1. Agricultural Land Values and Producers’ Balance Sheets Charles B. Moss

2. Introduction  Three stylized facts about farmland values:  Farmland values appear to be appropriately priced in the long run;  Farmland values are characterized by excessive volatility in the short run, raising the possibility of rational bubbles; and  Changes in relative risk affect the valuation of agricultural real estate over time.

3.  Three stylized facts about the agricultural balance sheet:  External capital is raised largely through increases in debt;  The Balance Sheet is dominated by farmland values; and  Most of the “returns” are unobserved returns from capital gains.

4. Three Current Efforts  These stylized facts raise a number of questions:  What does this say about pure capital theory?  What do these stylized facts mean for consumption decisions?  What are the implications of boom/bust cycles?  What are the implications for agricultural policy?  What are the implications for agribusinesses?

5. Balance Sheet Mechanics  Starting with three standard accounting entries AccountDebitCredit Cost of Goods SoldXXX CashXXX Interest ExpenseXXX CashXXX CashXXX SalesXXX

6. T-Accounts Income Summary DebitCredit SalesXXX Cost of Goods SoldXXX Interest ExpenseXXX IncomeXXX

7. Owner’s Equity DebitCredit Initial EquityXXX IncomeXXX Distribution (Consumption)XXX Ending EquityXXX

8.  Following classical Generally Accepted Accounting Principles there are very specific rules regarding the recognition of income.  Let me start by borrowing an equation from my previous work on optimal debt  The typical approach from a management point of view is to construct a market-valued balance sheet

9. Balance Sheet AssetsLiabilities CashXXX DebtXXX InventoriesXXX Equity EquipmentXXX Farmland Total AssetsXXXTotal EquityXXX

10.  From an accounting perspective the question becomes one of recognition of income.  Following accounting principles returns are only recognized when they can be objectively established via a market transaction.

11. Table 1. Aggregate Agricultural Balance Sheet 2007 AssetsOwner’s Equity Percent (Common Valued) Financial Assets3.6Debt9.6 Purchased Inputs0.3Equity90.4 Crops Stored1.0 Machinery and Motor Vehicles4.9 Livestock and Poultry3.6 Real Estate86.5

12.  The salient point is that real estate represents 86.5 percent of all agricultural assets or $ 1.9 trillion.  From a historically based accounting system this figure is overstated in that the current market price of farmland is much higher today than what was paid by these producers.  Strict GAAP viewpoint the equity level is overstated.

13.  Implicit in the change in equity equation is the assumption that consumption can be supported by either returns from operation or capital gains.  However, capital gains only provides funds for consumption if the asset is liquidated.  Consumption can only be supported in excess of current returns by additional borrowing

14. Balance Sheet AssetsLiabilities CashXXX Debt InventoriesXXX Equity EquipmentXXX Farmland Total AssetsXXXTotal EquityXXX

15. Optimal Paths  Working through the debt-to-asset ratio  This deterioration increases the probability of equity loss.  The debt and solvency may be emblematic of the recent housing debacle.  This linkage may have consequences for the cost of debt capital to the farm sector and, hence, for the value of farmland forming a feedback to capital gains.

16. Relative Information on Changes in Equity  Moss, Gao and Schmitz (2008) examines the relative information on changes in agricultural equity from changes in real estate values, returns on agricultural assets, and interest rates.

17. Table 2. State Level Effect of Changes in Land Values, Returns and Interest Rates on Solvency State Regression Estimates Total bits of Inform ation Bits of Information Constant Real Estate Return on Assets Interest Rate Real Estate Return on Assets Interest Rate Southeast Florida0.142-0.5530.000-2.7100.7250.4990.1470.078 (0.049)(0.120)(0.000)(1.959) Southern Plains Oklahoma0.012-0.233-0.0021.2710.5580.1860.2910.081 (0.034)(0.095)(0.001)(0.798) Texas0.105-0.4360.000-1.6570.6710.4570.0360.178 (0.027)(0.098)(0.001)(0.614)

18. Table 3. Informational Results for the Fixed Effect Panel Specification Region Regression Estimates Total bits of Inform ation Bits of Information Real Estate Return on Assets Interest Rate Real Estate Return on Assets Interest Rate Lake States-0.396-0.0012.0950.9380.5730.2730.092 (0.049)(0.000)(0.936) Corn Belt-0.4700.000-1.0920.7570.6460.0600.050 (0.044)(0.000)(0.725) Northern Plains-0.428-0.001-0.3000.4880.3580.1030.026 (0.061)(0.000)(0.600) Appalachia-0.2620.000-1.1200.2140.0960.0910.026 (0.059)(0.000)(0.507) Southeast-0.3690.000-1.7260.2380.1030.0880.047 (0.086)(0.000)(0.662) Southern Plains-0.216-0.0010.0620.4330.0780.3410.014 (0.082)(0.000)(0.536)

19. What now?  The results are interest on two grounds.  First, while the results in the Southern Plains indicate that an increase in returns to agriculture reduce the aggregate debt- to-asset ratio the aggregate results suggests that increasing the rate of return on agriculture does not reduce the aggregate debt-to-asset ratio.  Second, while the informational content of returns to agriculture is high for Oklahoma and the Southern Plains, in general there is relatively more information in the appreciation of farmland than returns to agricultural assets with regard to changes in the sector’s solvency.

20. Factors Driving Farmland Values: Changes in the Housing Market

21.  In order to examine the interaction between farmland prices and house values, this study starts with a model of farmland valuation which explicitly allows for the possibility of conversion.  The resulting long-run equilibrium can be expressed as

22. Effect of Solvency on Farmland Values  Mishra, Moss, and Erickson (2008) investigate this potential linkage based on a slight reformulation of the traditional farmland valuation specification we allow for the possibility that the cost of credit to the sector could be a function of the sector’s solvency.

23. Panel Cointegration Results Returns to Farmland0.6996 Real Interest Rates-4.3291 Debt to Asset Ratio-0.0397 Government Payments-0.8205 R-Squared0.7273 R-Bar-Squared0.0217

24.  The lower the solvency of the sector could increase the market equilibrium interest rate by increasing the probability of default.  The empirical results of this study support the hypothesis that the sector’s solvency affects farmland values. Specifically, an increase the debt-service-ratio reduces farmland values through time.

25. Conclusions: What does it all add up to?  What does it mean for agricultural capital markets?  Investments in agriculture share some of the characteristics of growth stock stocks.  The internal rate of return may be very high due to capital gains on farmland, but the cash income to be used as dividends is low.  There is a persistent problem with scale: Farmers may want to downside to control their debt payments by selling farmland, but this will eliminate most of their long-run profit from appreciation.  There is a potential problem with agricultural labor as a quasi-fixed asset.  Live poor and die rich or live rich and die poor (i.e. do you finance consumption from capital gains by debt?)  Given the tendency to finance with debt and the endogeneity of the cost of debt, there is an increased tendency to sustain boom/bust cycles.

26.  What does this mean for Agricultural Policy?  The aggregate estimate of firm equity (and solvency) is probably overstated in boom periods and understated in bust periods.  There is a real dichotomy in agricultural policy with respect to payments to farmers.  Direct payments coupled with production have two possible effects:  They could increased consumption by providing spendable cash, or  They could be bid into farmland values leading to increased appreciation.