Why farms are still Undervalued

By Ian Robinson

(email ian@robinsonsewell.com.au if you want a copy of the farm valuation calculator).

The greatest debate is how farms are valued or should be valued.  What should you really pay for a farm?  What if you had access to a formula to work it out for you?   We all know that the recent neighbour’s price is a fundamentally flawed analysis, but no one has provided a solution to this issue.

Until now that is.

Just about every buyer thinks they paid too much on the day.  Every seller thinks they sold too low (especially when the price of land goes up further over the next year or two).

For mortgage purposes, valuers look at comparable sales around the district and conduct a per acre basis view on the value.  Any financial economist will promote that this methodology attains little commercial rationality given it has no linkage to its income generating capacity.

In sympathy we must remember that valuers are operating under the instructions of the banks so there cannot be any adverse vindication back to the valuer for mere sympathetic reasons other than they are doing what they are told.  Banks are therefore assuming that farm values are continuous.  That is, the values move in a somewhat predictable linear fashion compared to the previous sale.  Nothing like keeping it simple.

All mute points, truth be told.  Just trying to stir debate.

But what about viewing farm valuations from a completely different perspective.  How about working out the Net Present Value (NPV) of the predictable future income over a timeline that will determine true value?

 

Let’s work through this together.

 

The variables to this equation are as follows;

  1. Long term average (yearly) appreciation of the price of the farm. This is broken down into two components.  “Inflation” + “Premium Growth”.  I will add virtue to “Premium Growth” later.
  2. Net lease income as a % of Current Market Value (CMV). The income (net of costs) you can earn from leasing the farm to an independent third party.
  3. Discount rate. The opportunity cost of capital.  That is, what your capital could earn in a similar risk class.
  4. The term of the investment. Farmland is more a generational asset, but for simplicity I have linked it to just one generation being 30 years.
  5. The prospective purchase price that achieves the above outcomes.

For an elementary calculation, I have assumed the following

  1. 0% (2.0% for inflation and 4.0% for premium growth)
  2. 5%
  3. 5%
  4. 30 years
  5. T (now) purchase price of a farm = $10,000,000
  6. T + 30 is 30 years from now.

Results of the Calculation

Market Value of the $10m farm in 30 years is $57,434,912

Total lease income (net of costs) over 30 years is $21,200,419

Net Present Value of all future income = $13,083,327

Premium above the $10.0m purchase price = $3,083,327

Hence, you could pay an additional 30.8% premium on the original purchase price to break even on your purchase analysis.

So, what makes up the “Premium Growth”?

 

Premium Growth = 1 + 2 + 3 (accelerated growth above the current fundamentals)

  • Population Growth: growth in demand for food.

According to the United Nations Population Division, “the dawn of agriculture, about 8000 B.C., the population of the world was approximately 5 million. Over the 8,000-year period up to 1 A.D. it grew to 200 million (some estimate 300 million or even 600, suggesting how imprecise population estimates of early historical periods can be), with a growth rate of under 0.05% per year”.

“A tremendous change occurred with the industrial revolution: whereas it had taken all of human history until around 1800 for world population to reach one billion, the second billion was achieved in only 130 years (1930), the third billion in 30 years (1960), the fourth billion in 15 years (1974), and the fifth billion in only 13 years (1987)”.

World Population Clock at the time of writing this article was 7,814,818,850 and is growing at around 1.0% per year and is forecast to increase to 9 billion by 2037.

Refer to the World Population CLOCK for the current population as it stands NOW.

You tell me how much this matrix alone feeds into the “Premium Growth” for land assets?

 

  • Scarce Resource: Shrinking agricultural landscape

About one third of the world’s land area is noted as agricultural land.  According to The World Bank Group it peaked in 1990 at 39% and is now at around 37.4%

It must also be noted that certain agricultural activities also can degrade natural resources.

According to The World Bank “poor farming practices can cause soil erosion and loss of soil fertility. Efforts to increase productivity by using chemical fertilizers, pesticides, and intensive irrigation have environmental costs and health impacts. Excessive use of chemical fertilizers can alter the chemistry of soil. Pesticide poisoning is common in developing countries. And salinization of irrigated land diminishes soil fertility. Thus, inappropriate use of inputs for agricultural production has far-reaching effects.”

“Total land area does not include inland water bodies such as major rivers and lakes. Variations from year to year may be due to updated or revised data rather than to change in area.”

 

  • Farming Innovation: increasing productivity of any given unit of land

Productivity is an important measure of Australian agricultural performance. It shows how efficiently inputs (labour, capital, land, materials and services) are used to produce outputs (crops, wool, and livestock) over time.

According to the department of Agriculture Water and Environment;

  • Over the period 1977–78 to 2018–19, average annual productivity growth in the broadacre industries was 0%. From 1978–79 to 2018–19, average annual productivity in the dairy sector was 1.3%.
  • Productivity growth rates varied significantly by industry. The cropping industry experienced the fastest rate of growth at 1.5% per year, whilst productivity growth in the sheep industry was just 0.3% per year.
  • Agricultural productivity is sensitive to the effects of climate, with productivity falling in both 2017–18 and 2018–19 largely as a result of widespread drought across much of eastern Australia. Forthcoming ABARES work will identify the effects of climate on productivity estimates, to produce climate-adjusted productivity indexes for each broadacre industry.

 

Historical Evidence of Premium Growth: Long term appreciation of farmland

Rural Bank chief executive Alexandra Gartmann says on average Australian farmland has delivered compound annual growth of 7.5 per cent over the past 20 years. “It’s a remarkable result and it highlights that investing in farmland over the long-term will deliver, through good times and bad,” Gartmann says (Aug 18, 2020).

Assuming that long term inflation has been around 3.5%, this leaves the “premium growth” to be historically around 4.0% p.a.

 

Conclusion

I will leave the conclusion to you, but I will leave it wide open for debate.  We are looking forward to hearing from you on this topic.

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