Income vs. Cap Rates: Unpacking the 1980s Farmland Bust
By Brent Gloy and David Widmar
Many of us know the short version of farmland’s infamous bust during the 1980s. First, the farm economy derailed as commodity prices tumbled, resulting in fewer earnings generated by an acre of farmland. Second, Paul Volker and the Fed’s mission to bust the back of inflation sent farm-level interest rates upwards of 18%. Then a wave of farm failures and bankruptcies flooded the market with land for sale.
This Weekly Insights article – which summarizes recently posted AEI Premium articles – quantifies the specific role of cash rents and capitalization rates during this period.
Farmland Value Trends
Figure 1 shows the value of average-quality Indiana farmland from 1975-2005. In 1981, farmland values peaked at $2,100 per acre, up from just $864 in 1975. Unfortunately, this data set doesn’t provide any earlier data, but it’s safe to assume that farmland’s sharp trend upward began earlier in the 1970s.
By 1987, average-quality Indiana farmland had tumbled to just $913 per acre, a 56% decline from the peak. Furthermore, farmland values would not cross the $2,100 high-water mark again until 2000. When adjusting for inflation, valuation didn’t exceed the 1981 peak until 2010 (not shown).
Cap Rates Versus Cash Rents
There are two major drivers of farmland values – cash rental rates and capitalization rates. During the 1980s, Indiana cash rental rents fell from $106 per acre (1981) to $72 (1987), a 37% decline. Cap rates – or the relationship between the income generated by the asset and the asset’s value – increased from 5.0% (1981) to 8.1% (1986). With both trending unfavorably for farmland values, we can unpack the specific effects using an accounting variance analysis (more details available here).
Figure 2 shows the cumulative sources of change in Indian farmland values from 1981 to 2001. To clarify, these data report the change from the 1981 peak in farmland values.
Overall, these data show how heavy-handed cap rates were during this period. At the extremes, cap rates weighed on farmland values by -$690 per acre in 1986.
At the worst, cash rental rates – which declined by more than one-third – erased $520 from farmland value by 1987. Of the nearly $1,200 per acre lost in farmland values from 1981 to 1987, 56% was attributable to the increase in cap rates. The remaining 44% of declines came from lower cash rents.
Figure 2 also provides insights into farmland’s slow but eventual recovery. Cash rents returned to $110 per acre in 1997, and cap rates returned to 5% in 2001.
Wrapping It Up
There are two important lessons to bear in mind. First, big changes in farmland values should be expected when the effects of cash rent and cap rates push in the same direction. From 1981 to 1987, both factors trended unfavorably, and farmland valuations contracted significantly. This is why inflationary periods – where the fix is higher interest rates- make the adage of history rhyming uncomfortable.
Secondly, the role of rising cap rates – due to an increase in interest rates throughout the overall economy – is perhaps undervalued by many of us. From farmland peak to bust, cap rates accounted for 56% of the downward pressure.