In addition to keeping an eye on the daily, weekly and monthly gyration of grain prices, we also need to take a step back to regularly review bigger-picture, longer-term business decisions and investment plans.
Whether it’s selling the farm, retiring from active farming, transitioning to the next generation or looking to expand and diversify your investments, farmland values are a key factor in that process. And for the past several years, farmland values have been steadily moving higher.
That’s also been the case for most other real assets like houses, cottages, condos, recreation properties, land, private businesses, the stock market and commodities. Money and inflation pressures have been flowing into these real assets for years but even more so since COVID.
Low interest rates, easy credit and all the money governments around the world are pumping in the system — it has to go somewhere. While some of it is going to fill in the economic voids from lost jobs and wages, reduced incomes and business bankruptcies created by the pandemic, a lot of this money continues to flow in to real physical assets.
This is easy to see by looking at publicly traded stock and commodity markets. North American stock markets are steadily trending upward to all-time highs and so is a basket of commodities like energy, foodstuffs, livestock and metals, as measured by the Dow Jones Commodity Index. Farmland is at an all-time high as well, so how do you gauge its value or attractiveness?
A couple of years ago, I looked at the price-earnings ratio, or PE ratio, of farmland. The PE ratio is just a measure of the profit, cash or earnings an investment generates based on the amount invested. In essence, it shows how much the market is paying for $1 of profit. Expressed another way, the inverse of the PE ratio is the earnings yield; it’s like the percentage cash flow return. It’s just the earnings divided by the price.
Using FCC data, the PE ratio for Canadian farmland since 1992 has ranged between about eight and 14, with an average of about 11 and a corresponding average earnings yield of nine per cent. During that same time, the PE ratio for U.S. stocks has mostly been between 15 on the low end and 30 on the upper end with an average of 25 for an average earnings yield of four per cent. These figures give a sense of how the market is valuing different assets.
However, it’s not as easy as just comparing PE ratios to determine if an asset is cheap or expensive, whether it’s a good buy or not, nor if it’s going to go up or down. Some asset valuations are higher, others are lower depending on their history, perceived riskiness, profit track record and, of course, current demand and supply dynamics for the asset.
You can also use land rental rates as another investment value gauge for farmland. The rent-to-price (RP) ratio is a useful tool to assess trends in cash rental rates relative to the price of farmland. The rent-to-price ratio is simply the cash rental rate per acre divided by the value of farmland per acre.
A recent FCC analysis showed that across the Prairie provinces, the average rent-to-price ratio is about 2.7 per cent, but there is a lot of variability between the three provinces and even within the provinces. For instance, the Alberta average is 2.2 per cent, Saskatchewan is 3.3 per cent and Manitoba is near the middle at 2.6 per cent. However, rates range from as low as 1.2 per cent to as high as 3.9 per cent in Alberta, 1.6 per cent to 5.9 per cent in Saskatchewan with Manitoba between 1.4 per cent and 5.0 per cent.
So, if you add the average two per cent, three per cent or four per cent rent rate to the five per cent, six per cent or seven per cent capital appreciation we’ve seen in the past five years, that’s a good seven per cent to 10 per cent potential return from farmland. By comparison, a balanced investment portfolio of stocks, preferred shares and corporate bonds would have provided similar results.
Bottom line, financial investments like stocks, bonds and exchange-traded funds can work in conjunction with farm assets to balance risk and reward.
Many farmers are building up assets both inside and outside the farm to diversify investments and create a valuable source of income outside the farm. Investment tools like a Tax-Free Savings Account (TFSA) allow you to earn capital gains, dividends and interest tax free, while an RRSP with tax-deductible contributions or even a corporate investment account can all play an important role in your long-term investment, tax and succession planning strategies.