmland transfers, as illustrated in the next section.) The other

major shift in real estate debt outstanding that has taken place is the increasing share held by commercial banks, up to 18.5 percent in 1989. Activity by the FmHA in financing farm real estate also increased as a percentage of total debt during the financially troubled years of the 1980s.

New Money Loaned Table 3 indicates that the percentage of debt outstanding held by each supplier does not vary widely from year to year. There is, however, a substantial year-to-year variation in new money loaned (Table 4). When interest rates are rising, as in 1980-82, insurance companies and commercial banks have investment opportunities that return more than farm loans. During such periods, sellers provide more financing to promote sales. In 1982, sellers financed 41 percent of the credit-financed transfers of farmland, and the FLB portion went up to 37 percent as FLB interest rates remained lower compared with those of banks and life insurance companies. These lower FLB interest rates were primarily the result of average cost pricing policy that did not fully reflect rising interest rates. As interest rates began to fall after 1982, seller share dropped and commercial bank lending activity increased. The dramatic shifts in 1987 in FLB and bank lending were probably due to the relatively high FLB interest rates. These higher FLB rates were caused by financial stress in the FLB system and average cost pricing, which did not immediately reflect declining rates. Commercial banks, with more flexibility to change interest rates, apparently attracted borrowers from the FLB, emerging in 1988 as the most important source of new credit for farm real estate transfers in for the first time in recent history. Seller financing, a dominant source of new credit in the 1970s, steadily declined in importance after 1982. Financing by the FmHA remained fairly constant through the 1980s but has recently been reduced substantially. The major real estate sources for financing farms have unique characteristics along with some common features. Potential borrowers need to understand each major lender before evaluating local alternatives. The following section describes each lender generally. Details that may govern operations at a specific time in a particular location should be investigated case by case. 31

Proportion of total loans held Total farm real estate debt1 millions 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

Federal Land Banks

Life insurance companies

Commercial banks

Farmers Home Admin.

Individuals and others

- - - - - - - - - - - - - - - - - - - - - - - percent - - - - - - - - - - - - - - - - - - - - - - -

29,183 30,346 32,192 35,094 39,527 44,705 45,331 50,497 58,445 66,707 79,704 89,647 98,682 102,505 104,806 103,691 97,690 88,472 80,786 76,696

22.9 23.6 24.5 25.7 27.5 30.1 32.2 33.4 33.6 34.0 34.3 37.0 40.8 42.9 43.0 43.7 42.2 9.3 37.0 36.0

19.7 18.5 17.3 16.3 15.3 14.3 13.7 13.6 13.9 14.5 14.1 13.4 12.3 11.6 11.3 11.2 11.3 11.5 11.4 11.6

12.1 12.4 13.1 13.4 13.5 13.1 12.4 12.0 12.0 11.6 9.8 8.7 7.7 7.4 8.1 9.0 10.7 13.2 16.5 18.5

7.8 8.0 8.1 8.0 7.6 7.2 6.7 6.6 6.2 5.7 7.8 8.3 8.2 8.2 8.3 8.9 9.8 0.7 11.4 11.8

37.5 37.5 37.0 36.6 36.1 35.3 35.0 34.4 34.3 34.2 34.0 32.6 31.0 29.9 29.3 27.2 26.0 25.3 23.7 22.1

Source: Agricultural Finance: Outlook and Situation Report. U.S. Department of Agriculture, Economic Research Service, AFO-32, February 1989. 1 Excluding operator household real estate debt. January 1 of each year.

Table 3 (above) Estimated total U.S. farm real estate debt outstanding, by lender, January 1, 19701989. Table 4 (right) Credit-financed transfers of farmland, percentage of credit volume extended, by type of lender, United States, for years ending March 1, 1980-1985, and February 1, 1986-1989.

Sellers

Commercial banks

Insurance companies

Federal Land Banks

Others (including FmHA)

- - - - - - - - - - - percent of annual new credit extended - - - - - - - - - 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

38 40 41 33 28 33 32 30 24 24

4 4 4 9 11 13 21 28 32 34

7 4 4 4 7 3 5 7 5 7

34 37 37 37 36 31 25 19 25 29

17 15 14 16 18 20 17 16 14 6

Source: Agricultural Resources: Agricultural Land Values and Markets, U.S. Department of Agriculture, Economic Research Service, AR-14, June 1989.

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Farm Mortgage Lenders Farm Credit System The Farm Credit Banks (FCBKs) are part of the Farm Credit System (FCS), a nationwide farm cooperative making short-term and long-term loans—including first-mortgage farm and rural residence loans for up to 40 years. The entities making long-term loans have historically been known as Federal Land Banks (FLBs) and Federal Land Bank Associations (FLBAs). These were established by an act of Congress in 1916 and operated as part of the Cooperative Farm Credit System as defined in the Farm Credit Act of 1971 and amendments of 1980, 1985, and 1986. The 1987 Agricultural Credit Act provided for significant restructuring of the FCS that combined Federal Land Banks and Federal Intermediate Credit Banks at a district level into Farm Credit Banks. The local lending associations extending long-term farm real estate loans to farmers operate under various names depending on their location, charter, and merger status. Common names include Agricultural Credit Associations, Federal Land Credit Associations, and Federal Land Bank Associations. Increasingly, mergers at the local level are combining the traditional Federal Land Bank Associations and Production Credit Associations (short- and intermediate-term lender) into a single Farm Credit Association that makes both long-term and short-term farm loans. The government provided partial capitalization of the FCS in early years, but by 1968 government capital had been totally replaced with farm borrower capital, to make FCS a nongovernment, borrower-owned cooperative. The 1987 Agricultural Credit Act provided up to $4 billion of government assistance to FCS institutions on a long-term loan relationship, with the government sharing part of the interest cost on the loan. Regulation of the FCS is by the Farm Credit Administration (FCA), an independent agency within the government. The FCS was operating with twelve Farm Credit Districts as the 1990s began, but the 1987 legislation encouraged mergers that could reduce that number to as few as six. Whatever the structure evolves to, local farmers will continue to be served by a local farm credit association making the long-term, first-mortgage real estate loans. If the farm credit association covers a large geographic

area, farmers are served by a local farm credit service center. Farm credit associations are owned exclusively by their borrowers, who purchase stock and become an owner as a condition of borrowing. The 1987 legislation dramatically lowered the dollar amount of stock ownership by allowing associations to require stock ownership as low as 2 percent of the loan up to a maximum of $1,000 stock. Capitalization of the FCS after 1987 will rely more on retained earnings and less on farmer-owned stock. Each local farm credit association is controlled by a board of directors, composed of elected stockholders, plus one outside director selected by the other directors. Each voting stockholder has one vote, regardless of the amount of stock owned. The board employs a chief executive officer to manage the association. The Farm Credit Act of 1971 defined the basic maximum real estate loan limit as 85 percent of the appraised market value of the security for the loan. Appraised value tends toward market value in general. But in times of extreme changes in land values, farm credit appraisals tend to vary from selling prices. Appraisals may also vary among geographical areas over time. Loans may be made for any agricultural purpose and for other credit needs of the applicant, as long as the borrower can offer a first mortgage on real estate for security. Farmers, ranchers, rural residents, and farm-related businesses are potentially eligible borrowers, subject to requirements spelled out by the farm credit acts. Repayment plans are flexible to accommodate the anticipated cash flows of borrowers. While loans may extend to 40 years, the FCS system still offers complete repayment privileges at all times with no prepayment penalties. Loan funds come primarily from the sale of Federal Farm Credit Banks Consolidated, Systemwide-Bonds, and Discount Notes in the national money market. In this way, the system links its borrowers with investors. The investing public has been willing to purchase FCS bonds at rates only slightly higher than rates on government securities of comparable maturities. Operating margins are added to the cost of funds to determine lending rates. Variable interest rates predominated throughout the FCS from the early 1970s through the 1980s. However, as the 1990s

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began, the FCS was developing products to offer borrowers fixed interest rate alternatives.

Life Insurance Companies

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These large corporations are organized under state laws, primarily to provide life insurance. Life insurance companies are of two types—stock and mutual. Stock companies sell insurance to make profits for their stockholders. Mutual companies are organized to benefit policyholders through either low premiums or high dividends on premiums. In either case, there is little difference in the principles that guide their investment of funds. Investment funds available to life insurance companies come primarily from premiums paid by policyholders, but also from accumulations of pension plans and investment income earned. Investment objectives of life insurance companies are generally long-range plans guided by a quest for high return, low risk, and liquidity. Certain real estate mortgages, government securities, and corporate stocks and bonds meet these objectives well. Farm mortgages have typically attracted a small percentage of their total available investment dollars. Life insurance companies are attracted to low-risk, high-quality farmland, where they concentrate on larger loans to be more efficient in the loan-making process. Note some major differences between the FCS and insurance companies. Federal Land Banks and some farm credit associations are federally chartered and exempt from federal, state, municipal, and local taxation on income earned. As a result, they are required to make farm loans available across the United States. An insurance company is not exempt from taxation and has no obligation to make any farm loans. Farm loans are extended only when an insurance company believes it can benefit. Most insurance company farm loans are concentrated in five companies. Commitments by individual companies vary over time. Overall, 3 percent or less of the life insurance industry’s total investment portfolio is in farm loans. The life insurance companies that are serious farm mortgage lenders typically operate with full-time, salaried representatives who handle farm loans. Territories per per-son range from a few counties to several states. These farm loan agents are quickly

available to borrowers and potential borrowers by telephone and through local bankers, realtors, mortgage companies, or attorneys, who act as correspondents in originating business. An insurance company may buy an existing loan—for example, a commercial bank may set up a loan and process it, with a prior arrangement for an insurance company to take it over; or a bank or other institution services a loan originally made by a company, providing a local contact. Interest rates and loan terms vary over time, as returns and conditions of alternative investments change. During periods of tight money with correspondingly high interest rates, substantial shifts away from farm loans have occurred. As conditions change, so do allocations to farm loans. But loan-volume statistics show insurance companies have steadily diminished their share of the market. In the tight money periods of the late 1960s and 1970s, some insurance companies closed their farm loan departments. The financial market conditions of the early 1980s caused many companies to reduce significantly or even suspend their farm loan activity. But by the mid-1980s, there was some resurgence of farm loan activity by life insurance companies. In the past, insurance companies have primarily offered fixed interest rates. Fixed rates, combined with the increased financial volatility of recent years, have caused insurance companies to shift from 20- to 25-year loans to 10- to 15-year loans. To keep annual loan payments reasonable, loan terms often include balloon payments (an amortized payment schedule based on 30 years, for example, with a large balloon payment due at maturity). Interest rate adjustments at regular intervals (for example, five years) are also common. Insurance companies, like many lenders, are exploring alternative loan policies to reduce the risk associated with long-term, fixed rate lending. The amounts loaned per acre by insurance companies are generally competitive with the FCS and other lenders. Prior to 1971, the amount loaned often exceeded what the Federal Land Bank would loan. But this competitive advantage disappeared with the Farm Credit Act of 1971, which increased the FLB loan limit from 65 percent to 85 percent of the appraised value. Insurance companies have played a key role for many years in financing U.S. farmland. Their decreasing role as a farm

Sources of Funds

Uses of Funds

Capital and surplus

Cash and reserves

BANK

Deposits Borrowed funds and participations

mortgage lender is viewed with concern. Agriculture needs competitive alternatives in the farm mortgage field to assure ample funds for farm loans. The emerging secondary market for farm real estate loans (see commercial bank section) will increase competition in farm mortgages and may offer insurance companies a new way to participate in the market—especially as poolers of such loans.

Commercial Banks A bank is a for-profit corporation chartered by either the federal government or the state in which it operates. Stockholders invest money to capitalize the bank and elect a board of directors to hire management and establish operating policy. A bank profits by serving the community as a financial intermediary. Its major obligation is to the depositors, who make demand deposits (checking accounts) and time deposits (savings accounts). The bank must be able to honor deposit withdrawals whenever requested, but yet must put deposit funds to work earning income. Otherwise, the bank could not cover operating costs, pay interest to savers, and earn a profit for the stockholders. To understand the role of a bank in farm mortgage lending, consider the broad perspective of the bank as a financial intermediary. The diagram above shows the major categories for sources and uses of funds. The bank acts as intermediary between savers and users. Most local banks adapt to serve community needs, but the portion of total deposits committed to loans varies significantly. While banks differ on maxi-

Investment securities (government securities, municipal bonds, agency securities, etc.) Loans (personal and installment, commercial non-ag, farm non-real estate, farm mortgage)

mum acceptable loan-to-deposit ratios, that level has risen to about 70 percent. Each bank determines how much cash and liquid reserve it needs to meet deposit withdrawal requests. The results determine how aggressively loans will be made and vary significantly from bank to bank. Bank policy is determined by judgments about risks, returns, effort, knowledge about various uses of bank funds, and basic philosophic attitudes. Once a bank determines a desired total loan volume, it establishes preferred loan types—real estate versus non-real estate, farm versus nonfarm commercial, business loans versus personal and installment-type loans. Again, serving community needs is a prime concern, within liquidity, risk, and return guidelines. Real estate loans commit bank funds for a number of years, while deposit commitments are short-term. This explains why banks typically are not a major source of farm real estate loans. Table 3 shows a nearly constant proportion of outstanding farm real estate debt to banks, from 1970 to 1986. Note, however, that in the late 1980s banks showed a substantially increased share of the total farm real estate loans outstanding. Loan limit per borrower can be a concern to farmers dealing with banks. For an individual, nationally chartered banks are usually limited to lending 15 percent of the sum of the bank’s unimpaired capital and unimpaired surplus. State laws governing individual loan limits vary among state-chartered banks. Whenever loan limits are restrictive for a given borrower, the bank usually prefers to finance the operating loan and have the real estate financed elsewhere.

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A new opportunity for commercial banks came with the 1987 Farm Credit Act that established the Federal Agricultural Mortgage Corporation (FAMC). Better known as Farmer Mac, FAMC aims to assist in developing a secondary market for agricultural real estate loans by providing federally backed guarantees on securities that either represent interests in pools of agricultural mortgage loans or are collateralized by the pools. The opportunity for commercial banks is to operate as an originator and servicer of such loans without having to keep these long-term, fixed-rate loans in their own loan portfolio. When a bank does make a farm real estate loan and keeps it in the portfolio, the term is usually 15 years or less. An amortization plan may be for 20 to 25 years with balloon payments at loan maturity. Bank closing costs for such loans are often less than required by other real estate mortgage lenders. Since a bank typically has a close and ongoing relationship with its clients, it can often tailor loan arrangements to fit the borrower. The secondary market for farm loans will further enhance the ability of commercial banks to meet the needs of local borrowers.

The FmHA The Farmers Home Administration (FmHA) is a government lending agency operated within the U.S. Department of Agriculture. The FmHA exists to supplement credit from the private sector in rural areas. The lending authority of the FmHA, as defined by the Rural Development Act of 1972 and subsequent “adjustment acts,” goes beyond the farm sector. More than one-half of the FmHA’s outstanding loans are in the rural development programs of rural housing, community development, and rural business and industry. FmHA loan activity in the farm sector extends to farm ownership, farm operating, emergency disaster, economic emergency, and soil and water conservation. The remainder of this section focuses on the farm ownership loans still available through the FmHA. Total loans outstanding in the farm ownership category increased from $2.9 billion in 1976 to $7 billion in 1989. These loans, limited to borrowers unable to obtain sufficient credit elsewhere at reasonable rates and terms, can be used to buy farmland, make 36

improvements, or refinance existing debt. Some nonfarm enterprises to help supplement farm income, along with forestry development and facilities to produce fish, may also be financed through farm ownership loans. These loans may come directly from FmHA funds (referred to as insured or direct loans) or from commercial sources, with the FmHA providing a guarantee against losses. In the direct loan program, the FmHA may provide all of the funds or participate with other lenders or sellers. In such loan participation, which can finance up to 100 percent of the appraised value, FmHA funds are secured by a second mortgage. Any direct loan may not exceed 40 years and is subject to a maximum limit. The limit was $200,000 in 1990, but it changes as farm credit needs and government policy change. Interest rates on direct loans are based on the cost of government funds (see Table 2). Lower rates are available to some limitedresource borrowers until such borrowers have sufficient repayment capacity to pay current rates. Direct loan borrowers are expected to refinance the loans as soon as their financial positions qualify them for commercial credit. This “graduation policy” has been emphasized more strongly in recent years. Funds for direct loans come from two sources—revolving loan funds and congressional appropriations. Revolving loan funds are provided by the Federal Financing Bank, which sells certificates of beneficial ownership to the U.S. Treasury. Farmers Home Administration repayments on these funds go into a revolving loan fund for future loan commitments. Direct congressional appropriations make up any shortages in FmHA repayments and provide the agency’s annual budget. Congress sets limits each year on these direct appropriations and on the amount of funds that the FmHA can obtain through the Federal Financing Bank, referred to as its direct lending authority. In addition to these direct farm loans, the FmHA can make up to a 90 percent guarantee on loans made by other lenders. Repayment terms and interest rates are set by agreement of the borrower and lender, but are subject to a maximum loan amount ($300,000 in 1990) set by the FmHA. The guarantee loan program grew modestly in relation to the direct loan program until

1986. The Food Security Act of 1985 called for a phased shift from direct to guaranteed FmHA loans beginning in 1986. For the 1990 fiscal year, 85 percent of the allocation for farm ownership lending was for guaranteeing loans, with 15 percent for direct loans. Other policy changes considered recently point to decreasing farm ownership loan activity while increasing the emphasis on operating loan assistance. Such policy, if implemented, would also change the form of farm ownership assistance described above. The FmHA serves all 50 states through “state” and “county” offices. Some state offices serve more than one state, and county offices frequently serve more than one county. A county supervisor and a staff of assistants are the farmer’s contact. The state director appoints a three-member committee to administer each county program, along with the county supervisor. At least two of the committee members must be local farmers. Administrative duties of the county committee include helping determine the eligibility of applicants and making recommendations concerning certain actions on loan approval and loan servicing.

Individuals Sellers continue to play an important role in financing real estate, especially in the initial transfer of land. Individual sellers provide financing through installment land contracts or mortgages. Sellers taking back mortgages typically take a down payment plus a first mortgage like other real estate lenders, but may accept a second mortgage. A second mortgage is more often used to finance the down payment or supplement the credit provided by a commercial lender, who would generally insist on being a first mortgage holder. While mortgage financing is important, more often sellers use an installment land contract to finance real estate purchases.

The Installment Land Contract The installment land contract, or “contract for a deed,” is a conditional sale of real property. The buyer makes principal and interest payments over time to the seller, with the seller retaining title to the property until the specified payments have been made. The buyer’s right to the deed is conditional on making the necessary payments. Even though the seller retains the legal title, the

buyer takes possession and becomes the “beneficial owner” upon making the down payment and signing the contract. Drafting the contract is crucial for both parties, since this contract will govern their relationship for years to come. Each party should be represented by an attorney. Items to be agreed upon are price, interest rate, down payment, repayment schedule, and prepayment privileges. The contract could include many other provisions to clarify the rights and duties of the parties. These provisions are included to avoid future disagreement or misunderstanding. In general, legal provisions can be included to clarify the following issues: 1. Procedure and cost of the transfer 2. Dates of performance and possession 3. Payment procedure and schedule 4. Maintenance and alteration of the property 5. Assignment of interest (to third parties) 6. Conversion of the contract into a deed and mortgage 7. Ownership revenues and expenses (for example, rent and taxes) 8. Violation of contract provisions A third party, such as a bank or a law firm, often acts as an escrow agent for the buyer and the seller. The seller signs the deed and delivers it to the escrow agent. The escrow agent collects payments from the buyer and holds the deed until the contract provisions have been fulfilled. If the seller dies before the contract is completed, the right to receive the remaining installments passes to the seller’s estate as personal property in most states (or if a will exists, to whoever is named). The buyer is unaffected. If the buyer dies before completing the contract, the property generally passes as real estate to the heirs, who are obligated to fulfill the contract. There are legal ways to designate that the debt obligation is to pass to the estate and not to the party or parties receiving the land; this must be spelled out in a will. At any rate, someone will carry out terms of the contract with the seller on behalf of the buyer, just as if the buyer were alive.

Advantages to the Seller There are six major advantages to the seller of an installment land contract.

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1. Flexibility allows negotiation on those points that are important to both parties. 2. Significant savings on federal income tax are available to the seller. In an installment sale, the seller is liable for income tax only on the amount actually received each year. The seller pays taxes on the percentage of each installment payment that is a capital gain in the year of receipt, rather than the entire gain being taxed in the year of sale. Thus, it is possible for the seller to spread out the tax on capital gains over time at reduced marginal tax rates. An outright sale would tax the entire gain in the year of sale at, most likely, a higher marginal tax rate. The actual amount of potential tax savings is highly variable among sellers, depending on the initial marginal tax rate of the seller, the size of the capital gain, and the discount rate used to value the tax savings. Prior to January 1, 1987, another tax advantage existed. This resulted from the ability, via a land contract, to convert ordinary income into capital gains income, which was taxed at a much lower rate. The method was to trade a higher selling price (in effect higher capital gains) for a lower contractual interest payment (lower ordinary income) while keeping total payments the same. However, income tax law revisions taking effect in 1987 specify that capital gains will be taxed at ordinary tax rates, eliminating this income tax savings. 3. The installment land contract can be used in estate planning if the sale is to a family member. First, a low down payment can be used to help a family member make the purchase. Second, all or part of each installment payment can be returned as a gift within the guidelines for federal gift tax exemption. If started early enough, significant lifetime transfers can be made tax-free. Since the contract price is fixed, later increases in the price of land will not increase the size of the estate. Anyone seeking to exploit this advantage of the installment land contract should consult a tax specialist. Certain IRS regulations, such as minimum interest rates and bona fide arm’s length transactions, must be satisfied. 4. The installment payments can be arranged to provide attractive annuity payments as retirement income for older land owners. 5. Sellers retain an investment in a business with which they are familiar and interested.

6. A “good” contract containing favorable terms for buyers will make the property more attractive. The cost of these terms may be more than offset by a higher selling price, made possible because the farm will appear to be “affordable” to more buyers. Increased competition among buyers could raise the price. A buyer might also be willing to pay more for a farm when the terms make it easier to meet the payments.

Disadvantages to the Seller 1. When a small down payment is used to initiate the contract, the seller has a higher risk because of the low equity position of the buyer. This risk is less important in times of rapidly rising land prices; but with falling prices, such risk could be a major concern. In severe market declines, even a large down payment may not eliminate the risk of loss in the value of the seller’s investment. The seller bears the risk that the buyer may damage the property and not pay the taxes. 2. Older people who retire on the installment payments from contract sales may be faced with the inflationary problems of living on a fixed income. What looks good at the time of the contract sale may not be adequate 10 or 15 years later. 3. Lack of liquidity of the contract may cause problems, especially when emergency funds are needed. Sellers may find it more difficult to borrow against or sell their interest in a contract than to borrow against or sell their interest in a mortgage. Such borrowing or selling of interest could come at possibly heavy discounts in value since the seller’s interest is being held in escrow. In certain cases, not having the entire selling price available for reinvestment may also be a disadvantage.

Advantages to the Buyer 1. The ability to negotiate the interest rate and payment terms is important to the buyer. A land contract might enable buyers to purchase land and obtain the financing when they would be unable to do so with a direct sale requiring financing with a commercial lender. If buyers can negotiate favorable terms that make installment payments nearly equal to cash rent, not totally uncommon in the contract sales market, purchasing becomes an attractive alternative to renting. 2. Depending on the terms of the contract, the buyer can often achieve a lower net

cost, in present value terms, through a contract purchase compared to a purchase made with conventional financing. This is due primarily to lower interest rates of most contract sales, often 1 to 2 percent below commercial loan rates. 3. With a low down payment, the buyer has a low equity investment but still receives the security of ownership and the benefits of land inflation. The risks of land value decline and default on the contract, on the other hand, are usually less severe than with a mortgage default. 4. Tax savings are also possible for the buyer through the trade-off between interest and sale price. The buyer’s case is the reverse of the seller’s. The buyer would prefer a high-interest, low-sales-price combination because interest is fully deductible as a current expense. Reducing the sale price increases the buyer’s potential long-term capital gain, which will be taxed in the future. However, these tax payments have a low present value since they are not likely to occur until well into the future.

Disadvantages to the Buyer 1. The buyer should be aware of the consequences of default. Default occurs when a buyer substantially fails to comply with the terms of the contract. When default occurs, a forfeiture provision allows the seller to declare the contract null and void. This remedy allows the seller to extinguish the buyer’s interest in the property by a “summary nonjudicial procedure.” It also allows the seller to keep all payments received and to repossess the property, including all per-manent improvements made by the buyer. Because legal requirements for using the forfeiture remedy vary from state to state, legal counseling is especially important. Because of the inequity often involved, courts of equity abhor forfeitures. So upon proper application, a court may disallow forfeiture and order foreclosure by judicial sale instead. However, there is no general rule for describing the instances in which forfeiture will be disallowed. The attitude of the courts and the many statutory procedural requirements restrict the use of forfeiture as a remedy to default. Yet, forfeiture is usually the first remedy a seller attempts to use against a defaulting buyer. The seller could respond to default by invoking an acceleration provision, in which

the seller may declare the full amount of the contract due and payable in case the buyer defaults. In short, the installment land contract may contain a number of provisions crucial to the buyer in case of default. Therefore, all such items should be understood completely before signing a contract. 2. Installment land contracts often cover 10 to 15 years, while FCS and FmHA mortgages may run from 30 to 40 years. The shorter repayment period on contract purchases could lead to cash flow problems, especially if the buyer experiences several years of low net income.

Summary Comments on Land Contracts The buyer and seller must consider many factors before electing to use an installment land contract. Despite their complexity, contracts have become a popular means of financing land purchases. Sound legal counsel enables buyers and sellers to use the installment land contract to adapt to individual circumstances.

References Barry, Peter J. “Agricultural Lending by Commercial Banks.” Agricultural Finance Review, vol. 41, July 1981. Comptroller of the Currency, Administrator of National Banks. Comptroller’s Manual for National Banks. Washington, D.C., August 1984. Farm Credit Act of 1971, Public Law 92-181, Sec. 2001. Freshwater, David. “The Farm Credit System: Troubled Past, Uncertain Futures.” Agricultural Outlook, May 1986. Hopkin, John A., Peter J. Barry, and C.B. Baker. Financial Management in Agriculture. 4th edition. Danville, Ill.: The Interstate Printers and Publishers, 1988. Krausz, N.G.P. “Installment Land Contracts for Farmland.” Cooperative Extension Service Circular 823. Urbana, Ill.: University of Illinois, College of Agriculture, 1976. Lee, Warren F., Michael D. Boehlje, Aaron G. Nelson, and William G. Murray. Agricultural Finance. 8th edition. Ames, Ia.: The Iowa State University Press, 1988. Lins, David A. “Life Insurance Company Lending to Agriculture.” Agricultural Finance Review, vol. 41, July 1981. Norris, Kim. “The Farmers Home Administration: Where Is It Headed?” Economic Review. Federal Reserve Bank of Kansas City, November 1986. Uchtmann, Donald, J.W. Loomey, N.G.P. Krausz, and H.W. Hannah. Agricultural Law: Principles and Cases. New York: McGraw-Hill Inc., 1981. U.S. Department of Agriculture. Farm Ownership Loans. Farmers Home Administration Program Aid No. 62, July 1984.

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Terms and Characteristics Associated with Real Estate Financing Commonly Used Terms and Concepts Term of loan. This refers to the time until the last payment on the loan contract is due. Method of payment. Loans are usually repaid by annual, semi-annual, or monthly payments. The choice is referred to as the method of payment. Balloon payments. To reduce the amount of each regular payment, a substantial “balloon” payment may remain on the final due date of the loan. For example, a farmer might start with a 20-year loan for $100,000. The last payment could be $30,000. Prepayment privileges. One of the most important considerations in a real estate loan agreement is whether prepaying the loan amount, in full or in part, is permitted. Some contracts explicitly prohibit paying off the contract ahead of time. Others establish prepayment penalties or impose prepayment limits during the life of the loan agreement, often becoming more lenient in the later years. Some have no prepayment penalty. It is very important for a prospective buyer to fully understand and evaluate the allowable prepayment privileges of any mortgage or installment land contract—before signing it.

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Open-end note. The note and real estate mortgage is greater than the amount actually borrowed. The borrower has approval to use the additional amount (up to the agreed-upon level) without another application and without redoing the mortgage. For example, assume a farmer borrows $100,000 to buy a tract of land. The lender is willing to loan $150,000. The farmer plans to erect some hog confinement buildings within two years at a cost of about $30,000. The open-end note makes the additional $30,000 available when the farmer needs it, with little additional cost or paperwork and with no interest on the money until it is used.

Credit life insurance. Many real estate lenders offer borrowers term life insurance that declines along with the principal amount outstanding on the loan. The life insurance is usually on the principal borrower, in the event of whose death, the insurance proceeds pay off the loan. Prospective borrowers should view their life insurance program as a whole and not make a decision based on a mortgage. Borrowers should compare the rates and terms on the credit life insurance offered by the lender with other alternatives. Life insurance offered by lenders is almost always term life insurance, which is for protection only and does not build a cash value. Interest rate. This is one of the key considerations on a real estate loan contract. Over the life of the loan, even a slight difference in the interest rate means a substantial difference in total interest paid. Interest rates may be fixed or variable. A fixed rate does not change over the life of the loan. A variable interest rate fluctuates, with the original loan agreement specifying precisely how the rate will be determined from time to time. In a period of general inflation, lenders become increasingly unwilling to commit loan funds for a long period at a fixed rate. If a lender does not offer a variable rate, some attempt may be made to offer loans of shorter duration. The “remaining balance method” is commonly used in calculating interest on real estate loans. Under that method, interest is paid only on the outstanding principal.

Repayment Plans Nearly all real estate loans are amortized, in which regular payments gradually reduce the outstanding loan balance. Two alternative amortization schedules are frequently used, the level-payment plan and the decreasing-payment plan. A third plan, delayed payment, is an adaptation of the other two. Level-payment plan. Payments are equal throughout the life of the loan. Each payment is first applied to interest due, with the remainder reducing the principal. In each successive payment,

an increasing portion of the payment goes toward principal as the amount required for interest decreases. The last payment exactly pays off the remaining principal on the due date of the loan. Decreasing-payment plan. The payment amount declines with each payment, which applies an equal amount to principal throughout the life of the loan, plus an amount sufficient to pay the interest each time. Since the loan balance is reduced with each payment, less interest is required in the following period, and the payments become successively smaller. Payments in the decreasing-payment plan are greater in the early years but smaller in later years, compared with payments in the levelpayment plan. The higher cash flow required to make payments in the early years of the loan is a disadvantage of the decreasing-payment plan. On the other hand, total interest paid during the life of the loan is less because the principal is paid back sooner. Either plan can be used to set up a balloon payment. Delayed-payment plan. This approach delays principal payments. All payments on principal are usually deferred for the first few years, but the interest is paid in each payment period. Later, the principal payments start at some given level, perhaps increasing to higher levels later in the loan. For example, if principal payments were deferred for five years on a loan for $100,000 covering 25 years, the principal payments might be a level $5,000 per year for the last 20 years of the loan. Such plans are especially attractive to farmers just getting started. Recent innovations. In recent years, various innovative repayment plans have been introduced, or at least proposed. No one scheme has yet gathered widespread and continued use, however. Some of these are the graduated payments mortgage, the shared equity mortgage, and the payment-in-kind mortgage. The introduction and use of these innovations often coincide with the degree of change in land values.

Title Considerations There are frustrations associated with purchasing and financing real estate. A lawyer’s advice helps minimize frustrations and can determine the status of the title. The following provides an understanding of what the lawyer and the loan representative can do. Deeds. On a typical real estate transfer between a willing buyer and a willing seller, the seller conveys title to the property by executing a “deed” and delivering it to the buyer. A warranty deed is used most often. In a warranty deed, the seller (called the “grantor”) makes certain warranties about the condition of the title being transferred. A quit claim deed simply transfers whatever right, title, and interest the grantor has in the property. No warranties are made about the title. If purchase is made from an institution holding the property in trust, as trustee for one or more individuals, title to the property would likely be conveyed by a trustee’s deed. The process is complicated further if the transfer is by judicial sale, will, or some other method. Once the buyer gets a deed, it must be recorded immediately in the recorder’s office of the county in which the land is located. Evidence of good title. Getting or having title to real estate is no guarantee that the title is clear or unencumbered. There are two alternatives to assure good title. 1. Abstract of Title. This is a chronological listing of all recorded transactions or events that have affected the title to the land. An up-to-date abstract shows the current status of the title. However, the abstract must be evaluated by an attorney for an opinion as to whether the title is good. Lending institutions will also have the abstract evaluated before they close the loan. 2. Title Insurance. For a one-time fee, title insurance companies will guarantee good title to property. Title insurance has become fairly widespread in recent years, but may still not be available in all counties. 41

42

6

Land Sale Methods Donald L. Uchtmann University of Illinois at Urbana-Champaign

A buyer and a seller can be brought together to complete a sale of farmland in several ways. “Sale” is defined as the voluntary transfer of land between buyer and seller for a reasonable consideration. The four most common methods of land sale are by private treaty, through a broker, by auction, and by sealed bid. These methods vary in their application to transfers of farmland, legal characteristics, and methods of determining the selling price. Nevertheless, the four methods also have some similarities. Private sales and brokerage sales appear to be the most popular methods of land sale, although methods vary by region. Survey results published in Farm and Land Realtor for 1973 indicate that private sales of farmland accounted for approximately 24 percent of the total farm sales in Illinois; brokerage sales, for some 58 percent; auction sales, for about 15 percent; and sealed bid sales and other methods, approximately 3 percent. A breakdown by region within Illinois showed that brokers accounted for at least half of the farm sales in all regions—northern, central, and southern; direct private sales were more common in southern Illinois (33 percent) than in northern or central Illinois (19 percent and 24 percent, respectively); and the proportion of public auctions was considerably greater in central Illinois (22 percent) than in northern or southern Illinois (8 percent and 12 percent, respectively).

Private Agreement Perhaps the simplest method of selling land is by private agreement. This method involves a contract between two individuals, usually without a third party. The following example illustrates a sale by private agreement.

For many years, Farmer Jones had wanted to purchase his neighbor’s 160 acres. Jones owned about 500 acres and wanted the adjoining 160 acres. The neighbor was elderly, and none of his children had any interest in the land. In 1965, Jones made an offer for the 160 acres. The neighbor did not accept the offer. Several years later, the neighbor retired and offered to sell him the land. Jones still wanted the land, but thought that the asking price was too high. Reluctantly, Jones decided not to purchase the land. The following year, Jones changed his mind and offered his neighbor the asking price. The neighbor accepted, and an attorney prepared the deed. The sale by private agreement had been completed. Sale by private agreement is common when the seller wants land to go to a particular buyer, such as in a parent-to-child sale or when a buyer has interest in a certain parcel of land, for example, for development or addon farm acreage. In such situations, the potential buyer and seller are known; the only unanswered questions are whether there will be a sale and, if so, at what price per acre. The price-determining mechanism for the sale by private treaty is basically “take it or leave it,” with some room for bargaining. Buyer is pitted against seller, for they must decide on a mutually acceptable price. Most other methods of selling land pit buyers against other buyers in some form of competitive bidding. Since the market forces of a competitive bidding system are not available to help determine a market price in sales by private agreement, the buyer and seller must rely on other techniques to determine a “fair” selling price. An appraisal based on expected returns from the land and recent sales of similar properties is commonly used. 43

Through a Broker

44

Farmland can be sold through a licensed broker. This is common in the Midwest, as illustrated by the following example. Last September, Landlord Brown decided to sell his land. Brown and his family lived in town and had rented the property for the past 15 years. Landlord Brown designated Barbara Broker as “exclusive agent” to sell the property. Over the next few months, Barbara obtained offers from several persons. Brown rejected their offers, however, because they were all too low. Finally, Chris Purchaser made an offer to Barbara Broker that Brown accepted. A contract for the sale was drawn up by the attorneys, and in 30 days the property was deeded to Chris Purchaser. Selling farmland through a broker is an appropriate method when the present owner and the broker have good information about the value of the property and no deadline for the sale. Selling through a broker is similar to a sale by private agreement in that the sale price is determined by the buyer and seller rather than by competitive bidding, as is the case in a sale by auction or sealed bid. The broker method differs, however, in that numerous persons may look at the property and make offers, and the broker is available to advise the seller regarding price. In most states, real estate brokers and salespersons are licensed. Licensing helps ensure the competency of people in the real estate business. In Illinois, for example, every person applying for a real estate license must pass an examination that requires an understanding of deeds, mortgages, market prices, land contracts of sale, leases, and the legal obligation between principal and agent. The broker must act on the seller’s behalf in good faith, with reasonable care, and with full disclosure of all relevant information. Since the broker acts as the seller’s agent, and since many states require that such authority be in writing when land is concerned, the contract (listing) between seller and broker should always be in writing. A written contract is a good record of all aspects of the agreement, including type of listing. Real property can be listed with a broker as an open listing, exclusive-agency listing, exclusive right-to-sell listing, or multiple listing. In open listings, brokers will typically be paid a commission when they find a buyer who is ready, willing, and able to pay the

asking price. Sellers are allowed to use other brokers at the same time or to sell the property themselves. Because of broker resistance, open listings are now being used less and less. The exclusive-agency listing authorizes only one broker to sell the property. That broker may split the commission with another broker who actually sells the property. It is important to note, however, that the owner retains the right to sell the property. A sale by the owner avoids any responsibility to pay a commission to the exclusive broker. The exclusive-right-to-sell listing is generally sought by the broker. The exclusive broker is entitled to the commission if the property is sold by anyone (that broker, another broker, or the owner) under the terms and within the time period specified by the listing. The multiple listing is a pooling of exclusive-agency listings or exclusive-right-tosell listings. Multiple listing services are usually operated by real estate boards, subject to prior agreement among participating brokers. That agreement describes how the commission will be divided between the listing broker and the person who finds a buyer, if that occurs. Real estate brokers earn their livelihoods by commissions. For farm sales, commission rates are usually from 3 to 6 percent of the selling price, depending on the size of the tract, improvements, and other circumstances. To earn the commission, it is generally sufficient for the broker to find a potential buyer who is ready, willing, and able to purchase the property according to the terms specified in the original brokerage agreement and within the time period covered by the listing. As long as these conditions are met, the broker is generally entitled to the commission, even if the seller refuses to sell.

Sale by Auction By definition, an auction is a public sale of property to the highest bidder. Auctions are familiar to most people because of the public notices of the sale. The following example illustrates a sale by auction. In January 1976, Farmer Smith was killed in an automobile accident. By the terms of Smith’s will, the executor was directed to sell the farmland at public auction and distribute the proceeds among Smith’s heirs.

The executor and an attorney contracted a reputable auctioneer and set a date. The auctioneer placed a notice of the auction in area newspapers and distributed leaflets. At the auction, bidding started at a minimum of $500 per acre, then jumped to $1,200 an acre, where the bidding stood until the auctioneer’s hammer fell. In the United States, the ascending bid auction is most often used. The Dutch auction, however, is a public offer of property in which the auctioneer starts the bidding at a price considerably higher than the reasonable value of the property, then offers to sell at successively lower bids until one prospective buyer accepts. In a Japanese auction, all bids are made simultaneously, and the highest bid wins. The Japanese system is used in the sale of fish, and bidding is by simultaneous hand signs. The system has some similarity to the American sealed-bid system, which will be discussed later. Whether the landowner should sell property at auction rather than by some other method depends on the circumstances. The auction seems appropriate when there is competition for the property, when the sale must be made by a certain date (such as a fixed date by which executors are to close an estate), or when the value of the land is not known. An auction is probably not appropriate when the landowner has an exaggerated view of the property’s value or when the owner is not committed to selling. In such situations, an auction would probably result in an aborted sale. The sale of farmland by auction may be accomplished with or without reserve. If the auction is with reserve, the seller has the right to “bid in” the property if dissatisfied with the highest bid, or establish a price below which the property is not to be sold. If the property is sold without reserve, the seller must sell the property to the highest bidder, no matter the price. Although it may be safer to sell property with reserve, an auction without reserve may attract more bidders and result in a higher sale price. Auctions are subject to state regulation. Many states require that auctioneers be licensed and post a bond. Other states, such as Illinois, allow the individual municipality to license auctioneers. In either case, the right of the state or the municipality to regulate auctions is based on the state’s inherent power to prevent fraud and abuse.

Several other principles of law have evolved regarding auctions. The courts have generally held, for example, that “puffers” will not be condoned. A puffer is a person employed by the seller to raise the price by making fictitious bids. The puffer and the seller agree that the puffer’s bid will not be binding. On the other hand, price-depressing activities by potential buyers are also illegal. In one case, the property of a deceased person was being sold at public auction. The son of the deceased man was hired by a private party to act as the private party’s agent. People did not want to bid against the son, who appeared to be buying back the family property. Because the private party who employed the son used this “chilling” tactic for his own gain, the court found that it was a case of restricting the bidding. The fees charged for auctioning real property are usually a percentage of the sale price. Improved property and unimproved property may be charged under different rates. The size of the tract is also an important consideration. The fee usually ranges from 3 to 6 percent. The auctioneer may have the power to complete the sale and bind the seller with the fall of the hammer. In that case, the auctioneer is also likely to be a licensed real estate broker, as would be required by many states. Or, the auctioneer may simply find the person willing to pay the highest price. Once the high bidder is found, that person and the seller’s attorney are brought together to complete the contract for sale. The auctioneer does not sell the property, but brings the highest bidder and the seller together. Since auctioneers do not actually sell the property, some courts have held that they need not be licensed as brokers, only as auctioneers.

Sealed Bid In February, Farmer White was killed in an accident. The White will appointed a local bank as the executor of White’s estate and directed the bank to sell the farm in a commercially reasonable manner, distributing the proceeds among White’s heirs. The trust department of the bank elected to sell the property through sealed bids. Invitations to bid were made in numerous nearby newspapers and in farm papers of wide circulation. The conditions stated that 45

(1) all bids must be postmarked by midnight, July 1; (2) the highest sealed bid above $1,200 per acre will be accepted; (3) bids will be opened at the bank on July 15 at 10 A.M.; and (4) all bidders are welcome to attend the opening of the bids. On July 15, seven bidders arrived at the bank at the appointed time. One by one the bids were opened and recorded. The bids ranged from $1,201 to 1,507 per acre. The farmland was sold for $1,507 per acre. With the sealed-bid method, potential buyers can bid only once and without knowledge of competitors’ bids. Thus, bidders are, for the most part, in an information vacuum. As a result, many prospective buyers do not like this method. In some local areas, a “hybrid” method of sealed bidding has developed. Initially, this method resembles the usual sealed-bid procedure. However, once the sealed bids are opened, the persons submitting bids are allowed to make oral bids as in an auction. In effect, this “hybrid” method is identical to the auction method except that a person must have submitted a sealed bid to bid at the auction.

Summary When selling farmland by auction and by sealed bid, numerous prospective buyers compete to determine the selling price. When selling through a broker or by private agreement, one buyer and one seller try to agree on price. From a legal standpoint, the methods vary. For example, both brokers and auctioneers generally are subject to regulation by the state. In addition, both may have certain duties of acting in good faith with the seller, acting with reasonable care on the seller’s behalf, and fully disclosing all relevant information. All four methods have a number of similarities. Most states require the actual contract for sale to be in writing and signed by both parties if that contract is to be enforceable in the courts against either party. Also, regardless of the method, the property must ultimately be deeded from the seller to the buyer in a manner employing all of the typical formalities—a writing delivered to the buyer containing the names of both parties, the signature of the seller, the words of transfer, and a legal description of the property. 46

References Cassady, Ralph, Jr. Auctions and Auctioneering (1967). Goldberg, Samuel A. Sales of Real Property (1971). Farm and Land Realtor. Vol. 25, No. 5 (May 1973). Illinois Revised Statutes, Ch. 24, Sec. 11- 42-1. Illinois Revised Statutes, Ch. 59, Sec. 2. Illinois Revised Statutes, Ch. 114 1/ 2, Secs. 101 et seq.

7

Estimating the Value of Farm Real Estate Donald G. Smith University of Illinois at Urbana-Champaign

An appraisal is a measure of market value. A common definition of market value is the highest price, estimated in money, that the property would bring if sold in the open market, with a reasonable time allowed in which to find a buyer who has knowledge of all the uses and purposes to which the property is best adapted, and for which it is capable of being used. An appraisal is a written, verified estimate of market value. The appraiser is responsible for gathering all pertinent facts regarding the property to be appraised and all similar properties that have been sold. An appraiser must be informed of all factors contributing to market value and must work from the general to the specific by compiling all the relevant facts and presenting them in a logical manner. Making appraisals requires training, knowledge, and experience. This is a brief summary of some appraisal procedures. If an appraisal is needed, the author recommends retaining a professional rural appraiser. Lists of competent appraisers are available from agricultural economics departments of land grant universities or from the offices of appraisal societies.

The Appraisal Process and Procedures In professional rural appraisal, three approaches to value are considered and usually applied: 1. The market-data (or comparison) approach 2. The cost (or inventory) approach 3. The income-capitalization (or earnings) approach These approaches may vary in order, depending on the circumstances; however,

all approaches apply data derived from the market. The Market-Data Approach. This approach analyses and interprets circumstances surrounding sales of farmland in the community. Each property is compared with the subject property (the one being appraised). The sales are selected for comparison according to the highest and best use of the property. These sales should be compatible as well as comparable with the subject proerty. Five factors are considered: time of sale, size, location, land, and improvements. Since no two properties are alike, each factor on each sale is given a dollar value (usually per acre) in comparison with the subject property. These adjustments are then added to (if positive) or subtracted from (if negative) each sale to indicate a value of the subject property compared with the sale property. This concept of comparable sale is based on the economic principle of substitution, which states that no one will pay more for an item than for another item of equal utility. Time adjustments on comparable sales are usually based on indexes and the appraiser’s knowledge and experience. Index numbers of statewide farmland values may be found in various U.S. Department of Agriculture publications. These indexes should be supplemented and localized by applying the appraiser’s knowledge of the local area. Size adjustments are based on the assumption that smaller tracts are more attractive to more buyers than larger ones. Generally, small acreages have a higher price per acre than large ones. However, this adjustment should be used with discretion, since there is evidence that in some areas, size is not an overriding factor, or at least is not as important as it once was. 47

Location adjustments reflect differences in the demand for closeness to markets, allweather roads, schools, shopping areas, recreation sites, as well as environmental advantages or disadvantages. Land adjustments are based on soil productivity, drainage, the growing season, anticipated yields, and the unit’s shape, size, and ease of operation. Improvement adjustments reflect differences in quality and usefulness. These are measured by considering cost and depreciation for the sale property and for the subject property. Sales should be “arm’s-length,” recent, and as similar or comparable as possible to the subject property. They should reflect the market. The Cost Approach. The appraiser analyzes the components of the subject property and estimates market costs for replacement with property of like utility and value. Land is broken into market classes, with each class evaluated according to its cost in the market. Improvements are appraised on reconstruction cost new (RCN), less depreciation. Depreciation is defined as the loss in value from any cause—physical wear as well as functional and/or economic obsolescence. The Income-Capitalization Approach. The appraiser calculates the annual net income under typical use and management. Typical yields, prices, and expenses are used. The capitalization rate is derived from the market, using estimated or actual net returns from similar properties, expressed as a percentage of the current market value of those properties. The appraiser has an estimated or actual farm net return and the market value for each comparable sale. From these sales, the appraiser derives the “going” capitalization rate to be used in the income-capitalization approach for the appraisal. The final process is that of correlating the approaches, giving the greatest weight to the one that seems most applicable to the subject property. All approaches are useful and should supplement each other in estimating the final value.

48

Some appraisals may be more detailed than others. In a complete and thorough appraisal, the following format might be followed: 1. Appraisal certificate 2. Authorization, purpose, definitions, zoning, assumptions, and limiting conditions 3. Summary of appraisal 4. Legal description 5. Area description 6. Property plat 7. Narrative description of the subject property 8. Soils map for the subject property 9. Farmstead plat for the subject property 10. Photographs of the subject property 11. Inventory of resources for the subject property 12. Appraisal process and procedures 13. Market-data approach 14. Location and sales map 15. Photographs of comparable sales 16. Cost approach 17. Income-capitalization approach 18. Correlation of values 19. Appraiser’s qualifications 20. Addenda

Sources of Information To appraise a property and present a verified and written estimate of its value, the appraiser needs access to detailed information about the area, recent sales, and the subject property. Appraisers may have a personal appraisal library; but in a new area, organizations and individuals can be valuable resources. These include: 1. Service organizations a.

Universities and junior colleges

b.

Lending agencies: banks, the Farm Credit System, insurance companies

Appraisal Outline

c.

Grain elevators

Appraisals are used for different purposes. The appraiser should have a clear understanding of the appraisal assignment before starting. A written authorization from the client is desirable.

d.

Farm-building, equipment, and supply organizations

e.

Chambers of commerce

f.

County offices: recorder, assessor, treasurer, and zoning

g.

Soil Conservation Service (SCS)

An Illustration

h.

Agricultural Stabilization and Conservation Service (ASCS)

i.

Economic Research Service (U.S. Department of Agriculture)

j.

Regional planning commission

The following appraisal format illustrates the market-data, cost, and income-capitalization approaches, as well as the correlation of these approaches. After collecting the data and inspecting the properties (subject and sales), the appraiser analyzes the information and decides the value. The appraiser then proceeds with a written presentation. Example 1 is a narrative description of the subject property.

2. Service individuals a.

Cooperative Extension Service personnel

b.

Attorneys

c.

Real estate brokers

d.

Lenders

e.

Auctioneers

f.

Sales representatives

g.

Vocational agriculture teachers

h.

Professional farm managers

i.

Professional rural appraisers

Market-Data Approach

3. Local residents a.

Farm operator of the subject property

b.

Farm operators in the community

c.

Buyers and sellers in recent real estate transactions

We will assume an appraisal date of June 29, 1986. The appraiser first lists comparable sales in a format similar to Example 2. (Although one sale is used in this example, usually five or six comparable sales would be used, if available. The appraiser should consider, analyze, and weigh each sale with great care.) Next is the narrative description of comparable sales to the subject property. Sale No. 1 might be described to the client as in Example 3.

Example 1. Narrative Description Subject property. The subject property of 403 acres is 121/2 miles west of Springfield, 41/2 miles northwest of New Berlin, and 51/2 miles south and one mile west of Pleasant Plains on an oil and chips road. The farmstead is neat and well kept. The topography is level to medium rolling. There are 341 tillable acres, and the balance is in farmstead, permanent pasture, and roads; it is approximately 84.6 percent tillable. There are several waterways. The soils consist mainly of Tama silt loam and Ipava silt loam. Some Radford silt loam and Denny silt loam are in the low areas. The farm is in the New Berlin School District with bus service to school. It is in the New Berlin Fire District. There are two grain elevators at New Berlin and an elevator at Pleasant Plains. There is an adequate water supply with a six-inch drilled well. The building improvements are typical for the community and have a contributory value of $67 per acre. The farm is operated under a 50-50 crop share lease with pasture rental.

Example 2. Comparable Sales Sale no. and date

Grantor

Grantee

Type of sale

Type of deed

No. of acres

No. 1 (11-85)

Corrington Estate

Armstrong

Auction

Executor

240

Sale price per acre $1,825

49

Example 3. Description of Comparable Sales Sale No. 1. Corrington Estate to Armstrong. $1,825 per acre. I. Morgan County Deed Drawer 2, Card 2520, Doc. #196349 Consideration, $146,000 Stamps, $146.00 Legal Description: E1/2, SE1/4, Sec. 28, Twp. 16N, R8W of the 3rd P.M., AND II. Sangamon County Book 671, Pg. 619, Doc. #361248 Consideration, $292,000 Stamps, $292.00 Legal Description: SW1/4, Sec. 27, Twp. 16N, R8W of the 3rd P.M. The above described 240 acres are located 41/2 miles south and 31/2 miles west of Pleasant Plains and across the road from the subject farm. A minus time adjustment and a minus size adjustment were made. There was no location adjustment, since Sale No. 1 is in the same neighborhood on the same road as the subject farm.

Example 4. Adjustment Table Sale no. and date

No. of acres

Price per acre

No. 1 (11-85)

240

$1,825

Time −146

Size −40

Location

Land

—

−75

Improvements −35

Indicated value of subject property per acre: $1,529

Following the narrative description of the comparable sales is the adjustment table, showing comparisons between the subject farm and comparable sales. Again, Example 4 uses Sale No. 1. The comparison technique is illustrated in Example 5. The foregoing technique and presentation are followed on all the comparable sales. The indicated values of the subject property are then weighed to estimate its value. These are guides, and the most comparable should be used. For this illustration, the market value from the market-data approach is assumed to be $616,590, or $1,530 per acre, and the “going” capitalization rate is 5 percent. It is also desirable to include in the appraisal report a community map showing the locations of the subject property and comparable sales and photographs of the sales. 50

Example 5. Comparison

Example 6. Cost Approach

Time: There was an approximate 8 percent price decrease from July 1985 to June 29, 1986. This 8 percent decrease since the date of sale gives a per acre discount to the subject property of $146 per acre (8 percent × $1,825). Size: The value was adjusted $20 per acre for each 80-acre increase. The subject property is 163 acres larger than the sale, thus the $40 discount. Location: No adjustment was made for location, since the farms are in the same neighborhood across the road from each other. Land: Soils on the two farms are similar, but the sale has more tillable land (97 percent vs. 84.6 percent) and is shaped for greater ease of operation. The subject farm was discounted $75 per acre. Improvements: Improvements on Sale No. 1 were valued at $100 per acre. Improvements on the subject farm were valued at $67 per acre. The difference ($33) was rounded to $35, and the subject farm was discounted. To estimate the capitalization rate from Sale No. 1, we adjust the sale for time ($1,825 − $146 = $1,679), then calculate, if not available, the net income per acre. We will assume it is $85 per acre. The capitalization rate derived from Sale No. 1 would be 5 percent ($85 ÷ 1,679).

116 acres of best-quality tillable land @ $1,650/acre 232 acres of good-quality tillable land @ $1,500/acre 35 acres of medium-quality tillable land @ $1,350/acre 9 acres of farmstead @ $1,550/acre 11 acres of roads and ditches

$191,400 $348,000 $47,250 $13,950 0

403 acres, total land

$600,600

Contributory value of improvements

$26,950

Total value indicated by the cost approach ($1,500/acre)

land. Next, the contributory value of the buildings is added to the estimated land value to show the total value indicated by the cost approach. To illustrate, consider the subject farm. A natural classification of the farm by inspection and with information prepared by the U.S. Department of Agriculture Soil Conservation Service indicates for tillable land: 116 acres of best-quality land; 232 acres of good-quality land; 35 acres of medium-quality land; 9 acres of farmstead; and 11 acres of roads and ditches. The values of the various qualities of land were estimated from the comparable sales. These values are based on soil indexes and on the relative productivity of the soils. The roads and ditches make no contribution to income or to sale value. Example 6 indicates the estimated value of the property derived from the cost approach.

Income-Capitalization Approach Cost Approach This is an inventory of bare land values and the contributory value of improvements on the subject property. The quality and types of soil on the subject property are analyzed and classified. The classification might include the acres of tillable land of best, good, and medium quality; the acres of pasture or woods; the acres in farmstead; and the acres in roads and ditches. The different classifications are valued from the market and extended to give the dollar total for each classification. These are then added to show the estimated value for

Examples 7 through 9 show the method for working out the income-capitalization approach. In the process of selecting a rate at which earnings should be capitalized, the comparable sales are analyzed and compared according to the ratio of sales prices to net income. Other factors, including farm management experience, are also used in selecting the rate. An analysis of the sales indicated a capitalization rate of 5 percent. This rate is low, possibly because of the low variability in yields and net income from year to year in the area.

51

$627,550

Example 7. Crop Production Data Average yields for Sangamon County, Illinois, for the years 1982-1984, compared with the subject farm follow: Corn Soybeans Year

County average

Subject farm

County average

Subject farm

1984 1983 1982 3-year average

- - - - - - - - - - - - - - bushels per acre - - - - - - - - - - 135.9 138.5 38.8 44.2 90.7 125.0 33.2 36.5 146.9 140.0 45.3 46.4 124.5 134.5 39.1 42.4

A typical operator could be expected to produce 135 to 140 bushels of corn and 45 bushels of soybeans per acre.

Example 8. Calculation of Net Income

Crop Corn Soybeans Pasture Farmstead Roads and ditches Total

No. of acres

Yield/A (bu)

Total (bu)

171 170 42 9

140 45 -----

23,940 7,650 -----

11 403

-----

-----

Value

Total value

$ 2.00/bu 5.00/bu 12.00/A

$47,880 38,250 504

-----

-----

Owner’s percent

Owner’s income

50 50 100

$23,940 19,125 504

-----

----$43,569

Example 9. Calculation of Expenses Taxes, stabilized at

$ 4,800

Insurance ($1/100 on $26,950)

269

Maintenance on buildings (3 percent)

808

Maintenance on tile and waterways

450

Seed (341 acres × $8/acre × 50 percent)

1,364

Chemicals (341 acres × $9/acre × 50 percent)

1,534

Fertilizer (171 acres × $34/acre × 50 percent)

2,907

Storage & Drying (23,940 bu × $.15/bu × 50 percent)

1,795

Management (5 percent of owner’s gross income)

2,178

Owner’s estimated total expense Owner’s estimated net income (43,569 − 16,105) Capitalized at 5 percent Total value using the income-capitalization approach ($1,362.88/acre) 52

$ 16,105 27,464 549,280 $549,280

Correlation of Values The correlation-of-values approach is illustrated in Example 10. Based on a careful analysis of the above approaches to value, it is the appraiser’s opinion that the market-data approach most accurately represents market value as of June 29, 1985.

Closing Comments This chapter has summarized procedures for estimating the market value of real estate for appraisal purposes. If you need land appraised, you should retain a professional rural appraiser, who has the knowledge, experience, and expertise to give you a reliable estimate of the land’s market value.

References American Institute of Real Estate Appraisers. The Appraisal of Rural Property. Chicago, Ill.: The Institute, 1983. American Society of Farm Managers and Rural Appraisers. Professional Rural Appraisal Manual. 6th edition. Denver, Colo.: The Society, 1986. Murray, William G. Farm Appraisal and Valuation. 6th edition. Ames, Ia.: Iowa State University Press, 1983. Suter, Robert C. The Appraisal of Farm Real Estate. Danville, Ill.: The Interstate Press, 1974. U.S. Department of Agriculture, Economic Research Service. Situation and Outlook Report. Agricultural Resources: Agricultural Land Values and Markets. (Continuing annual publication)

Example 10. Format for Correlation of Values Market-data approach: 403 acres @ $1,530.00 = $616,590 Cost approach: 403 acres @ $1,556.08 = $627,100 Income-capitalization approach: 403 acres @ $1,362.98 = $549,280 Based on a careful analysis of the above approaches to value, it is the appaiser’s opinion that the market data approach most accurately represents market value as of June 29, 1985. Final valuation: 403 acres @ $ 1,530 = $616,590

Acknowledgment Many of the ideas and information in Chapters 7 and 8 are from schools, meetings, and appraisal discussions with colleagues in the appraisal profession—especially the American Society of Farm Managers and Rural Appraisers. This help and cooperation is gratefully recognized.

53

54

8

Buildings as Value Components Donald G. Smith University of Illinois at Urbana-Champaign

Buildings are part of a farm’s value and are usually appraised for contributory value. This process is presented in an appraisal under inventory of resources, along with soils, fences, tile, wells, and other improvements. Their contributory value is added to the value of the bare land in the cost-approach method of appraisal (see Chapter 7). Buildings must be appraised separately for the following reasons, among others: 1. Buildings may be sold separately from land 2. Land may be partitioned and sold 3. Insurance coverage 4. Tax purposes 5. Estimating the cost of depreciation and recapture 6. Rental 7. Comparison with buildings on other farms The appraiser should be well informed about building construction costs, forms of depreciation, trends in farm operation, and changing agricultural technology. On specialized buildings, the appraiser may need expert advice. Many sources of information listed in Chapter 7 can be helpful—particularly agricultural engineers, building suppliers, lumber suppliers, building contractors, other appraisers, appraisal companies, farm managers, and assessors.

Methods of Valuation Rural appraisers use three methods: square foot, quantity survey, and unit in place. The square-foot method is used most often and requires measuring the building and multiplying the resulting square footage by the construction cost per square foot.

The quantity-survey method involves adding the costs of all items, including material, labor, markups or discounts, and services performed. This method is sometimes used on specialty buildings. The unit-in-place method involves calculating the cost for each part of the building, such as the foundation, walls, roof, and permanently installed equipment. With each method, the appraiser must consider physical deterioration as well as economic and functional obsolescence. Economic obsolescence is the loss in value or desirability caused by economic factors external to the property, such as supply-demand relationships or farm enlargement resulting in surplus buildings. Functional obsolescence is the impairment of functional efficiency or capacity caused by such things as inadequacy, overcapacity, or obsolescence because of changes in farming or ranching practices affecting the use of the building.

Approaches to Value The three farm appraisal approaches may be used in building appraisal. The cost approach, as described in the methods of valuation, is the most commonly used in rural appraisal. The market-data approach is used by comparing the subject buildings with sales of similar buildings. The income-capitalization appraisal is made by capitalizing into value the net income stream generated by the building.

Building Appraisal: An Example To illustrate a typical farm building appraisal, consider the subject farm described in Chapter 7. 55

Narrative description of improvements. Since this farm is in a cash-grain area where country homes can be rented, the bulk of the contributory value of buildings comes from the house, grain, and machinery storage. Here is a narrative description of the subject farm:

tion shingle roof, frame construction, and concrete foundation. The cattle shed has a composition shingle roof and pole-frame construction. Both buildings are in poor condition and are functionally obsolete. The RCN on the barn is estimated at $5 per square foot; for the shed, $3 per square foot.

The house (building no. 1) is 37 by 29 feet (1,073 square feet). The house is an attractive and modern two-story frame unit with a composition shingle roof and a full basement. The first floor has a kitchen, living room, bedroom, and bath. There are two bedrooms and bath on the second floor. The house is heated with a propane, forced-air furnace. It is well landscaped and in excellent condition (except for a wet basement, which can be corrected). The reproduction cost new (RCN) is estimated at $30 per square foot, including the basement.

The storage shed (no. 7), 25 by 25 feet (625 square feet), has a composition shingle roof and frame construction, is on a concrete foundation in poor condition, and is functionally obsolete. No value was assigned to this building. The two grain bins (no. 8), 3,000 bushels each, are metal on concrete foundations. They are in fair condition, but functionally obsolete. The RCN is estimated at $1 per bushel. The corncrib (no. 9) holds 5,000 bushels, and the lean-to (no. 9a) is 20 by 40 feet (800 square feet). Both have a metal roof. The corncrib is frame on a concrete foundation, in poor condition, and functionally obsolete. The lean-to is a pole construction in fair condition. The RCN of the lean-to is estimated at $2 per square foot.

The double garage (no. 2) is 25 by 25 feet (625 square feet) and has a composition shingle roof, frame construction, and concrete foundation and is in excellent condition, but has some functional obsolescence. The garage is well built, with an estimated RCN of $6 per square foot. The smokehouse (no. 3) is 25 by 16 feet (400 square feet) with a composition shingle roof, frame construction, and concrete foundation. It is in good condition, but it is functionally obsolete. The estimated RCN is $3 per square foot. The machine shed (no. 4) is 40 by 60 feet (2,400 square feet), has a metal roof and pole construction, and is in good condition, but has some functional obsolescence. The RCN is estimated at $4 per square foot. The storage shed (no. 5) is 15 by 15 feet (225 square feet), with a composition shingle roof, frame construction, and a concrete foundation. The shed is well built and in excellent condition, but has limited storage. The estimated RCN is $3 per square foot.

56

The barn (no. 6) is 30 by 50 feet (1,500 square feet) with an attached cattle shed (no. 6a) 20 by 30 feet (600 square feet). The barn has a composi-

Improvement inventory. Present contributory values for the subject farm are shown in Example 1, based on the reproduction cost new, less physical depreciation, and less economic and/or functional obsolescence. The appraisal should include a farmstead plat, showing the location of buildings, and photographs of the buildings. Building appraisal can be complex. The appraiser should be up-to-date regarding factors affecting value of buildings and alert to changing technology.

References 1.

2.

3.

American Society of Farm Managers and Rural Appraisers. Professional Rural Appraisal Manual. 6th edition. Denver, Colo.: The Society, 1986. Murray, William G. Farm Appraisal and Valuation. 6th edition. Ames, Ia.: Iowa State University Press, 1983. Suter, Robert C. The Appraisal of Farm Real Estate. Danville, Ill.: The Interstate Press, 1974.

Example 1. Typical Farm Building Appraisal Building

Construction

Size

Reproduction cost

Percent good

Contributory value

1. House

Frame

37' × 29'

$32,190

55

$17,700

2. Double garage

Frame

25' × 25'

3,750

40

1,500

3. Smokehouse

Frame

25' × 16'

1,200

40

500

4. Machine shed

Pole

40' × 60'

9,600

45

4,300

5. Storage shed

Frame

15' × 15'

675

60

400

6. Barn

Frame

30' × 50'

7,500

10

750

6a. Attached cattle shed

Pole

20' × 30'

1,800

15

250

7. Storage shed

Frame

25' × 25'

2,500

0

0

8. Grain bins (2)

Metal

3,000 bu

6,000

15

900

9. Corncrib

Frame

5,000 bu

6,250

0

0

9a. Lean-to

Pole

20' × 40'

1,600

40

650

Total value ($66.87 per acre)

$26,950

57

58

9

Investment in Farm Real Estate J. H. Atkinson, Purdue University John E. Reynolds, University of Florida

Investors estimate answers to two questions before purchasing farmland: “What is the land worth?” and “How shall the purchase be financed—is cash flow sufficient to meet principal and interest payments?”

What Is Land Worth? The farmland market falls far short of the criteria for a perfect market. There is no widely accepted grading standard; therefore, the “product” is not homogeneous. Even where soils or productivity can be classified, buildings and other improvements remain a problem. Land is unique with regard to location. Value may be estimated relative to the distance of the tract from urban centers, but quantifying “adjoining farmer effects” seems almost impossible. In addition, market information is lacking. At best, market information consists of general information on average values and changes from one time period to another, usually over a fairly large geographic area. Buyers and sellers vary widely in their knowledge about “the market” and the factors that may affect land prices; and their level of knowledge is generally low, resulting in a high degree of uncertainty in the market. One result of this uncertainty is that instead of considering the “market price,” potential investors must either determine how close they can come to paying the asking price (which often is negotiable) or decide, in that unique situation, what the land is worth. Land value estimates are based on a simple theory: the present value of an asset is the sum of the discounted future net returns. Few buyers and sellers use this theory, since estimating future net returns is difficult and the discounting procedure is not widely understood.

Approaches to Estimating Land Value How can decisions about land purchases be made? The following approaches will be discussed: 1. Buy land if it will pay for itself. 2. Buy land if it is priced to yield an acceptable rate of return. 3. Capitalize the average expected net return to land and purchase at or below that price. 4. Use the “present value” concept, based on a definite planning horizon. The first two of these approaches are commonly used, and the third is fairly well understood. The fourth, although not widely used or understood, is likely to result in better decisions and can be understood and used by farmers and other investors.

Buy Land If It Will Pay for Itself Obviously, some restrictions must be placed on this statement. To the extent that the income-capitalization process works in pricing land, it is not possible for land to “pay for itself.” With 100 percent financing, the return to land pays the interest if the land is capitalized at that rate. Historically, however, land has been capitalized below the mortgage interest rate, thus compounding the difficulty of recovering capital from operating returns. Therefore, one of the first constraints placed on this rule must be the level of financing. For example, “Buy land if it will pay for itself with 20 percent down,” that is, if long-term mortgage payments can be covered by operating returns. Suppose land priced at $1,400 per acre yields a net return of $120 per acre. An 80 percent loan at 9 percent interest could be 59

60

paid off in about 20 years. Is this a “good” investment? Several problems are evident. What yield levels, product prices, and production costs were used? The $120 per acre net return could have been on excellent land with a high ASCS (Agricultural Stabilization and Conservation Service) corn acreage in a record-yield year. Both prices and costs should reflect expectations of the future—the period of time over which the loan will be repaid. Were fixed costs and family labor included? Labor and certain machinery costs are often fixed and thus not included in production costs associated with additional land. In other cases, additional machinery and labor will be required. Where these costs (or any part of them) are not included, more income is available for debt repayment; thus, a higher price can be justified for the land. This leads to the next difficulty. Is liquidity a potential problem? The individual’s management ability and treatment of fixed costs and operator or family labor will influence the prices paid for land. If fixed costs are not included in operating expenses, if the operator’s labor earnings are “plowed back into the land,” and if the value of above-average management is not counted as a cost, the operator may be willing to pay more than the market price. The question is: “If I had to sell this land in a year, would it bring as much as I can ‘afford’ to pay?” If not, liquidity may be a problem. To resolve the problem, determine if fixed costs have been included in cost-return calculations, representing a “profit” sufficient to offset the “excess price.” For example, the costs of machinery and labor may have been entered at $75 per acre. But if $50 of this represents fixed costs, in three years $150 could be recovered. Or, expectations of rising land values might offset the excess purchase price. An expected increase of 3.5 percent a year would mean an average annual gain of about $50 per year on $1,400 per acre land, or $150 over three years. Even though the land can be paid for, net worth (based on liquidation or actual values) may suffer. Given enough time, this condition might be overcome by increasing land values or accumulated “excess” earnings; however, the investor must consider a possible loss from forced liquidation during the interim. Will land prices change? Even if land is bought “at the market” and can carry itself, financial losses may occur if asset values

decline. Leveraging can result in large gains or losses of equity. Assume that $1,400 per acre land is bought with 20 percent down ($280). A change of 4 percent in land values the first year ($56) would result in a 20 percent gain or loss in the buyer’s equity. If returns from the land were sufficient to make payments of both principal and interest on a level payment, 34-year, 9 percent loan, a 4 percent annual increase in land values would cause net worth to more than double in five years. If land values decreased 4 percent per year, net worth would be $54 at the end of five years. As the loan is paid off, equity increases, and the percentage gain or loss from a change in land value diminishes. What about a return to owner equity? This analysis does not directly measure return to equity. The reward to the down payment is increased equity in the land from loan repayment or increased land values. Assume a cost of $1,250 per acre for land yielding a net return of $100. This return would pay off a loan of $1,000 an acre at 8.5 percent in 23 years. After 23 years, if the equity in the land is $1,250 per acre, the annual average compound rate on the $250 down payment would have been approximately 7.25 percent. At the end of the first year, equity per acre would increase by $15. (The $100 payment includes $85 of interest and $15 principal.) Because the interest rate is higher than the rate of return on the entire purchase price, the $15 principal payment represents only a 6 percent return on the $250 down payment. This rate of return to current equity would increase throughout the term of the loan and would equal 8 percent with 100 percent equity. If the interest rate were lower than the overall rate of return, the initial rate of return to equity would be higher than the overall rate and would decline throughout the term of the loan. A net return allowing a faster payout would result in a higher return to equity. A smaller return requiring a longer term would reduce the return to equity. For example, Table 1 shows that with 20 percent down and 8.5 percent interest, a net return that allows repayment in 15 years results in 9.5 percent compound return to equity. A lower income that requires a 30-year loan results in a 5.5 percent return. If the loan term is held constant, different levels of income change the required minimum down payment and the rate of return to equity. With 20 to 40 percent down and a payout period of 15 to 30 years, the

Payout (years) Percent down

15

20

25

30

Table 1 Approximate annual compound rate of return to initial equity for various payout periods and down payment percentages.

- - - - - - - - - - - - - - - percent return - - - - - - - - - - - - - - - 20

9.50

8.50

6.75

5.50

30

8.50

6.00

5.00

4.00

40

6.50

4.75

3.75

3.00

return to initial equity ranges from 3 to around 10 percent, assuming stable land values (Table 1). In view of these problems, some restrictions must be placed on the “Buy land if it will pay for itself” rule. Following are more explicit formulations: 1. With the expectation of no decline in land values and with a down payment of 20 to 25 percent, consider purchasing land with a net yield high enough to pay off indebtedness in 20 years or less (standard amortization). 2. With the expectation of even modest increases in land values (2 to 3 percent) and a down payment of 20 to 25 percent, consider purchasing land that will yield a net sufficient to pay the interest on the loan. These rules of thumb can be used as first approximations, or as a means of “flagging” situations that deserve a more detailed analysis. Such an analysis might include rethinking the cost-price-yield assumptions and the implications of omitting fixed costs. Alternate assumptions about future increases in land prices could be considered.

Buy Land If It Is Priced to Yield an Acceptable Return Net returns to land are calculated using long-run expectations of prices, costs, and yields. (Interest on land investment is not included in costs because the return to land is being estimated.) The expected annual operating return is expressed as a percentage of land cost (or the asking price). To this is added the expected annual percentage of increase in land values, producing a total percentage return. For example, assume that a tract of land is offered at $1,000 per acre and the expected annual net return is $75 an acre, or 7.5 percent of the price. Expectations of

an annual average increase in land values of 4 percent would raise the rate of return to 11.5 percent. Where part of the real estate does not contribute to farm income, that part of the value should be deducted from the price before figuring rate of return. Assume that the above example was a 160-acre tract with a small house not needed by the prospective buyer that could be sold for $8,000. This would reduce the land cost by $50 per acre and raise the return from farming operations to 7.9 percent. If a farm with crops is bought in July, the logical procedure is to estimate the net discounted value of that year’s crops, subtract this value from the sale price, then calculate the expected rates of return. Similarly, if a farm is offered in January, subject to an existing cash lease that is providing less net income than expected, the base price of the farm would be increased for calculating longer-run rates of return. If land values do not change, this farm will sell for a higher price next year—the difference being the loss of income due to the existing lease. After estimating the rate of return, the prospective buyer must decide if the rate is acceptable, usually by comparison with rates of return from alternate investments. The problems discussed under the first approach remain. Yield, price, and cost estimates are in terms of the vague “long term.” There is a possibility of paying more than “market price,” giving rise to the liquidity problem. As presented, the approach does not provide for calculating a return to equity. The calculated return is on a total investment basis. As such, it serves as a first approximation. If the calculated rate of return (including expected gains in land values) exceeds the farm mortgage interest rate, a further analysis could determine whether an acceptable rate on owner equity can be obtained.

61

On the other hand, if the calculated rate is below the mortgage interest rate and a return to equity at least equal to that rate is required, then the decision not to invest can be made (unless the purchase price is lowered). The return to equity can be calculated by including interest on the loan as an expense and expressing the remaining net plus expected gains in land values as a percentage of equity, as shown in Example 1. With this method of calculating return to equity, equity increases annually by principal repayments and increases in land values, thus decreasing the percentage return to equity. For example, assume that the principal payments per acre are 2 percent a year ($22). The increase of 4 percent in land values the second year would amount to $58, and the interest would be $99. This would leave a net of $59 ($100 + $58 – $99), or a return of 16 percent on the second year’s equity of $360—a sizable reduction from the 20 percent return from the first year. The figure would drop to about 11 percent in the sixth year, assuming constant operating returns. This declining rate of return on equity is not as serious as it might seem. The loan may be refinanced at any time, and the proceeds invested in additional land or other assets. In addition, declines in the rate earned on equity are partially offset by decreasing leverage risk. There is a trade-off between the equity percentage (or leverage risk) and the rate of return, a higher rate being required for lower equity. For example, the investor may face the question: Shall I borrow 80 percent, expecting a return to equity of 20 percent, or borrow 50 percent with a return of 13 percent the first year?

How can one determine an acceptable rate of expected return? It is difficult to establish schedules of acceptable rates based on the degree of risk or percent of equity. The practical solution seems to be an “If . . ., then . . .” approach: “If returns, including increase in land values, exceed the farm mortgage interest rate (or some other alternate rate), then I will invest.” Or there may be no stated minimum rate. Calculations could be made, then the decision to accept or reject. Perhaps the most difficult decision is whether to accept rate A with risk A or rate B with risk B, such as might occur with different levels of financing. One approach is to make calculations based on two or more levels of net income, as illustrated in Table 2. A probability must be assigned to alternate outcomes. For example, alternatives A, B, and C in Table 2 might be regarded as “most likely,” “probable,” and “unlikely.” With this ordering of risk, the decision might be to finance with an 80 percent loan, risking a negative 5 percent return to equity in return for a good chance at a 20 percent return. Someone averse to risk might choose to borrow only 50 percent of the purchase price, reasoning that there is a “good” chance of a 13 percent return; and even with “bad luck,” one would at least earn 3 percent on equity. Rate of return contains no safeguards against the liquidity problem that may arise from paying a price “above the market” for land. An individual may show an “acceptable” return to an above-market asking price because of spreading fixed costs, superior management, efficiencies in marketing, and the like; but paying such a price may mean a loss if the buyer had to liquidate. (There

Example 1. Return to Equity Asking price of land ..............................................$1,400 per acre e Expected net from operations ................................... $100 per acre or 7.1 percent return Expected annual increase in land values ........................................... 4.0 percent return Total rate of return ............................................................................. 11.1 percent return Financing $1,120 loan at 9 percent, $101 interest Returns from operations .................................................................. –$1 ($100 minus $101) e from increase in land value ............................................... $56 (4 percent of $1,400) Total .........................................................................................$55 XbXXXXXXXXXX Equity: $280 Return to equity: 20 percent 62

Alternative Alternative

Corn price (per bu) Corn price (per bu)

Table 2 First-year return to equity on various corn prices and levels of equity.

Percent of equity 20

50

80

100

- - - - - - -percent return to equity - - - - - A (most likely) B (probable) C (unlikely)

$2.25 2.00 1.75

20 7 −5

may or may not be someone who would expect as high a rate of return as the buyer.) Assume that the $1,400 example purchase price was $200 above the estimated liquidation value (market price). If a 4 percent annual increase is assumed, the estimated market price would equal the purchase price between the third and fourth years. If the rate of return to equity from farming operations alone were acceptable, one of two situations would prevail: 1. The rate might be considered the minimum acceptable. The time necessary for the market price to equal purchase price could be estimated. A decision to purchase the land would indicate a willingness to assume the liquidation risk and to assume that the business would continue over at least that period of time. 2. The rate of return might provide an excess over the minimum acceptable rate, in which case the excess could be compounded to reduce the length of time needed for the purchase price to “catch up” with the liquidation value (market price). The “excess” returns serve to reduce the real purchase price and shorten the firm’s exposure to possible loss from liquidation. This also applies when the general level of land values is assumed to be stable or declining. For time periods up to about five years, the exposure to liquidation loss can be approximated as follows. Add the sum of the estimated annual increase in land values and excess returns to estimated liquidation (market) value at the time of purchase. Then note the number of years until this figure will equal the purchase price. For longer periods, excess returns and assumed increases in land values should be compounded. The rate-of-return concept is considerably more sophisticated than the “buy if it will

13 8 3

12 9 5

11 9 6

pay for itself” method. The rate-of-return approach forces an estimate of both operating returns and land value increases. It allows a calculation of return to equity with various levels of down payment. Alternate levels of prices, costs, or yields can be analyzed in conjunction with varying degrees of leverage risk. The problem of declining rates of return to equity as equity increases is partially offset by the possibility of refinancing and the general tendency to accept a lower rate for lower risk (higher equity) situations. The liquidity problem can be partially analyzed, although in a somewhat crude fashion.

Capitalize the Average Expected Net Return to Land The familiar income capitalization formula, V = I/r (where “V” is present value, “I” is expected annual net income to land, and “r” is the expected rate of return or capitalization rate) is well known as an appraisal technique. Individual firm data on income and rate of return can be used to estimate the maximum price that can be justified. For example, assume that the capitalization rate is 8 percent and expected annual net income to land is $75 per acre. The capitalization of $75 per acre net income to land for an infinite period of time at 8 percent results in an estimated present value of $938 per acre. A constant expected annual net return to land may not be a realistic assumption. Many potential buyers may expect a gradually increasing return, with a consequent increase in land values. These expectations are usually expressed in percentages rather than dollars. The capitalization rate can be adjusted by subtracting the annual expected growth rate in returns and land values from the minimum acceptable rate of return. For example, assume that an 8 percent return is 63

required, that a net operating income of $75 per acre is expected, and that income and land values are expected to increase by 1.5 percent per year. Subtracting 1.5 percent from 8 percent leaves 6.5 percent as the capitalization rate, resulting in a capitalized value of $1,154 per acre. Using the capitalization process forces the selection of a specific rate, as opposed to calculating a rate of return, the magnitude of which may be sufficient to accept or reject without forcing the choice of a specific rate as a minimum. For this reason, the investor may want to capitalize at several different rates. That procedure will reveal another potential danger in the method—small absolute changes in rates may result in large changes in estimated values. Assume an alternate minimum rate in the previous example of 9 percent. Allowing for an annual increase in land values of 1.5 percent, the capitalization rate would be 7.5 percent and the value $1,000 an acre. Thus, increasing the capitalization rate by 1 percentage point results in a reduction of $154 in the capitalized value. As commonly employed, the capitalization process does not allow for different levels of equity, but seeks to evaluate the stream of income as if credit were not used. If the interest rate is equal to the minimum acceptable rate of return, the use of credit will not affect the capitalized value. If the minimum acceptable rate is lower than the interest rate, the use of credit would lower the capitalized value, while the opposite would be true if the interest rate were lower than the required rate of return. “Equity capitalization” shows the effect of credit use and can be calculated as follows: 1. Decide on the percent of the price to be borrowed. 2. Multiply the percent borrowed by the interest rate. 3. Multiply (2) by the reciprocal of the percent of equity, to express interest as a percent of equity. 4. Estimate the annual change in returns and land values and multiply the figure by the reciprocal of the percent of equity to express land value as a percent of equity. 5. Decide on an acceptable rate of return on equity; add (3) to cover the interest cost; then subtract (4) to recognize noncash 64

returns from the increase in land values. 6. Use (5) as the rate with which to capitalize estimated earnings without subtracting interest, which is accounted for in (3). Example 2 provides an illustration.

Example 2. Effect of Credit Use on Value 1. 80% to be borrowed 2. 80% borrowed times 7% (interest rate) = 5.6% 3. 5.6% times 5 (100/20) = 28.0% 4. 1.5% times 5 (100/20) = 7.5% 5. 8% (acceptable rate) plus 28% minus 7.5% = 28.5% 6. $75 net return divided by 28.5% = 263.16 (capitalized value of equity) The implied total value is 5 times $263.16, or $1,316 per acre.

Because of leverage, different levels of debt will result in different implied total values, as illustrated in Example 3. This is the mirror image of the rate-ofreturn situation, where increasing equity resulted in declining rates of return to equity. Instead of a fixed price or value, the capitalization process produces a fixed rate of return, allowing the implied price or value to vary. While the land market may not use equitycapitalization directly, there is a tendency for credit availability to influence the bid price. The danger is that the greater risk associated with lower equity may not be properly reflected in the implied land value. A minimum acceptable rate of return to equity, which varies inversely with the percent of equity in the repayment cycle, is needed.

Use the “Present Value” Concept, Based on a Definite Planning Horizon In some cases, capitalizing expected annual income for a finite period may be most appropriate. Returns to land for a finite period consist of annual net-operating income flow and recovery of capital. That is, there are two parts to the income capitalization formula—an estimate of the present value of the expected annual net income, and an estimate of the present value of land at the

end of the finite period. If a constant annual net income to land is assumed, the present value can be estimated using the following formula: n

V=I/r[1-1/(1+r) ] + AP/(1+r)

Example 3. Debt Levels and Implied Total Value

n

where “V” is the present value, “I” is the expected annual net income, “r” is the capitalization rate (acceptable rate of return), “AP” is the anticipated price at the end of the finite period, and “n” is the number of years in the finite period. Assume that the annual net return of $75 per acre is expected for the next five years and that land value will increase to $1,200 per acre at the end of five years. This could happen if a buyer feels that land values were temporarily depressed or if land is in the path of urban expansion. If 8 percent is an acceptable rate of return, how much should a potential buyer pay for the land? The value of the land is crucial, and in this case the assumption of increased land values means that a large part of expected earnings will be in this noncash form. The other part of earnings will be an estimated annual return of $75 per acre. The time value of the annual return is recognized by capitalizing at 8 percent, the minimum acceptable rate. The problem is to estimate how much the potential buyer can pay for the land if expected annual return is $75 per acre for five years, and if the value of land increases to $1,200 per acre and 8 percent is an acceptable rate of return on this investment. Using these assumptions and the information in Table 3, the present value can be estimated as shown in Example 4.

Percent of debt Percent of debt

Capitalized value of equity

80.00 66.66 50.00 33.33 0.00

$263.16 428.57 625.00 810.81 1,153.85

1 3 5 10 15 20

4 $1.0400 1.1249 1.2167 1.4802 1.8009 2.1911

$1,316 1,286 1,250 1,216 1,154

Example 4. Estimation of Present Value

In Example 4, the present value of $75 income per year for five years ($299.44) is added to the present value of the appreciated value of land five years hence. The purchaser could pay up to $1,116 per acre and receive an 8 percent rate of return. If any assumptions change, the estimated per acre value would change. For example, if Table 3 Compounded amounts per dollar for various rates and time periods, (1 + r )n

Amount per $1, compounded at each percent No. of years

Implied total value

6 $1.0600 1.1910 1.3382 1.7908 2.3966 3.2071

8 $1.0800 1.2597 1.4693 2.1589 3.1722 4.6610

10 $1.1000 1.3310 1.6105 2.5937 4.1772 6.7275 65

the purchaser believed that land values would not change over the ten-year planning period, the present value would be estimated at $938 per acre, the same as assuming a constant income stream for an infinite period. If the purchaser believed land values would decrease to $750 per acre at the end of five years, the estimated present value of the land and annual income would decrease to $809.89 per acre. Net income may be expected to decline after a few years, then remain relatively stable. Allowing for such changes in the income stream increases the number of calculations needed to estimate present value. Using “present value” based on a definite planning horizon to analyze land investment gives more precise answers under varying assumptions about time and returns than any other method discussed. Two disadvantages, however, are understanding the method and making the calculations. The concept of assets having “time values” is not difficult, but must be understood clearly. The second problem can be overcome by using a computer. In a number of states, the Cooperative Extension Service has computer programs for this type of investment analysis. Some are called “Maximum Bid Price” programs and incorporate financing and income taxes into the present value calculations. In investment analysis, capitalization (present value calculation) is used not so much to estimate value as to establish a figure above which one would not earn predetermined rates of return. This estimate could be compared to an estimated market value. If the capitalized value is higher than estimated market value, purchase the asset. The capitalized value could also establish the maximum bid. The important point is that capitalization is not a substitute for knowledge of the local land market. For the investor, capitalization is best used in conjunction with estimates of market value.

Farm Operators versus Investor-Buyers

66

Nonoperator investors compete with farm operators, many of whom buy land for farm enlargement. The farm operator may be able to spread fixed labor and machinery costs over the investment in additional land. The investor-buyer landlord, however, faces slowly changing leasing arrangements that

do not share the advantages of a larger acreage, especially in the short run. This situation has two implications. First, the investor-buyer should recognize the economic motivations of competing buyers. Two or three local farmers may bid prices above what land of similar quality might sell for in another location. Purchasing at slightly higher than someone else’s bid does not mean that the purchase has been made “at the market,” in the sense of having some assurance that it could be resold at that price. The next highest bidder may purchase other land and be out of the market. The investorbuyer, in the meantime, will not “recover excess” price through economies of size by renting out the land on a conventional share lease. This introduces the second implication: departing from the conventional share lease. Cash leases tend to be more responsive to unique economic situations. In other words, the nearby farmer who sees the greatest advantage in farming more land can bid up the cash rent. Other possibilities also exist— custom farming or custom-incentive operations. While these alternatives offer the chance for greater return to the investorowner, they may also involve more risk and management responsibility. Investor-buyers may have the edge on operator-buyers in two areas. First, the investor may be in a higher tax bracket and place a higher value on noncash returns to land (that is, increases in land values over time). In addition, the investor-buyer may be better able to meet cash-flow demands under certain financing situations. The market for land is imperfect. A prospective buyer needs to analyze land investments case by case to avoid a disappointing investment or liquidation loss.

Financing Land Land investment decisions can be summarized in these two questions: Will it pay? Can it be paid for? Previous discussion centered on the first question, with attention to (1) the method of analysis; (2) major factors related to net returns, such as yields, product prices, production costs, and expected changes in land values; and (3) personal and business characteristics, such as the length of the planning horizon and the minimum acceptable rates of return under different risk situations.

The second question involves cash flow: Whether the cash outflow for loan payments, production expenses, and family living costs can be met from all sources of income, and whether excess cash inflow or credit reserves give reasonable confidence that a bad year will not force an unacceptable liquidation of some part of the business. The cash flow is especially important if the operating return to land is below the interest rate of the farm mortgage. Increases in land values do not pay the mortgage.

Trends in Land Values U.S. land values increased rapidly from 1912 to 1920. During the 13-year postwar decline, land values declined steadily. By 1933, land values were down more than onefourth from 1912 levels. Recovery from the bottom of the Depression was not spectacular. Land values increased about 19 percent from 1933 to 1937, then remained stable until 1941. The World War II decade saw land values rise by 2.4 times. In 1948, U.S. farmland values had risen to 1920 levels. Increases occurred in most years from 1951 to 1971. The 10-year increase ending in 1961 was 50 percent, and for the 1961-71 period, 77 percent. From 1971 to the record-high values of 1981, U.S. land values increased by 261 percent. By 1987, values had declined by about one-third. Many states followed the general pattern of these land value movements with differing degrees of change. For example, from 1912 to 1920, land values in Iowa more than doubled, but were up only 58 percent in Ohio. For the United States as a whole, 1920 levels were reached in 1948; but for several Corn Belt states, this did not occur until 1955-57. The 1981 index of farm real estate values was higher in most Corn Belt states than for the entire United States, and the decline since then has been much more severe. Since 1912, U.S. land value trends have persisted for long periods of time, with very few reversals. The trend was up for the 8 years ending in 1920, down for 13 years, up for 48 years, and down for 6 years. The family that started farming in the Corn Belt during the Depression and bought before World War II saw its equity in land increase tremendously by 1981. A son or daughter who joined the family farming business in the late 1950s would also enjoy

windfall gains. But the third generation, joining the business in the early 1980s, saw land values in the Corn Belt drop 55 percent from 1981 to 1987, putting values back to the levels of the mid-1970s. Equity used as down payment could have been lost, just as the great-grandfather of this young family might have lost equity (and land) after World War I. Somewhat different trends emerge if land value estimates are adjusted by the consumer price index. The upward move from 1912 to 1920 disappears (Figure 1). The all-time 1981 peak in U.S. land values was 27 times the 1933 low in nominal values, but only four times the low in inflation-adjusted terms. Finally, the decline from 1981 to 1987 was more pronounced. In nominal terms, the decline was about one-third, while adjusted values declined nearly 50 percent. Figure 1 includes values for Indiana as a representative Corn Belt state. Note that the 1981 peak was higher for Indiana than for the United States and by 1987 had dropped to a lower level, having declined 65 percent. To the extent that this adjustment by the consumer price index (CPI) results in a measure of purchasing power, an acre of Indiana farmland could have been exchanged for about the same amount of goods and services in the mid-1950s as in 1987. Tremendous losses in purchasing power have occurred for those who purchased land in the late 1970s and early 1980s. Figure 2 shows the movement of farmland values and the producer prices index (PPI) from 1950 to 1989. (During this period, the CPI increased 4.7 times, versus 3.8 times for the PPI.) From 1950 to 1972, producer prices increased very slowly, while land values rose more rapidly. With the explosion in prices of several major farm products, land prices rose much more rapidly than did producer prices. Major changes occurred that affected much of agriculture, especially in the Corn Belt. Devaluation of the dollar, several years of weather-related declines in the world production of grains and oilseeds, improved trading relations between the Soviet Union and the United States, and a reduction in U.S. government held grain stocks affected land values. Furthermore, rates of inflation (whether measured by the CPI or the PPI) increased to levels higher than in previous decades. This stimulated the desire to own land as a means of protecting accumulated wealth against losses

67

Figure 1 Index of average U.S. and Indiana farmland values adjusted by the consumer price index for selected years.

200 180

United States Indiana

160

Index (dollars/acre)

140 120 100 80 60 40 20 0 1912

1922

1932

1942

1952

1962

1972

1982

Figure 2 Comparison of the producer prices index with the index of U.S. and Corn Belt farmland values, 1950-1989 (1967 = 100)

600

Corn Belt United States

500

Index (dollars/acre)

Producer prices index 400

300

200

100

0 1950

1955

68

1960

1965

1970

1975

1980

1985

because of inflation. The speculative demand for land also increased as buyers expected land prices to increase faster than inflation. Adding fuel to the fire were very low real interest rates. Some farmers developed a philosophy that production efficiency was secondary to owning land. Indeed, for several years, “returns” in the form of increasing land values exceeded returns from farming the land. Cash rents had increased faster than Corn Belt land values from 1960 to 1975 when land values spurted ahead for several years (Figure 3). When the drop in land values began in 1981, cash rents held steady for several years, then declined more slowly, perhaps because of government programs that provided income security in the short run. In a similar fashion, net farm income per farm was closely related to U.S. farmland values from 1950 to 1970 (Figure 4). The big jump in net farm income from 1971 to 1973 was no doubt a factor in increasing land values; but while net farm income was dropping for 1974 to 1977, land values continued to climb. In addition to these declines in the return to land and other farm resources, other factors associated with the land boom reversed their influence and exerted downward pressure on farm incomes and land values. Interest rates rose to record levels. The value of the dollar increased, thus making U.S. farm exports more expensive and contributing to sharp declines in exports. Foreign debts extended during the 1970s became more burdensome for many countries. Trade relations with the Soviet Union turned sour. Production increased outside the United States, partly in response to U.S. efforts to support prices for our own bumper crops and growing surpluses. In retrospect, events warning of the end to rising land prices appeared from the late 1970s to 1981. Land prices, especially in the Corn Belt, were at levels in 1981 that clearly anticipated continued inflation and increasing farm incomes. The conclusion seemed obvious that a substantial reduction in the rate of inflation and a leveling off or decline in farm earnings would be accompanied by substantial declines in land values. But at the time, the picture was not so clear, especially with regard to the likelihood of curing inflation and the strong medicine for that cure. The rate of inflation by the late 1960s was around 5 percent per year, or roughly

twice the rate during most of the previous 20 years. In another 10 years the rate had again doubled, and double-digit inflation was accepted by many as a way of life. With nearly 50 years during which land values not only kept up with inflation but exceeded that rate, it is not surprising that the speculative and inflation-hedge demands for land remained strong.

Should Farmers Own Land? From the early history of the United States, public policy has been oriented toward the family farm and ownership of land by those who operate it. Thus, to question the tradition of farmers’ owning all the land they operate seems almost un-American. But given the experience of 1981-87 and the environment of 1987, especially the low inflation rate, the question is appropriate. Two major disadvantages of owning land stem from the fact that land investment is high in absolute terms, as well as high relative to operating earnings. First, the strong desire to own land and the consequent failure to analyze the economic investment can prevent the producer from investing in highreturn production inputs such as machinery, equipment, operating expense, livestock facilities, and inventories. Investing in these items can, of course, be increased to the point where returns are low; but in general the rate of return to these investments exceeds the traditionally low (3 to 5 percent) operating return to land. Second, the high capital requirement for land purchase often requires credit, increased leverage, and greater risk. Leverage works both ways. If the rate of return to the total investment exceeds the interest rate on borrowed funds, then the rate of return to equity increases as credit use increases. On the other hand, if returns are lower than expected and fall below the cost of credit, the return to equity decreases and eventually becomes negative with larger amounts of credit. With the tendency of land values to move in the same direction as farm earnings, an upward trend in earnings is doubly profitable. A downward trend is doubly disastrous: Income to service debt is reduced, and net worth declines. Those who buy land, especially if they use credit, must be aware of the opportunities for gain and the risk of loss. Farming is possible without owning land. In 1982, about 15 percent of all U.S. farmers

69

Figure 3 Index of cash rent and farmland values for the Corn Belt, 1960-1989 (1960 = 100).

800

Cash rent

700

Land values

Index (dollars/acre)

600

500

400

300

200

100

0 1960

1965

1970

1975

1980

1985

Figure 4 Index of U.S. farmland values and net income per farm, 1950-1989 (1967 = 100).

600

Value/acre

Index (dollars/acre)

500

Income/farm

400

300

200

100

0 1950

1955

70

1960

1965

1970

1975

1980

1985

with gross sales of over $10,000 owned no land. Another 42 percent owned all the land they farmed. The remaining 43 percent, part owners, own some land and rent the remainder. What are the reasons for owning land? 1. As a home site and base of operation for machinery storage and repair, grain drying and storage, and intensive livestock production facilities. Relatively small acreages are needed for these uses. Noneconomic returns such as a sense of permanence and pride of ownership may be as important as economic returns. 2. Security of tenure. Most land is rented year to year. Although many rental arrangements continue for a decade or more, there is the chance that the farm won’t be available next year. Owned land is always there to be farmed. Ownership of land insures against the loss of at least that acreage to the farming operation and the costs that might be incurred in replacing rented land, such as finding land to rent, greater travel distance, and lower yields due to lack of knowledge about the land. 3. As an investment. Many farmers have investment alternatives within the farm business, some of which may offer high returns. Especially when there is considerable uncertainty about future trends in land prices, the producer should invest in nonland assets until the expected marginal rate of return at least equals the expected returns from land. If the return appears to be more secure, the rate of return for investments other than land may be less than the rate expected from land.

Considerations in Land versus Nonland Investments Short- and intermediate-term farm investments have the advantage of a more rapid rate of capital turnover, compared with land investment. Thus, meeting cash flow needs may be easier, and errors can be corrected more quickly. In addition, the return tends to be in cash, whereas increasing land values may be an important part of total returns. Current or near-term income given up to get future increases in land values may be very valuable to a young, growing family. In such cases, the rational decision is to select the investment that provides more spend-

able dollars, even though the rate of return may be less. Other farmers may seek alternatives outside the farm business. Special knowledge may be required to analyze an investment and manage it. Farmers can apply their knowledge of the farm business to nonfarm real estate or other small businesses. Consider: “Do I know enough about this business?” “Will I have an opportunity to exercise my abilities in running the business?” The answer to the first question may be “Yes,” but the answer to the second one will be affirmative only when an ownership interest carries management responsibilities with it. This usually is not the case when investing in common stock. In considering the purchase of land versus common stock, farmers should keep in mind that they can influence the price of the land and its productivity. With most investments in common stock, the price is set by market forces, and the business is run by hired managers. By contrast, the farmer has the ability to find a “good buy” in land, to exercise these abilities and the related knowledge in farming the land, and, if the opportunity arises, to shift to nonfarm uses. The farmer, presumably knowing more about the land than anyone else, can make a “good sale”—in other words, do something about an investment other than simply decide to buy or sell. Stock prices, as measured by the Standard and Poor Index, increased much more slowly than did land prices during the 1970s. The reverse was true from 1950 to 1965. From 1982 to 1987, stock prices moved up sharply while land values declined (Figure 5). Farmers tend to consider two types of common stock—shares listed on major exchanges or newly formed companies. With new companies the risk may be high. Because of this, returns on investment vary widely—from large losses to big gains. Variations in investment returns with well-established companies may also be large. Major U.S. companies that have not done well or have gone out of business prove that severe losses can and do result from some stock-market investments. There are also success stories where returns have been great. By comparison, land is subject to a much smaller chance of extreme losses. Some stocks become absolutely worthless, but land seldom does. The value of some stocks doubles or triples in a year, which does not happen very often with land.

71

600

Corn Belt 500

United States

Index (dollars/acre)

Standard and Poor Index 400

300

200

100

0 1950

1955

Figure 5 Index of U.S. and Corn Belt farmland values and common stock prices (Standard and Poor Index), 1950-1989 (1967 = 100).

1960

1965

1970

What of the Future? The prospective land buyer always asks, “Where are land values headed?” Usually the answer has been, “Higher—over the long run.” Even as land values were falling in the 1980s, a common opinion was that values would be higher in the long run—10 years or more. What accounts for this belief? Following are some reasons: 1. A slowly growing U.S. population, with the same or higher real income per capita. 2. Growing worldwide demand caused by increasing economic development and population growth. 3. Continued inflation, resulting in higher land prices due to the demand for land as an inflation hedge. 4. Technological benefits that can best be realized by larger farming units, thus increasing the demand for land for farm enlargement. 5. Increased demand for farm products for motor vehicle fuels, sweeteners, and other nontraditional uses.

72

6. Continuation of governmental farm pro-

1975

1980

1985

grams that tend to get capitalized into land values. 7. The conversion of land to nonfarm uses. 8. The likelihood of one or more years of serious worldwide shortfalls in production, during which production in the United States would not suffer as much as production in countries with less favorable soils and climate. 9. The weak dollar and possible changes in international trade policies that would tend to increase U.S. farm exports. 10. A change in government subsidies from those that stimulate production to those that may reduce production. Almost all these factors have affected farming profits and land values in the past. A number of these factors may exert upward pressure on land values in the future, but perhaps not to the same extent as in the past. For example, the effect of inflation on land values may be reduced by actual or expected increases in interest rates. Technology may shift to a focus on existing land rather than advances in mechanization, which lead to farm enlargement and the demand for more

land. Economic development has not been robust for many potential importers of U.S. agricultural products. Finally, there is increasing pressure to “get government out of farming.” A period of relatively stable land values may lie ahead as the United States and the rest of the world make gradual adjustments in production and use of farm products. Such adjustments would result in reduced surplus stocks of grain and set the stage for improved prices that might be triggered by a major production shortfall somewhere in the world. This scenario is not certain. Buyers of farmland must finance to withstand lowerthan-expected earnings from land. In much of the Corn Belt, this means a down payment of at least 25 to 30 percent or the availability of nonfarm income or reserves. The purchase of land is seldom without risk, but farmers and investors are risktakers. The challenge is to reduce risk by careful analysis and financing, then plan to cope with unfavorable events if they should occur.

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North Central Regional Extension Publications are subject to peer review and prepared as a part of the Cooperative Extension activities of the thirteen land-grant universities of the 12 North Central States, in cooperation with the Extension Service - U.S. Department of Agriculture, Washington, D.C. The following states cooperated in making this publication available.

*University of Illinois 69 Mumford Hall 1301 W. Gregory Drive Urbana, IL 61801 217-333-2007 Purdue University 301 S. Second St. Lafayette, IN 47905-1092 317-494-6795 Iowa State University 112 Printing & Publ. Bldg. Ames, IA 50011-1050 515-294-5247 Kansas State University Umberger Hall Manhattan, KS 66506 913-532-5830 Michigan State University 10B. Ag. Hall East Lansing, MI 48824-1039 517-355-0240 University of Minnesota 3 Coffey Hall St. Paul, MN 55108 612-625-8173 University of Missouri 115 S. Fifth St. Columbia, MO 65211 314-882-2792

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