Box B: Dairy farm land valuation - an examination based on price multiples

This page contains information on Dairy farm land valuation - an examination based on price multiples from the May 2016 Financial Stability Report.

Dairy farm land in New Zealand has historically experienced pronounced price cycles, with periods of market strength often followed by significant price corrections (figure B1). With dairy incomes remaining depressed for many seasons, there is concern that dairy land prices could decline sharply. This box examines the pricing of dairy farm land in a historical context to provide insight into current land values and the potential for prices to fall sharply.

Figure B1: Real dairy farm land prices (2015 dollars)

Figure B1 Real dairy farm land prices (2015 dollars)

Source: CoreLogic NZ, REINZ, Statistics New Zealand, RBNZ estimates.

Valuing farm land is an inherently complicated exercise as several factors may influence prices. For example, average dairy farm values are affected by the expected future profitability of the dairy operation, the value placed on nearby amenities and the option to convert the land to other agricultural or non-agricultural uses.1 However, if the relationship between profitability and these factors remains stable through time, simple financial metrics can provide useful insight into relative valuation. This box makes use of two such metrics: the price-to-revenue (P/R) and price-to-earnings (P/E) ratios.2

Figure B2 displays the historical relationship between dairy farm prices and revenues and earnings. Since 1978, prices have gone through three cycles, most notably the boom and bust centred on the GFC. Between 2002 and 2007, the P/E ratio increased from 13 to 29, implying a significant overvaluation relative to its long-term average. To justify such prices, profitability per hectare would have to almost double from its 2000-07 average and remain there in perpetuity. Profitability did rise significantly, with the 2008-15 average some 70 percent above 2000-07 levels. However, this was insufficient to prevent the 27 percent peak-totrough fall in dairy farm prices per hectare, which saw the P/E ratio revert back to a more fairly valued level.

Figure B2: Dairy farm land prices to measures of fundamentals

Figure B2 Dairy farm land prices to measures of fundamentals

Source: CoreLogic NZ, DairyNZ, LIC, MPI, REINZ, RBNZ estimates.

Note: Prices are annual averages. Revenues and earnings are five-year trailing averages.

Table B1 summarises the results of the ratio analysis over the entire period since 1978. Periods in which both indicators imply relative overvaluation were typically followed by a fairly sharp decline in land prices. By contrast, prices did not fall following the 1998-2001 period, where only the P/E ratio implied a land price overvaluation. Importantly, neither indicator suggests that dairy farm land prices were overvalued going into the current period of sustained income weakness, helping to limit any subsequent decline. Although the P/R and P/E ratios are around fair value as of 2015, dairy farm incomes are low and there is clearly potential for dairy farm land prices to fall from 2015 levels.

Table B1: Summary of estimated overvaluation in the dairy farm land market

Maximum overvaluation
(percent)
Peak-to-trough change
(percent)
Period P/R P/E Price/hectare Price/kgMS
1981-1984 23 - -50 -59
1994-1997 25 17 -17 -27
1998-2001 0 14 N/A N/A
2004-2009 68 115 -27 -41

Source: CoreLogic NZ, DairyNZ, LIC, MPI, REINZ, RBNZ estimates.

Note: Prices are annual averages. Revenues and earnings are five-year trailing averages.

It is difficult to gauge the extent to which prices could fall, particularly given the absence in recent history of similar sharp and protracted declines in incomes. However, insight can be gleaned through an adaptation of the price-to-earnings multiples applied above.3 For the purpose of this exercise, the potential evolution of land prices is assessed under the stressed payouts used in the dairy portfolio stress tests (see table 2.1). Farm prices are assumed to be a function of the expected future profitability of using the land as a dairy farm. Two alternative approaches are adopted to estimate these expectations:

  1. Approach 1 assumes that market participants have perfect foresight, with land prices estimated by multiplying long-term expected earnings under each scenario by the long-term average P/E ratio. Short-term overvaluation on the basis of backwardlooking multiples would be unwound via a catching-up of earnings.
  2. Approach 2 assumes that market participants are entirely backward-looking, with the dairy farm land price at any point in time inferred by multiplying a moving average of earnings over the previous five years by the long-term average P/E ratio.

While neither of these assumptions is likely to reflect the true expectations-formation process of market participants, the estimates from the two approaches should illustrate of the potential range for the farm price decline. Absent a marked deterioration in confidence or stressed sales, the estimate from approach 1 would be most appropriate.

However, confidence effects due to low incomes and potential market illiquidity, if significant, could push prices towards the level implied by approach 2.

Table B2 presents the results of this analysis. Under scenario 1, the two approaches imply an estimated peak-to-trough price decline of 19 to 49 percent. This suggests that the price decline could be comparable to the 27 percent price decline experienced in the wake of the GFC. Similarly, the estimated fall in prices in scenario 2 is 31 to 64 percent. Given that stressed sales would likely be taking place in this scenario, an overshoot relative to the value implied by approach 1 might push the price decline beyond that assumed in the dairy portfolio stress test of 39 percent. A decline of a similar magnitude has occurred in recent history, when real prices per hectare fell by 50 percent following the removal of farm subsidies in the mid-1980s.

Table B2: Scenario analysis of dairy farm land prices (per hectare, real % change, peak-to-trough)

Approach Scenario 1 Scenario 2
Approach 1 – Perfect foresight -19 -31
Approach 2 – Backward-looking -49 -63

Source: CoreLogic NZ, DairyNZ, LIC, MPI, REINZ, RBNZ estimates.

Note: Prices are annual averages. Revenues and earnings are five-year trailing averages.

The analysis above is, however, subject to a range of uncertainties. First, it assumes that the relationship between earnings and fair value is constant over time, which may not be the case, for example, if longterm discount rates vary significantly over time,4 or if amenity and option values are weakly correlated with earnings. Second, the expectationsformation process of market participants and the extent to which stressed sales occur are highly uncertain.

These estimated declines in farm prices should also not be interpreted as central forecasts, with scenario 2 in particular reflecting more difficult conditions than suggested by the current market outlook. Recent sales in the dairy farm land market indicate a peak-to-current price decline of around 15 percent, broadly in line with the lower bound of the estimated range under the scenario 1 payout.

 

1 Allan and Kerr (2014) model farm land prices in an econometric framework that considers these factors. See Allan, C and S Kerr (2014) ‘Examining the drivers of rural land values in New Zealand’, Motu Working Paper (draft).

2 Hargreaves and McCarthy (2010) also consider the price-to-revenue ratio in the context of New Zealand dairy farm land valuation. See Hargreaves, B and I McCarthy (2010) ‘Is New Zealand farm land worth what it will produce?’, Paper presented at the 16th Pacific Rim Real Estate Society Conference, 25-27 January.

3 While the price-to-revenue ratio offers a valuable longer-term historical perspective, it is less useful in a forward looking context given the changes in farm cost structures post-2000.

4 Preliminary work on a fundamentals-based model that accounts for changes in interest rates and leverage produces similar results.