For those concerned about keeping farmland in agricultural production, a key measure of farmland affordability is whether farm income is sufficient to service debt on farm mortgages. In recent years, farm incomes have increased and interest rates have declined, and these two trends have combined to increase the maximum value of farmland that can be supported by current farm incomes. In 2009 and 2010 and between 1986 and 2004, farm real estate values were closely aligned with farm income. However, during two periods in particular--1978-85 and 2005-08--income from farming alone was insufficient to service the debt on farm real estate purchases.  Nonagricultural factors likely had a large role in buoying farmland values during these two periods.

In addition to nonagricultural factors, thin farmland markets may be a reason for sustained high farmland values during periods when farmland is less affordable. Historically, relatively little farmland has been available for purchase, with some estimates indicating about 0.5 percent of U.S. farmland is sold annually. Evidence suggests that most farmland owners are slow to react to changes in the market value of their land and will not necessarily sell land when farmland values are high and affordability is low. Indeed, studies of farmland market activity reveal that sales of farmland are more often due to the death or retirement of the owner rather than a result of changing affordability levels.

Changes in farm earnings will determine whether farmland values will continue recent patterns and remain affordable. At present, the demand for crops for food and as an energy source is keeping commodity stocks tight and export demand strong. However, many farm operators also receive government agricultural payments which support farm income. Many proposals for the next farm bill call for an elimination or substantial reduction in some of these payment programs. Research has shown that these payments have increased farmland values, so if these programs are abruptly terminated and not replaced with programs that provide similar levels of payments, farmland values could decline.

Farmland values sensitive to prevailing interest rates

In addition to farm earnings, historically low interest rates in recent years have been a key contributor to increasing farmland values. Indeed, the low cost of borrowing has helped improve the affordability of farmland. Record-low farm mortgage interest rates benefit farm operators who use debt to finance farmland purchases. Data from USDA's Agricultural Resource Management Survey (ARMS) reveal that land purchases by farm operators in 2008 and 2009 were financed predominantly by credit. 

In 2000, average interest rates were equal to the long-term average Treasury note rate of 6 percent. Had interest rates remained at this 6-percent level over the decade, the stream of cash flows from farmland would not have been sufficient to support the increasing farmland values experienced over the past decade. But because interest rates have generally declined over the past decade, farmland has been more affordable than it would have been had interest rates remained steady. Improved affordability can increase demand for farmland and put upward pressure on farmland values. 

This relationship can be better understood by looking at the cropland price-to-capitalized value ratio (see box, "What Is Capitalized Value?"). In 2010, this price-to-value ratio was about 0.9 based on the then-current interest rate of 3.2 percent (price-to-value ratios less than 1.0 indicate cropland values are supported by farm earnings). This suggests that farmland was somewhat undervalued given expected returns to cropland and borrowing costs, encouraging the observed appreciation in farmland values. However, it also demonstrates how quickly that could change if interest rates should begin to rise. If interest rates were to jump to the long-term average of 6 percent, the price-to-value ratio would sharply increase to over 1.5, signaling that cropland values are not supported by the stream of rents the land could earn. Abrupt changes in interest rates are not common, however.

While rapid increases in interest rates could make it difficult for some farm operators to service debt, most farm operators are not leveraged to the extent that they were leading up to the farm crisis of the 1980s. As real farm debt has remained stable while real farm asset values have increased, the farm sector debt-to-asset ratio has decreased from 0.22 in 1985 to 0.11 in 2010 (see ERS Topics page on Farm Economy).