FARMLAND PRICING IN AN INFLATIONARY ECONOMY WITH IMPLICATIONS
FOR PUBLIC POLICY
K.L. Leathers J.D. Gough
RESEARCH REPORT NO. 162
Agricultural Economics Research Unit Lincoln College
Canterbury New Zealand
THE AGRICULTURAL ECONOMICS RESEARCH UNIT Lincoln College, Canterbury, N.Z.
The Agricultural Economics Research Unit (AERU) was established in 1962 at Lincoln College, University of Canterbury. The aims of the Unit are to assist byway of economic research those groups involved in the many aspects of New Zealand primary production and product processing, distribution and marketing.
Major sources of funding have been annual grants from the Department of Scientific and Industrial Research and the College. However, a substantial proportion of the Unit's budget is derived from specific project research under contract to government departments, producer boards, farmer organisations and to commercial and industrial groups.
The Unit is involved in a wide spectrum of agricultural economics and management research, with some concentration on production economics, natural resource economics, marketing, processing and transportation. The results of research projects are published as Research Reports or Discussion Papers. (For further information regarding the Unit's publications see the inside back cover). The Unit also sponsors periodic conferences and seminars on topics of regional and national interest, often in conjunction with other organisations.
The Unit is guided in policy formation by an Advisory Committee first established in 1982.
The AERU, the Department of Agricultural Economics and Marketing, and the Department of Farm Management and Rural Valuation maintain a close working relationship on research and associated matters. The heads of these two Departments are represented on the Advisory Committee, and together with the Director, constitute an AERU Policy Committee.
UNIT ADVISORY COMMITTEE B.D. Chamberlin
Gunior Vice-President, Federated Farmers of New Zealand Inc.) P.D. Chudleigh, B.Sc. (Hons), Ph.D.
(Director, Agricultural Economics Research Unit, Lincoln College) (ex officio) ]. Clarke, CM.G.
(Member, New Zealand Planning Council) ].B. Dent, B.Sc., M.Agr.Sc., Ph.D.
(Professor & Head of Department of Farm Management & Rural Valuation, Lincoln College) Professor RH.M. Langer, B.Sc. (Hons.), Ph.D., F.RS. N.Z.,
(Principal of Lincoln College)
A.T.G. McArthur, B.Sc.(Agr.), M.Agr.Se., Ph.D.
Head of Department of Agricultural Economics & Marketing, Lincoln College) E.]. Neilson, B.A.,B.Com., F.CA., F.CI.S.
(Lincoln College Council) P. Shirtcliffe, B.Com., ACA (Nominee of Advisory Committee)
E.]. Stonyer, B.Agr. Se.
(Director, Economics Division, Ministry of Agriculture and Fisheries) ].H. Troughton, M.Agr.Sc., Ph.D.,D.Se., F.RS.N.Z.
(Assistant Director-General, Department of Scientific & Industrial Research) UNIT RESEARCH STAFF: 1984
P.D. Chudleigh, B.Se. (Hons), Ph.D.
Research Fellow in Agricultural Policy ].G. Pryde, O.B.E., M.A., F.N.Z.I.M.
Visiting Research Fellow
E. A. Attwood, B.A., Dip.Ag.Sc., M.A., Ph.D.
Sellior Research Economists A.C Beck, B.Sc.Agr., M.Ec.
RD. Lough, B.Agr.Sc.
RL. Sheppard, B.Agr.Se.(Hons), B.B.S.
Research Economist RG. Moffitt, B.Hort.Se., N.D.H.
].R Fairweather, B.Agr.Se.,B.A.,M.A.,Ph.D.
Assistant Research Economists L.B. Bain, B.Agr., LL.B.
D.E.Fowler, B.B.S., Dip. Ag. Econ.
G. Greer, B.Agr.Sc.(Hons) (D.S.I.R,Secondment) S.E. Guthrie, B.A. (Hons)
S.A. Hughes, B.Se.(Hons), D.B.A.
M. T. Laing, B.Com.(Agr), M.Com.(Agr) (Hons) P.]. McCartin, B.Agr.Com.
P.R McCrea, B.Com. (Agr), Dip. Tchg.
].P. Rathbun, B.Sc., M.Com.(Hons) Post Graduate Fellows
CK.G. Darkey, B.Se., M.Sc.
Secretary '-- 3. McNicol
LIST OF TABLES LIST OF FIGURES PREFACE
INTRODUCTION 1.1 The Problem 1.2 Study Objectives
1.3 Data Sources and Method of Analysis 1.4 Organisation of the Report
RECENT RESEARCH AND PERSPECTIVES ON LAND VALUE 2.1 Introduction
2.2 Review of Recent Research
2.3 Analytical Approaches to Land Value Analysis
CHAPTER 3 THE I<:HPIRICAL ANALYSIS AND RESULTS 3.1 Introduction
3.2 The Bid-Price Approach 3.2.1
Sensitivity analysis of model parameters Time series analysis
3.3 Summary and Limitations CHAPTER 4 SU~mARY AND CONCLUSIONS
4.1 Overview of Results
4.2 Implications for Present Policy 4.3 Suggestions for Further Research LIST OF REFERENCES
(i) (iii) (v) (vii) (ix)
2 3 3 5 5 5
9 17 17 17 17 20 29 32 35 36 38 42 43
A Detailed Description of Data Sources and Assumptions Used to Estimate the Bid Model Coefficients
B Regression Analysis of Time Series Data
LIST OF TABLES
1 Rates of Return to Equity in Farm Production Assets in Relation to the Rate of Inflation and Non-Farm Investment Returns, 1960-61 to 1979-80, 'All Classes
Average' Sheep and Beef Farm Data. 10
2 Illustration of Equilibrium Cash Flow to Owner-Operator in the Initial Year with Full Debt Financing of Farmland with Alternative Rates of Inflation, Real Growth in Land
Earnings and Real Rates of Return. 15
3 Sensitivity Analysis: Percentage Change in Individual Variables and Related Percentage Changes in Bid, Non-
Inflation Base Period 1969-70. 22
4 Sensitivity Analysis: Percentage Change in Bid Values Over a Feasible Range of Change in Model Variables,
Base Period 1969-70. 23
5 Analysis of Model Sensitivity Comparing Two Alternative Measures of Annual Net Income, 1969-70 Base Period. 24 6 Sensitivity Analysis of Inflationary and Non-Inflationary
Effects on Model Parameters: A Comparison of 1969-70 and
1979-80 Economic Conditions. 25
7 Bid Value Comparisons for Three Types of Land Purchasers Under Inflationary and Non-Inflationary Conditions. 28 8 Model Simulation Results for the Historical Time Series,
9 Weighted Average Pastoral Land Sales Prices per Hectare,
1960 to 1984. 49
10 Capital Value per Hectare of Land, Buildings and
Improvements, "All Classes Average" as Given by the Meat and Wool Boards' Economic Service vs. Valuation
Department Sales Indices. 50
Estimates of Residual Returns to Land Calculated as a Weighted Average of Classes 4 and 6 Farms, 1960-1980..
Residual Return to Land for Classes 4 and 6 Combined as a tiTeighted Average Using the Estimated Number of
Properties in Each Class.
Parameter Values Used for Bid Value Comparisons for Three Types of Farm Land Purchasers.
Selected Parameter Values for Post-1980 Bid Model Land Value Estimates.
15 Variables Used in the Correlat.Lon and Regression Analysis.
Partial Correlation Coefficients for Land Value and Selected Variables, Farm Classes 4 and 6 (Simple Average), 1969-1979.
Summary of Regression Statistics.
LIST OF FIGURES
1 Annual Net Farm Income, Nominal and Real Capital Gains, New Zealand "All Classes Average" Sheep and Beef Farms,
1960 Through 1984 (Values in 1960 dollars). 7 2 Real Value of Farm Production Assets and Percent Return
to Farm Capital. New Zealand "All Classes Average"
Sheep and Beef Farms, 1960 Through 1984 (Values in 1960
3 Comparison of Annual Bid Values and Five Year Moving Average Model Bids with Actual Market Prices of
Fattening and Grazing Land Since 1960. 31
While the importance of production and policy is well process not well understood.
the price recognised,
of land in agricultural land price formation is a
The study reported here was aimed at an examination of the cause and implications of farmland price inflation in New Zealand over the past 20 or so years. The report attempts to isolate some of the factors other than annual earnings that could explain the sudden increase in the market value of farmland during an inflationary period.
The report was written by Dr K.L. Leathers and Ms J.D. Gough (both now with the Centre for Resource Management at the College).
Financial assistance to the project from the Ministry of Agriculture and Fisheries is gratefully acknowledged.
This study was carried out as part of a larger investigation on farm size and amalgamation funded by the Economics division, Ministry of Agriculture and Fisheries. The authors' also wish to acknowledge the considerable support extended by the Valuation Department (Christchurch) in accessing and interpreting land and sales price statistics, and the assistance of Rob Davison, Meat and Wool Boards' Economic Service, in accessing the time series of sheep and beef farm income data. Ron Sandrey of the Department of Agricultural Economics and Marketing provided some constructive comments on an earlier draft of this report. The authors' are especially grateful to Peter Chudleigh for his assistance in reviewing the final draft.
The market price for farmland in New Zealand and throughout the world generally rose more rapidly in the late 1970's and early 1980's than any previous decade this century. The causes of land price inflation are not clear, but the consequences are beginning to be recognised as a serious potential threat to the future of the traditional family farm. This study examines the implications of farmland price inflation on two important national policy objectives:
efficiency of resource use and equity in ownership transfer. The general problem is characterised as one of low current returns and high farm asset values, focussing on the question ••• Is farmland overpriced?
Adopting the view that an asset is worth what a rational individual ought to be willing to pay for it, an analytical framework was formulated to depict the demand-side of the land market. Valuation Department and Meat and Wool Boards' Economic Service data provide an annual time series of farm income, production asset values and land prices for the empirical analysis covering the period 1960 through 1983. The specific study objectives were: (1) to identify the factors or decision variables which influence land value determination, (2) to evaluate the relative importance of the value determinants under inflationary and non-inflationary economic conditions, and (3) to identify the implications of selected policies for controlling inflation or for remedying associated problems such as low cash returns.
The results of this analysis reject the contention that farmland has been overpriced in recent years. Indeed, it was found that the two components of farmland earnings - current (cash) and deferred (capital appreciation) provided a return to productive farm resources equivalent to (and in some cases better than) other forms of productive investment. While it is hypothesised that large deferred earnings tend to distort resource allocation decisions in the short run, a careful examination of this effect was beyond the scope of this study. The liquidity problem which arises as a result of low current returns in an inflationary economy however was clearly demonstrated. Without special policies to augment current incomes,entry-level farmers and farmers with high debt loads cannot sustain the ownership cost of their
productive assets. Farm transfer via inheritance and purchase by individuals with significant non-farm income are less affected by rapidly rising land values. It was also clear that measures to tackle the cash flow problem such as subsidised inputs and product price supports are themselves inflationary as they are quickly capitalised into land values.
Use of the demand-side approach to the problem revealed some possibly significant insights into the causes of land inflation. The willingness to payor "bid" model produced an upper bound on the offer price considerably greater than the actual sales price in years of high rates of inflation. This "excess demand" condition did not occur for that part of the time series characterised as non-inflationary. On the basis of this finding it was hypothesised that the so-called excess demand put an upward pressure on farmland prices during the mid 1970's
to early 1980's, resulting in observed market price changes considerably in excess of the inflation rate as measured by the Consumer Price Index. A sensitivity analysis of the model parameters suggested that certain factors had a greater relative (individual) impact on excess demand than others. The variables which had the greatest influence on the bid value are in order of importance: the general inflation rate, a tax on deferred earnings (capital gains), the opportunity cost of capital, and the length of the planning horizon.
Some implications of specific policies to alter land price inflation and liquidity are discussed along with suggestions for further study.
During the past decade, farmland prices have risen considerably faster than current net farm incomes would seem to warrant. Since the early 1970's unrealised capital gains have accounted for a greater proportion of total land earnings than realised cash income, a result that has never been consistently observed in previous decades. The amount of this inflation-induced wealth creation is staggering when one considers that it is a world-wide phenomenon. Using New Zealand's 14 million hectare pastoral sector as an example, nominal capital gains have ranged between $0.5 and $1.5 billion per annum in recent years, or up to one third of this country's gross agricultural export earnings.
This report examines the causes and implications of farmland price inflation in New Zealand. The root causes of inflation are generally understood, but the relationship between general price inflation and the market value of farmland is not readily apparent. The capitalisation of land earnings, as conventionally measured by net annual returns (rent) to the land owner, is no longer a reliable predictor of market value. In an inflationary economy it has become clear that factors other than annual earnings play an important role.
The purpose of this study was to analyse the land value mechanism in a market economy during an inflationary episode, and to identify the substantive issues and implications for farm policy.
1.1 The Problem
Market evidence in recent years indicates that the price of farmland has increased at a rate greater than the general rate of inflation. Since 1960, the price of land for fattening and grazing uses increased by nearly 800 per cent while the general inflation rate, as measured by the Consumer Price Index, increased by about 500 per cent. The change in land values during the past two to three years has been most notable: the general farmland price index increased by 33 per cent in 1980-81 and by over 40 per cent in 1981-82, but declined slightly in 1982-83. In contrast, net farm income in real terms (i.e., adjusted for price inflation) has essentially remained unchanged since the early 1970's. On the surface these rates of change in market value suggest that farmland may be overpriced as a productive asset.
The implications of land price inflation are cause for considerable concern to policy makers. U.S. researchers, for example, Melichar (1979) and Stevens (1978), have shown that severe liquidity problems can arise from the situation where land provides a low current return and a relatively high deferred return in the form of capital gains a "growth stock" behaviour. More recently, Tweeten (1981) examined the question of whether the source of the cash flow problem was inflation or a real increase in land earnings, and he concluded that the land market has exhibited a "text hook" response to the
condition of the 1970's. Webb (1982) has demonstrated how investors with a high marginal tax rate can effectively (and rationally) "bid away" land from investors in lower tax brackets. Others, particularly accountants and appraisers, have explored the implications of negative
"effective" borrowing rates for land purchase as a hedge against inflation (Gibbons, 1980).
The extent of research on the causes and implications of land price inflation in New Zealand is very limited. None-the-Iess recent changes in policy regarding tax exemptions for the sale or exchange of farmland are likely to have significant implications on how the farmland market operates in the future. The recent legislation (NZ Government, 1982) was a major attempt to lessen the effect of non-farm 'speculative' incentives to land ownership. If farmland is treated as a growth stock-type investment, then the position of the young or entry-level farmer must be looked at very carefully. The possibility that the price of farmland can be bid up by speculators with outside sources of income to supplement farm earnings is an issue of current importance to policy makers. Accordingly, there is a need to identify the various groups which compete in the farmland market. These groups vary between countries according to government policy on land ownership (for example, foreign investment in farms is strongly discouraged in New Zealand), but the same principles of competition apply. In most countries, and particularly in New Zealand, it is considered desirable that young farmers aspire to farm ownership, and considerable emphasis is placed on government policies to assist with this objective
With capital gains being a large component of farmland earnings during an inflationary period, farmer expectations may lead to suboptimal investment decisions from the national economic efficiency point of view. New Zealand policy makers are concerned that "farming for capital gain" might have a distorting influence on investment flows, with scarce capital resources tending to favour longer-term gains at the expense of maintenance and shorter-term development which is necessary to sustain a desired rate of growth in agricultural output.
The implications of inflation on cash flow and liquidity, land tenure and ownership transfer and sustained productivity are not well understood, and so far very little research work has been directed to these issues. One problem which may be important relates to the definition of inflation; i t is conceivable that the results of an analysis of inflationary impacts would depend on the definition of inflation used. More importantly. however, are the criteria appropriate to assessing impacts as these relate directly to policy objectives and alternative policy instruments.
1.2 Study Objectives
The primary aim of this study was to provide an explanation of the recent inflationary trend in farmland prices and to identify the implications for agricultural policy. The specific objectives were:
1. to construct a theoretical model of farmland valuation as an aid to identifying the factors which influence value determination, particularly the factors of inflation, interest rates and expected earning flows;
2. to apply the model in an analysis of New Zealand pastoral land prices during the past two decades; and
3. to examine the possible consequences of selected policy measures to influence land values directly or to remedy problems associated with inflation, such as liquidity.
1.3 Data Sources and Method of Analysis
Data for the analysis were obtained primarily from two sources:
the Meat and Wool Boards' Economic Service (MWBES) and the Valuation Department. It is recognised that historic prices based on market transactions will differ from the standard measures of value, notably the income capitalisation approach, hence both data series are required in the analysis. The MWBES data provided basic information on annual farm income, production assets, liabilities and net worth for sheep and beef farms covering the period 1960 through 1983. The MWBES 'all classes average' farm was used so the results of this analysis could be broadly representative of conditions in the sheep and beef sector as a whole. The Valuation Department data series was used to construct price trends for land classes consistent with the MWBES definition of the 'all classes average' farm.
TWo basic types of Quantitative analysis were undertaken. Using a modification of the Lee and Rask (1976) capitalisation formula, a sensitivity analysis of the bid-price model parameters representing New Zealand conditions was used to identify causal relationships between capitalisation (willingness to pay) variables and land price.
Cross-section analysis, depicting bid responses for different types of farmland purchasers, and time series analysis of bid responses in comparison with actual market prices observed since 1960 formed the basic approach to this study. Linear regression techniques were also applied to the time series data in an attempt to estimate statistical relationships between land value, returns, inflation and other factors.
1.4 Organisation of the Report
The findings of the study are reported in the three remaining chapters. Chapter 2 presents a brief review and interpretation of the data and approaches used to assess the implications of farmland pricing during periods of general price inflation. In Chapter 3 the results of the empirical analysis are reported, and in Chapter 4 the policy implications to be derived from the analysis are summarised. The time series data on land prices, current returns and production assets and the adjustments used to prepare the data for analysis are summarised in Appendix A.
RECENT RESEARCH AND PERSPECTIVES ON LAND VALUE
Classical economic theory treated land as a productive asset fixed by nature, and equated its value to its ability to generate rent or income. Ricardo was among the first early economists to explain the relationship between the market value of land and its marginal productivity. However, the land problem that preoccupied early social policy makers - namely, the spectre of excessive rent accruing to the landlord as a result of land scarcity - has not so far materialised.
The barrier posed by nature has evidently been "pushed back" by technological advances in agricultural production methods and enlightened social policies regarding land tenure. With the exception of the 1970's and early 1980's, historical analyses demonstrate the close correspondence between land value (as reflected by market price) and capitalised annual net earnings (Melichar, 1979).
If land value is to be defined in terms of land rent, or returns to the factor land, then the question "Is land overpriced?" requires a careful, evaluative comparison of changes in asset value and net farm income over time. The crux of the problem in making such a comparison lies in the fact that the meaning of 'value' and, in particular, 'rent', is open to different interpretations. Recent research however has helped to clarify some of the issues pertinent to the present policy debate and the implications of policy actions.
2.2 Review of Recent Research
Melichar (1979) studied the relationship between real capital gains and the current return to farm assets using aggregate U.S. data.
He hypothesised that " ••• a farm economy characterised by rapid growth in the current return to assets will tend to experience large annual capital gains and a low rate of current return." The time series analysis confirmed the hypothesis that the rate of change in current income was capitalised into land value, and that policy actions seeking to increase the growth rate of current return will in fact depress the rate of current return due to the increase in capital appreciation. He concluded that the farming sector, at current interest (discount) rates, would continue to experience low returns on the market value of farm assets. In the mid to long term, farmland provided an attractive investment with eventual high rates of return to the established farmer or non-farm investor with large cash reserves.
While persons of limited means (young or part-time farmers) might find it difficult to undertake such an investment, Melichar's main point is that any aid provided to these people should be designed to
avoid increasing the growth rate of the current return.! This implication was reinforced by Reinsel and Reinsel (1979), who argued that the process of land inflation was likely to be accentuated by current U.S. policies designed to assist the beginning farmer. Further implications of continuously rising land values were that land ownership will become concentrated in fewer hands and that entry into farming will occur mainly through inheritance.
Working from the assumption that it is undesirable to have agricultural land concentrated in a few hands and that this is the inevitable end of inflating land value, Plaxico (1979) suggested some alternative policy objectives: reduce the rise in land prices, reduce the appeal of wealth increases relative to current income via taxes, reduce the ability of farmers to hand the wealth on to their children, and design commodity support programs so that returns accrue to factors other than land. While he was referring to the U.S. situation, these could make for useful further discussion in the New Zealand policy context.
Data similar to that used by Melichar (1979) were constructed from the Meat and Wool Boards' Economic Service (MWBES) Sheep and Beef Survey 'All Classes Average'. In Figure 1 real capital gains and nominal capital gains versus current net income, in $1960, are summarised. To be correct conceptually nominal capital gains should measure the increase in the value of physical assets minus total net investment and net transfers into the farming sector (Bhatia, 1971).
The MWBES data however do not provide information about net investment and net transfers. An estimate of real capital gains was computed by adjusting the nominal capital gains for the gains or losses resulting from each year's change in the value of the funds tied up in assets and liabilities. It should be noted that this approach only provides an approximation of the 'net' change in equity.4 A three year moving average was used in the 1960's since at this time land valuations were revised at three year intervals. A concise summary of land price trends and the assumptions made in calculating capital gains for the period is reported in Appendix A.
The New Zealand result is very similar to that presented by Melichar. Net income has remained fairly constant over the 23 year period while real and nominal capital gains fluctuated more noticeably.
The pre 1970's non-inflationary period is clearly distinguished in these data (also see Appendix A). Prior to 1972 capital gains were at a level of about one third of net income, and after that the two were more nearly equal. Nominal capital gains have exceeded annual net income since 1971-72. The drop in real capital gains in 1974-75 and the increase in 1978-79 are attributed to product price changes.
1. In other words assistance to beginning farmers would best be found as subsidised loans and debt service policies rather than price and income supports, which would enhance the cash flow of all farmers in general.
2. While the conclusions are dependent on a rather crude measure of net investment, the authors' do not believe a more refined estimate would substantially change the overall results.
$ per Hectare 110
100 90 80 70 60 50 40 30 20 10
Annual Net Farm Income, Nominal and Real Capital Gains, New Zealand "All Classes Average" Sheep and Beef
1960 Through 1984 (Values in 1960 dollars)
Annual Net Farm Income Nominal Capital Gains Real Capital Gains
/ \ I
I:: \ f
/. • \ /\ I
/0° \ I \
I: V V
I / I
1960 62 64 66 68 70 72 74 76 78 80 82 84 Year
Real Value of Farm Production Assets and Percent Return
$ per Hectare 1+00
350 300 250
200 1 SO IOU
to Farm Capital, New Zealand "All Classes Average"
Sheep and Bee f Farms, 1960 Th rough 1984 (Values in 1960 dollars)
Real VaLue of Farm Production Assets Including Land
Perc(Ont Return to PrnouctiOi1 Assets
I \ I \1 /
/ \/ - /
1960 62 64 66 68 70 77 78 8U
}~(" turn 10
Throughout the 1970's capital gains moved in the same direction as net income but in an exaggerated manner. The high farm i~ome in 1972-73 was accompanied by a massive capital gain, eventually evened out by the downturn in 1974-75. Realised or expected income is positively correlated with shifts in capital gains through the 20 year period, but it does not seem that capital gains compensate for years of low income.
The divergence between nominal and real capital gains reflects th~
increasing importance of farm debt servicing in the 1970's and 1980's.
Perhaps a more appropriate measure of the inflationary impact of land price on farm income is the residual return to production assets.
The rate of return to farm production assets is compared with the value of production assets in Figure 2. The rate of return was calculated according to the MWBES definition which includes an allowance for family and operators labour.4 The results clearly show a steady decline in the efficiency of farm capital investment, particularly from about the mid 1970's on.
Excluding the years of extreme fluctuation these data indicate an average annual rate of current return to production assets at between 2 and 6 per cent, with a rate of growth in current return varying from -0.4 to 0.1 per cent. The apparent zero growth rate may be due to limitations of the data or possibly in the assumptions used. 5 However, at such low rates much of the total return to farmland is in the form of unrealised capital gains. In a theoretical examination of the relationship between current return, capital gains and assets at equilibrium, Melichar concludes (with respect to the U.S. experience) that the substantial capital gains received are no greater than would be expected to occur at equilibrium with the current growth rate in net income in the neighbourhood of 2 to 6 per cent.
Economists have generally avoided adding current income and capital gains to obtain a total return to farmland. The two measures are often incompatible because income is a realised gain whereas capital gains are generally unrealised. Bhatia (1971) concluded that farmers tend to have a high propensity to save from capital gains
3. Nominal capital gains, that is the appreciation in asset value relevant to liabilities at current prices, is not easily translated into a form of 'net worth' or equity that is of immediate benefit to the farmer. In a period of high price inflation 'real' capital appreciation can be considerably less than the "nominal" gain, yet the terms of borrowing are typically based on nominal value estimates. The resulting effect is that many farmers who are in the process of expanding their operations find it difficult to service new mortgage obligations out of current income and/or real 'realised' capital gains through the sale of previously held farmland.
4. In this case "efficiency" is measured in terms of the net return to the productive farm assets employed, which is the appropriate measure from the national viewpoint (Leathers and Gough, 1984).
5. See for example Bhatia (1971).
probably because they have little choice. It may be, however, that unrealised capital gains may become realised as farmers seek to refinance mortgages on an ongoing basis or expand their operations
through amalgamation based on improved leverage.
Assuming that a broad view of the rate of return is relevant, namely that a portion of all of the annual capital gain is treated as annual farmland earnings, then the above conclusions might lend themselves to a different interpretation. Rates of return to equity in farm production assets, including cash income and capital gains, are summarised in Table 1 for MWBES 'all classes average' data covering the last two decades, 1960-61 through 1979-80. The calculations for current returns, real capital gains and production assets are consistent with the measures used in constructing the data series reported in Figures 1 and 2. For comparison purposes, Table 1 also reports the real rate of return on secured savings (as a surrogate for non-farm investment opportunities), the inflation rate as measured by the Consumer Price Index, and the corresponding U.S. decade averages (in brackets) for rates of return as reported by TWeeten (1981) in a recent study of farms in the American midwest.
The conclusions drawn from these time series data are summarised as follows:
1. Annual returns in the form of unrealised capital gains are more volatile than residual returns out of cash income;
2. capital gains have become a progressively more important component of the returns to farmland ownership, especially during the 1970's and particularly in the latter years of the series;
3. the relative proportions between current residual cash returns to equity and capital gains for New Zealand and the U.S. during this time period are almost mirror images of each other; and
4. the percent return to farm equity, measured by cash income and capital gains, has generally exceeded the real expected rate of return on secured (riskless) non-farm investment (savings) opportunities.
Clearly the inflation-hedge aspect alone - an average real gain of 4.6 per cent versus -0.6 per cent on insured deposits during the 1970's and early 1980's - made land an attractive investment during this period. It is also clear that land is not overpriced at these rates of return. In TWeeten's view of the definition of land rent, the net returns, both realised and expected (capital gains), fully explain the prices observed in the market for farmland in recent years.
2.3 Analytical Approaches to Land Value Analysis Harris
and Nehring (1976) constructed a theoretical model of the price prospective buyers would be willing to offer to
. Rates of Return to Equity in Farm Pr.oduction Assets in Relation to the Rate of Inflation and Non-Farm Investment Returns, 1960-61 to 1979-80, 'All Classes Average' Sheep and Beef Farm Data a
Percent Return to Rate of Return Inflation Farm Equity b on Secured Rate b
Savings b Farm Real
Residual Capital Total Year Income Gains Earnings
% % % % %
1960-61 4.8 -3.5 1.3 3.1 2.0
1961-62 3.7 -7.7 -4.0 2.3 2.9
1962-63 5.5 1.5 7.0 3.3 1.9
1963-64 5.5 16.5 22.0 1.8 3.3
1964-65 4.5 ... 3.2 1.3 3.1 3.6
1965-66 3.8 -0.3 3.5 4.1 2.6
1966-67 2.7 14.8 17 .5 1.1 5.9
1967-68 3.3 -2.8 0.5 2.8 4.4
1968-69 4.5 -2.4 2.1 2.0 5.0
1969-70 3.7 13.1 16.8 0.9 6.6
1960-70 4.2 2.6 6.8 2.5 3.8
US averageC (3.7) (3.1) (6.8)
1970-71 3.0 -6.2 -3.2 -2.1 10.6
1971-72 3.9 -3.0 0.9 0.4 6.8
1972-73 8.7 31.5 40.2 -0.9 8.1
1973-74 4.0 9.5 13.5 0.7 11.3
1974-75 -0.1 -3.8 -3.9 -2.5 14.5
1975-76 3.2 -0.5 2.7 -4.0 17.0
1976-77 4.7 5.9 10.6 -0.4 14.4
1977-78 1.9 -3.1 -1.2 2.2 11.8
1978-79 2.4 8.1 10.5 1.7 13.8
1979-80 2.4 7.1 9.5 -0.7 17.2
1970-80 3.4 4.6 8.0 -0.6 12.6
US average C (4.8) (7.3) (12.2)
1960-80 3.8 3.6 7.4 0.9 8.2
US average C (4.3) (5.2) (9.5)
a. Data expressed in terms of per average farm statistics.
b. Refer to Appendix A for definitions and method of calculation.
c. US average data as reported by TWeeten (1981).
obtain a risky asset. 6 The variables included in the model were net income, income variability, wealth, degree of risk aversion, marginal income tax, rate of pure time preference and expected rate of growth in land earnings and relationships between different types of buyers competing in the land market. 7
The major difficulty faced in this approach concerns the specification of utility functions for the purchasers. One of the major factors affecting the ability of one group to outbid another proved to be the degree of risk aversion, and it is by no means certain that the largest farmers will always offer the highest bid.
Plaxico and Kletke (1979) analysed unrealised capital gain in farmland with the use of a capital budgeting approach. Three alternative models were used to compare capital gain decisions. The first model considered the present value of capital gains only when the asset was sold. Essentially this model defines value as equal to the discounted expected return divided by the capitalisation rate. The second decision model viewed the stream of unrealised annual capital gain as equivalent to a tax deferred income stream with tax being paid at capital gains rates when the property was sold or at the end of the planning horizon. With this approach equity increases occur annually and can be viewed as increased reserves. Whilst the second model assumes that the equity increases have value only in the year in which they occur, a third model considered the increase as an annual cumulative equity being continuously re-invested with interest paid each year.
The above study did not attempt to compare the characteristics of different farm operations, but it does illustrate the effects of varying attitudes to increases in land value. The rate of land price inflation and the length of the planning period were varied to show the effects on the annual capital gains. Whereas the third model produced the highest total value of capital gains, the second model produced the highest present value gain. The authors also examined the sensitivity of a number of other variables and concluded that factors besides capital gain could be possibly more important as a basis for policy decisions regarding farmland marketing.
In a paper by Lusht and Zerbst (1980), variations on the standard capitalisation formula are suggested and results compared for periods of high inflation in land value. Particular emphasis was given to mortgage market factors and equity positions.
6. For present owing to the contrast to bonds which investment.
purposes farmland is considered a risky variability of annual net returns.
a riskless investment such as government specify guaranteed premiums for the
investment This is in stocks and term of the
7. The rate at which future income is discounted in terms of the present. The concept of a pure rate of time preference as distinguished from an opportunity cost of capital measure is appropriate here (D'arge, 1970).
A somewhat similar approach has been adopted by TWeeten (1981).
He examines land pricing under stationary and inflationary conditions and obtains solutions for 'breakeven years' or years in which interest payments are first covered by annual income. The question of realising capital gains by refinancing mortgages was analysed, and it was shown that this method would lessen the problem of cash flow faced by new farmers.
For the purposes of the present analysis, the conceptual framework suggested by TWeeten (1981) was adopted. Essentially the TWeeten framework is an expansion of the classical Ricardian model of asset valuation. The market value of an asset is computed by dividing the expected annual return by the rate of return of the next best alternative for the time period in question.
In the TWeeten formulation expectations of future land earnings, hence current price per hectare Po, are a function of the initial earnings Ro and the rate of growth in earnings attributed to inflation i, the earnings increment in
,excess of general inflation and alternative investment options i , the difference in tax rates that favour capital gains €, the potential benefits from leverage Land
"cheap" mortgage money when the borrowing rate is less than the rate of inflation. Given a real rate of return a, the discount rate provides an estimate of the present worth of a hectare of farm land:
(l ) P = R / (O'.-i '--E:-i]JL /0'.) o 0
Under perfect knowledge and competitive equilibrium Po= ~/O'.. But in an inflationary economy with less certain expectations on the part of borrowers and lenders, severe distortions can be introduced into the land market. As the denominator in (1) approaches 0'., land price increases and the current rate of earnings decreases. If the rate of inflation i is 9 per cent and 0'.= .04, ]J= .02 and L =.8 (disregarding i ' and € for the moment), the annual rate of increase in nominal earnings is 12.5 per cent. If the purchaser pays cash (L = 0) or if the mortgage interest rate is in line with the inflation-adjusted land returns (]J = 0), the capitalisation formula in equation (1) no longer applies. If ]J
>0, say 1 per cent, the land value/earnings multiplier 1/ ( ex - i]J L/ 0'.) is increased from 25 (when = 0) to 45 which yields a land price 80 per cent higher than if concessional mortgage financing did not exist. The correct capitalisation formula becomes:
Jt=o e _0 _ _ rt dt
e natural log base
t 0, 00 time horizon
R o r-J
CO'.+i) - i = R o 0'.
r discount rate or nominal expected rate of return
Money market disequilibrium can occur from several sources, the most important being a negative real rate of interest for borrowed
funds. Under perfect expectations, between lenders and borrowers. But fixed mortgage interest rates, i
lenders and borrowers, benefiting shown by the expression:
no real wealth transfer would occur with unanticipated inflation i1and
0, real wealth w transfers between the borrower when i
>o. This is
(3) w R e (i + i ')t o
r t e
fOO t=o R 0 eit dt
r t e
i "p o
Several important consequences of concessional credit and leverage in a period of unanticipated inflation follow from Tweeten's conceptual model:
1. net transfers of real wealth to farmers;
2. the more highly leveraged farmers gain the most;
3. larger farmers are in a position to "bid" away land from small farmers, providing the stimulus for amalgamation;
4. non-farm investors in farmland are disadvantaged B in benefiting from concessional credit due to the lending policies of the Rural Bank (but their role in the farmland market may increase due to
the problem of liquidity); and 5. in the absence of government
borrowing rate, the money market as lender expectations adjust.
subsidies which disequilibrium
influence the should dissipate
Inflation results in a severe cash flow or liquidity problem because the initial rate of return falls by i' as can be seen in equation (2). Finaoce instruments have terms which are normally fixed over time, hence e1t drops out of the formula and r is replaced by 0+ i where 0 represents the real rate of market interest in competitive equilibrium and i the inflation premium. With a perpetual mortgage on the land, annual interest payments are Po (0
+i) with surplus cash in year t:
- P (O+i)
o p P (cxeit - (O+i)) o
B. In New Zealand concessional terms and conditions for farm development loans available through the Rural Bank are limited to individuals whose primary income source is farming. The major exceptions to this rule are programs such as the Livestock Incentive Scheme and the Land Development Encouragement Loan which are based on a 'performance test' rather than a 'tenure test' in granting assistance.
oif i = 0 and a
Since high levels of inflation have their greatest impact on cash flow in early years, large cash deficits affect new landowners more than established farmers.
The liquidity problem is illustrated in Table 2. A 'with and without" inflation case was compared using two alternative rates of growth in real farm land earnings (a) and rates of return of 4 and 6 per cent which were consistent with the historical data presented in Table 1. The non-inflationary state assumes a mortgage interest rate of 3 per cent, and at 15 per cent inflation the results illustrate what happens if the "effective" borrowing rate is 3 percentage points below the nominal rate, that is from the earlier discussion
w=0.03. A full perpetual mortgage was assumed and no allowance is made for principal repayment. The results are a good indiction of the liquidity problem faced by many New Zealand farmers during the 1970's.
Tweeten (1981) concluded from his empirical analysis that the hypothesis of the land earnings/price ratio being invariant to inflation should not be rejected. His results for ten mid-western U.S.
States were consistent with those found using New Zealand pastoral sector data (Table 1) and Melichar's (1979) aggregated U.S. data. The long run implication was that the current rate of return to farm production resources will fall until total real earnings are in line with all other investment opportunities, ceteris paribus. So far this has not happened because capital gains are not easily realised.
Further, if the present trend continues through the 1980's, non-farm investors will find farm land increasingly attractive, and young aspiring farmers will find it less attractive, leading to a change in the social structure of land ownership. Part-time farmers with non-farm incomes and large corporate farm organisations will be in an improved bargaining position in the land market.
As illustrated in Figures 1 and 2, the rapid decline in inflation in 1983 along with a downturn in farm income resulted in a sharp decline in nominal capital gains as a component of farmland earnings.
This is a significant result for it is the first time in nearly a decade that the rate of price inflation has dropped below a double digit figure (see Table 1). If a low level of inflation were to continue through the 1980's it would have the effect of reducing the attractiveness of investing in farmland by non-farmers. If inflation were to return after several years then it is likely that the recent trend in the change of land ownership would continue. namely an increasing proportion of non-farm income earners and corporate farm organisations participating in the farmland market.
Illustration of Equilibrium Cash Flow to Owner-operator in the Initial Year with Full Debt Financing of Farmland with Alternative Rates of Inflation, Real Growth in Land
Earnings and Real Rates of Return
Measure of Cost and Return Items for Consideration
Current earnings Deferred earnings
Real capital gains Nominal capital gaIns Total Returns a
Mortgage interest rate Cash-flow surplus b
Inflation and Real Land Earnings Growth Rate No national inflation and
annual real growth in land earnings of:-
opercent 2 percent
"'.04 =.06 "'.04 "'.06
Fifteen percent national inflation and annual real growth in land earnings of:-
opercent 2 percent
~.04 <=.06 =.04 =.06 Percent of Land Value
(0) (0) 4
(0) (0) 6
2 2 (2) (0) 4
4 2 ( 2) (0) 6
15 (0) ( 15) 19
2 17 (2) ( 15) 19
4 17 (2) ( 15)
Source: Adapted from Tweeten (1981) p.19.
a. Rate of return to farm production assets
b. Current land earnings rate less mortgage interest rate on a perpetual mortgage. The cash flow surplus would be smaller if nrincinal DAvrnpnrs h l P r p ;nf'll1n",n
THE EMPIRICAL ANALYSIS AND RESULTS
The dramatic increase in farmland value since 1970, as discussed in Chapter 2, is only partially explained by the residual returns to land. Indeed the evidence presented suggests that the level of current earnings (residual cash income) plus unrealised capital gains during the 1970's could have supported even higher land values than the market prices actually observed. In this chapter the various determinants of the conventional valuation formula are examined in detail. As an extension of the theoretical framework suggested by TWeeten (1981), a bid-price model was used to examine the importance of selected variables on the purchasers' "willingness to pay" or demand for land ownership. The chapter concludes with a summary of the empirical results and limitations of the analysis.
3.2 The Bid-Price Approach
This approach to land value determination considers the 'bid' or offer price that the prospective buyer is willing to pay under a set of specified conditions. The bid-price is dependent upon a number of factors which vary according to the financial position and resources of the buyer. Lee (1976) and Lee and Rask (1976) developed the approach as a Quantitative framework for calculating the maximum bid-price.
With this model it is possible to look at changes in land value over time and also to examine the ability of different purchasers under varying financial conditions to service mortgage repayment obligations.
Factors hypothesised to influence land value are, in addition to earnings, current mortgage interest rates, current finance company or bank interest rates (the opportunity cost of alternative investments), the general inflation rate, the level of government subsidies to agriculture, current and expected product prices, the mortgage finance terms, and the length of the investment planning period, among others.
3.2.1 Model specification.
It is assumed initially that the bid-price will be dependent primarily upon the expected income from the land and the debt service obligation (including down payment and current mortgage interest rates). If the purchaser is a farmer seeking a farm unit to live and work on, then the expected income will be critical since servicing the debt and developing the property will come out of earned farm income.
In the case of a farmer owning a self-sufficient unit and seeking to purchase additional land, expected income may be less important.
However, for at least an initial period the income from the purchased land will be needed to service the debt. The latter case may not
necessarily apply to a businessman, with an outside source of income.
The conventional formula used widely by real estate appraisers to obtain a residual earnings measure of land value is:
where: r is the capitalisation rate,
I is the expected residual net return (rent) to land, and
V is the resulting land value.
The assumptions inherent in this formula are that the investment is expected to produce the same annual rent over time, that the capitalisation rate used to discount future net rent remains constant, and that the investment time horizon is infinite.
The improved formula developed by Lee (1976) is based on the premise that purchasing a parcel of land is an acceptable investment alternative if:
1. the present value of net cash receipts is equal to or greater than the present value of the cash outlays (that is, if the net present value is equal to or greater than zero), or
2. the yield or internal rate of return exceeds the opportunity cost of capital.
The cash inflows are annual income adjusted for capital gains tax (if any) at the end of the planning period, and the outflows are the initial cash outlay and interest payments adjusted for tax shelter effects.
Lee's improved capitalisation formula is:
IR(IIR)t t I [(I+IR)t-i+.l_
1J ( I-DP) (MTR) (IR).[ + ] L: .
t 1.=(I+CC)1 1
(I+IR) -I -I IR( I+IR)t-l+
Where the variables are defined as:
P the average price per hectare from recent sales CC = the after tax opportunity cost of capital
n the planning horizon of the purchaser
=the expected annual net cash income per hectare before taxes
GNI = the expected annual rate of growth in net cash income per hectare
=the purchaser's marginal income tax rate
DP = the proportion of the purchase price paid down
=the nominal rate of interest charged on mortgage loans INF the rate of inflation in the general price level
t the amortisation period of the loan T
=the capital gains tax rate, and
=the computed maximum bid or offer price per hectare.
The data used and/or assumptions for the parameters in equation (6) are summarised below:
P: The market price for fattening and grazing properties sold was obtained from annual Valuation Department reports from 1970 onwards. Prior to 1970, sales price indices for fattening and grazing units had to be used to compute a series for the 1960's.
Using the actual sales price for 1979 as the common basis, the two series were combined as a weighted average based on the number of sales reported by farm class in each ten year time period.
CC: The opportunity cost of capital was taken to be the secured savings rate available in the commercial banking system. Reserve Bank Bulletins provide a 'finance company rate' for no risk term savings of four or more years. This was reduced by a specified range of marginal tax rates to give the after tax opportunity cost rates or return.
ANI: TWo different measures of annual current returns were used. Before tax annual net income was calculated from the MWBES sheep and beef farm survey reports. Farm classes 4 and 6 were used to derive the time series income data. The residual return to land was calculated as gross profit minus total expenditure: plus salaries, interest and rent paid: minus a managerial reward and the interest on the capital value of stock and plant. A weighted average of the two classes was computed using the estimated number of properties sold in each class per year. The weighted average of classes 4 and 6 was thought to be a more reliable estimate of
income than the "all classes average" data. The residual return to land was used in preference to the net income, since it is the residual return that is used in estimating the value of land less mobile improvements.
GNI: There was no discernible growth in net income during the two decades under study. Accordingly, several alternative rates of growth were assumed for the purpose of sensitivity analysis.
MTR: The marginal tax rate was based on the average taxable earnings of a 340 hectare class 4 or class 6 farm. The New Zealand tax rate on this level of income assumes standard exemptions for a wife and two children, school fees, superannuation and life insurance.
IR: The nominal interest rate used was the average rate for new mortgages as reported in the monthly Reserve Bank Bulletins.
INF: The inflation rate used was the general price inflation index (the CPI) as reported by the Department of Statistics. 9
DP: The down payment on the purchase price was assumed to vary according to characteristics of the purchaser, but in general it ranged between 20 and 50 per cent.
n,t: The planning horizon and amortisation periods were specified at several alternative lengths of time in years.
T: The capital gains tax was varied from zero to 50 per cent depending on the particular situation under analysis.
3.2.2 Sensitivity analysis of model parameters.
The sensitivity of the bid values to changes in model parameters was examined at three levels: (1) to ascertain the relative importance of individual variables and interactions between variables, and to explore the effect of different definitions of land earnings; (2) to demonstrate the influence of price inflation on willingness to pay by comparing the model results between inflationary and non-inflationary time periods; and (3) to evaluate the effect of inflation on willingness to pay from the perspective of different types of land purchasers or assumptions regarding buyers' 'ability to pay'.
Assuming that the buyer responds rationally to market forces and formulates rational expectations about the future, the bid (or valuation) model should yield theoretically sound estimates of willingness to pay (or demand). The logical consistency and scope of the model in handling a broad range of variables and interactions should aid understanding of the influence that particular factors such
9. It should be noted that the INF variable (a measure of the value of the dollar) is different from land price inflation. That is, INF is used as an explanatory variable in the model to generate estimates of P or "bids" for comparison with actual sale prices (see P above).
as inflation have on market demand, hence land prices. The first step in the analysis was to formulate a 'base case' of conditions and to test the sensitivity of individual variables on bid values.
The purpose in establishing a non-inflationary 'base case' was to provide a basis for comparing the sensitivity of model parameters and interactions with that of an inflationary situation. It was hypothesised that both the relative importance of individual variables and the interactions between them would differ, since the relativities between the variables might be different in an inflationary versus non-inflationary environment. The base year selected was 1969-70, a representative pre-inflationary period in New Zealand. The values of the variables used in the model were obtained from secondary sources of published data on the base year (refer to the Appendix for a summary of the data series). The base case and results of the sensitivity analysis are summarised in Table 3. The values of each of the variables identified in the left hand column are believed to closely depict the actual market and other conditions which were experienced by farmland buyers in 1969-70. The values for nand t were arbitrary but, as will be demonstrated later, they have apparently little impact on