The most recent AgLetter from the Federal Reserve Bank of Chicago indicated that good farm land in Iowa decreased about 7 percent from the third quarter of 2008.  The average decrease for the five state region was 4%.  The good news that the price of good farm land increased by 2% over the second quarter of 2009.

The forecast for the fourth quarter prices were an additional decrease in values, but not at a great rate.  Pockets of strength seem to exist in areas where farmers have built up financial capital over the last few good years.  These farmers are either expanding their farm operation or trying to reduce their exposure to hikes in cash rents.

On the financial side, loan repayment rates for non-real-estate loans fell to their lowest ranking since 2006.  The index had peaked in 2008 at 150 and fell to 89 in the third quarter which is about a 40% decrease in loan repayments.  Both real estate and operating loan rates were at very favorable being in the low 6% range for the quarter.

Bankers also did not see conditions improving into the fourth quarter and beyond.

The University of Illinois had a recent October article on how land prices for Illinois had held steady from January 1, 2008 to January 1, 2009.  Prices for both years were slightly more than $4,500 per acre.  This contrasts with prior year increases.

Between 2003 and 2008, the average price per acre grew by $2,120 or about an 87% increase.  According to a surver of professional farm managers and rural appraisers in the state, prices for all of 2009 are still expected to remain steady primarily due to the expectations of cash land rents not dropping this year or next year.

These stable cash rents indicate an average of about $170 per acre in cash rents.  Just in the last three years, this average has gone up by about $38 per acre or a 29% increase.  These high cash rents may be leading to a net return to a farmer of almost zero based on a fully costed operation.  These returns compare to over a $50 per acre return in 2007 and 2008, which were considerable above average.

These low returns suggest that cash rents should drop, however, there is usually a year or two delay in this drop.  If the net return remains low for 2010, then we should expect that cash rents for 2011 and resulting land prices may drop and this drop may be dramatic.

For 2009, a taxpayer can leave an estate of $3,500,000 tax free to his/her heirs.  They can also leave an unlimited amount to their spouse.  With proper planning, this means that most farm families will be able to shelter $7,000,000 or more in farmland values from the estate tax. 

A benefit that the IRS provides to estates that have a large amount of real estate wealth such as most farmers would have is to allow the estate tax to be paid over a fourteen (14) year period.  For the amount of the estate that is represented by land values, the estate can elect to pay interest only for the first four years and then spread the principal payments over the next ten years.  The first $1,000,000 of tax related to these values is allowed an interest rate of 2% with the remainder at a rate that is still fairly low.

This election does have some drawbacks since the property needs to remain in the family and in production as a farm.  But for most farm families, this is normally the goal.

Please check this election with your estate tax advisor since it may allow you to keep the farm in the family.

After two years of steep increases, it appears that farmland values are either flattening out or starting to drop, according to the Federal Reserve Bank of Kansas City.

For example, Nebraska farmland values fell in the third quarter compared to a the third quarter of 2008 by about 5%.  The regional change was slightly lower at about a 2% negative change compared to last year.

In the third quarter, more District bankers reported weaker farm incomes primarily due to sagging protein demand and a summer decline in prices.  With shrinking margins, livestock producers have been cutting supplies by culling herds and consolidating feedlots.  In response to a special survey, bankers estimated that livestock returns would be about 10% lower than a year ago.

With lower incomes, farm credit conditions deteriorated in the third quarter.  More bankers reported lower loan repayment rates and a rise in loan renewals and extensions.  They expect this trend to continue to at least the end of the year.  However, bankers also indicated rising farm loan demand and they have plenty of money to lend to creditworthy borrowers.

Since farmland valuations spiked in the third quarter of 2008, year-over-year comparisons will show flat increases or moderate decreases.  This trend most likely will continue as long as farm income is lower than the previous year.

In the third quarter, the farm index fell to below 50, which is the lowest since 2003.  Closely tracking this index was the capital spending index, which also reached a survey low.  As you can see from the chart, these indexes peaked out in late 2007 early 2008 at levels which are about three times higher than the current levels.

 These trends need to be watched and make sure you have a good relationship with your banker and it may make sense to have at least another bank in waiting.

The USDA issued a report on Land Values and Cash Rents for January 1, 2008 to January, 1, 2009.  This is a highly detailed report that summarizes the changes in land values and cash rents by region for calendar year 2008.

Some of the highlights are as follows:

•  Average cropland values decreased by 3.9% or $110 per acre to $2,650 per acre.
• In the Cornbelt region, the decrease was 4.0% or $160 per acre to $3,870 per acre.
• In the Northern Plains and Delta regions, cropland values actually increased by 1.6% and .6%, respectively.
• Pasture values decreased by $20 per acre overall, however the Mountain region had a 16% decline in 2008.
• Although cropland values dropped in 2008, they have increased from $1,460 in 2000 to about $2,650 in 2009 or an overall 92% increase.
• In the Cornbelt, Illinois and Iowa still have average cropland values of more than $4,000 per acre.

Some highlights related to cash rents are:

• Annual cash rents rose by $4.50 or 5.3% for the year.
• Pasture rents remained unchanged.
• Cropland cash rents averaged $90 per acre, compared with $85.50 the previous year.
• The Cornbelt region had an average increase of $7 per acre to $146.
• Iowa had the highest Cornbelt average at $180 while Illinois was right behind with $170 per acre.
• California had the highest overall cash rent at $360 per acre and Washington was right behind with $245 per acre.  These were the only two states over $200 per acre.

There is a wealth of information in this report and it would be worth reading it to see how your farm operation compares to your state and region.

My partner Scot and I have a 1031 exchange company that handles many tax-deferred exchanges each year.  About this time of year I like to remind our clients that they may be able to sell their land or real estate for cash, yet defer paying the tax on the sale until 2011.

Here is how it works.

1.  Starting around July 4 or each year, you can sell your land for cash to a buyer.  You enter into a tax defer exchange agreement with a qualified company.  The money from the land sale will be parked at this company.

2.  You have up to 45 days to identify your property.  By this date, make sure to identify at least one or two properties that you would like to buy.

3.  After the 45 day date, you have an additional 135 days to purchase this identified property.  This adds up to a total of 180 days.  If you close the sale after about July 3, this 180 date will be in early 2010.

4.  If you are unable to purchase your replacement property, then the company holding your funds will refund it to you.

Under this scenario, this qualifies for an instalment sale treat.  This means that the case you receive in 2010 will be reported on your 2010 tax return and the tax will be owed either March 1, 2011 or April 15, 2011.

If you had a lot of debt paid off at the time of sale, this may not result in much of a tax reduction since that is considered paid off in 2009.

I will update you over the next several months on other ways to save money with tax deferred exchanges.

Fortune magazine just had a interesting article on farmland being a great investment, both in today’s environment over the last 5o years.  Part of the article was about investing in US farmland and part was about investing in farmland internationally.

I think the themes in the article hold true.  We will always need to eat and they really are not making any more farmland (we may be converting some, but we probably lose more to urban growth than we convert).

I think over the next generation, farmland will continue to do at least as well as other mainstream investments. 

My biggest concern is that certain hedge funds may start to invest in farmland and drive up the price to create a bubble.  This can distort the real return and cost farmers money in the short term.  The article mentioned an annual rate of return of 13% to 16%.  I think for a short time period this may be true, but over a longer period of time I think it may be tough to get much more than 10% to 12%, but this is still better than inflation and you can enjoy more than a share of stock or bond.

My other concern that normally when farmland is on the cover of a magazine like Fortune that we are usually at the top of the investment cycle for farmland at that time.  We shall see.

The Federal Reserve Bank of Chicago reported that for their district (Illinois, Indiana, Iowa, Michigan and Wisconsin) farm land values dropped 6% from the previous quarter (the largest drop for a quarter since 1985).  Also, the year-over-year increase in farmland values was up only 2% for the first quarter of 2009.  The drop ranged from 3% in Indiana to 7% for Iowa and Wisconsin.  Some parts of Iowa were down 12% for the quarter.

Increases in cash rental rates also slowed to an annual increase of 7%.  However, with the drop in commodity prices and the continued high input costs, this should continue to squeeze farmer’s margins.  State increases for cash rents were 8% for Illinois, 6% for Indiana, 8% for Iowa and 2% for Wisconsin, while Michigan’s cash rental rates declined for the year.

The increase in cash rental rates has outpaced the increase in land values.  This results in the price-to-earnings (P/E) ratio for farmland continuing to decrease.   This index (with 1981 equaling 1.0) has ranged from a low of about .75 in the mid-80’s to over 1.4 in about 2006.  The index currently stands at 1.25 compared to 1981.  A good rule of thumb is as this ratio gets too high, then farm land values are probably overstated.  As this ratio gets too low, then the opposite it true.

For the District, cash rental arrangements continue to be the large majority of leases.  For the quarter, cash rental arrangements were used 80%, crop-share were used 16%.  Cash crop rentals ranged from 68% in Illinois to 97% in Wisconsin.

As of April 1, District interest rates had reached an all-time low of 6.20% for new operating loans and 6.14% for farm real estate loans.  However, with the recent spike in 10-year Treasury Bond rates, it is my estimate that these rates may be materially higher for the second quarter (it would not surprise me that they are close to 1% higher).

Looking Forward – About 30% of the bankers polled expect farmland values to continue to drop, while the remainder expect the values to remain about the same.  This same ratio applied to expectations for new farm loans for real estate.