KEY POINTS:
The prospect of bumper payouts is luring farmers in other agricultural areas to switch to dairy farming.
But although rural lenders say forecasts of increasing dairy income are starting to justify the rising cost of farm land, they are warning against making decisions based on the short-term outlook.
Banks say the number of farmers seeking finance to buy dairy farms or convert their own operations increased this year when Fonterra raised its forecast 10c to $4.15 a kg of milksolids, and leaped again when the $5.53 forecast for the 2007/08 season was announced in May.
Interest has been highest in Southland, where up to 60 farmers are likely to switch to dairying in the next year, up from 30 last year.
Reserve Bank Governor Alan Bollard warned last year that it was increasingly hard to justify prices paid for rural land based on estimates of the future income from the land.
But with the record dairy payouts looming, prices have kept rising, and the Real Estate Institute says the national median dairy farm value was up 21 per cent in May to $2,930,000.
The National Bank's general manager of rural banking, Charlie Graham, said the increased payouts were starting to put dairy land prices "back in touch with their fundamentals".
But Rabobank's general manager of rural banking, Ben Russell, said farmers should make sure their investment was based on long-term outlook.
It was inevitable that dairy prices would drop from where they were now.
"People shouldn't be doing their budgets on the basis that prices are going to stay at $5.50."
Even excluding the land purchase price, it can cost $3.5 million to convert a 200ha property into a dairy farm.
The money goes on high-cost items such as irrigation development, fencing and dairying sheds.
"The business needs to be able to support costs of capital and operating expenses at dairy prices well below the current prices," said Russell.
When Fonterra forecast a dairy payout above $5 in May, the number of inquiries his bank received increased.
Southland was the standout region for dairy conversion, because it had good access to irrigation, he said.
Rabobank ran two seminars for dairy conversions in Invercargill and Gore and each was attended by more than 100 people.
"Interest has certainly increased in the past two months."
Although rural land was "very fully valued", a big drop in prices was unlikely.
But dairy farmers with a $5.53 payout should be generating reasonably strong cash surpluses "so they're going to be making adequate returns off their land".
Westpac's head of agribusiness, Dave Jones, said that although next season's payout could hit $6 a kg of milksolids, and stay there for the following season, farmers should base investment decisions on a medium-term forecast in the mid to high $4 a kg range instead.
Farmers expecting income increases should also budget for rising service costs, he said.
"When there is a strengthening in income generated for one participant, the suppliers for that industry will be looking to generate a better return for themselves when they've had rising costs themselves."
National Bank rural economist Kevin Wilson agreed dairying's profitability would not go up in direct proportion to revenue, because it would be affected by rising costs.
But other factors, including productivity gains and urban sprawl, would drive up land prices.
DO THE MATHS
* After Fonterra increased its payout for next season to $5.53 a kilogram of milksolids, an increasing number of farmers in other agriculture areas are seeking finance to convert to dairy or buy dairy farms.
* Dairy farmers are expecting added income of about $140,000 a year, but many sheep farmers are struggling to make a profit.
* The cost of dairy farms has risen 21 per cent in a month, and bankers say anyone planning to go dairying should make investment decisions based on medium-term forecasts in the mid to high $4 a kilo range, rather than the short-term $5 to $6.
