Agriculture's emphasis on capital gains is unhealthy, writes Andrew Gawith, director of Gareth Morgan Investments.

One of our most important industries, agriculture, appears to be one of our least commercially rational.

The idea that businesses should generate a return sufficient to cover the cost of capital doesn't seem to apply to farming. That is, the yield most farmers and horticulturalists achieve does not cover the cost of fully funding the market value of the assets they purchase.

It seems silly to have so much of the nation's capital tied up in businesses that don't meet this basic financial test.

Why does this situation prevail and what changes would need to occur to bring a little more sanity to this important sector?

Let's examine the apparent irrational enthusiasm for land. There are two earnings streams from farming: the income return and the capital return.

It's the income return that looks wonky; that is, the return required on the money invested in the farm.

Typically farmers and their funders (mainly the banks) focus solely on the ability to service the debt raised to fund the business.

So let's say the farm is worth $2 million and the bank lends the farmer $1 million, then all the bank is interested in is whether the farm can generate a net profit big enough to meet the interest payments on $1 million.

There's little or no interest in whether the farm can generate a net profit that also gives the farmer an appropriate return on the $1 million of equity, let alone a reward for the risks being taken.

Interestingly, farming is the most popular business for banks to lend to. While other areas of economic endeavour are starved of capital, banks have very nearly drowned farming with debt. The ease with which farmers can get capital has helped push up the price of land.

That has given banks a sense of security about their lending as the value of their collateral rises - they're happy. But it has also helped drive down the income return from farming.

Farmers are vulnerable here. If they can't service their loans the banks can force a sale of the property. Given the relatively low income returns there's often not much fat in the system to cope with a slump in output prices, drought, storms, disease, rising input costs, higher interest rates and currency gyrations.

Now banks are generally reluctant to force a sale - they don't want to spread panic and undermine the value of their collateral. So why do farmers take such big risks for such pathetic income returns?

The answer: capital gains. If they can survive on the smell of manure, farmers will eventually collect a handsome, untaxed, capital gain.

The value of farmland has risen even faster (10.7 per cent a year) than housing over the past 20 years. That's a very healthy return given there's no tax to pay.

We're talking about a real after-tax return of something in the order of 7 per cent to 8 per cent a year.

A portfolio of world shares over much the same period would have yielded a real post-tax return of between 4 per cent and 5 per cent a year.

The rationale for investing in farms becomes clearer and stronger, but heavily dependent on rising land prices.

As discussed above, the willingness of banks to throw capital at farming has definitely helped push land prices up.

Given land's credentials as collateral, banks are unlikely to abandon farming as a major lending market, though there's some evidence they have pulled their heads in a bit over the past year or so.

The value of farm land is also underpinned by an impressive track record of productivity growth.

Farmers are constantly looking for better ways to do things, and there has been a quiet revolution in downstream processing and marketing activities which has seen major productivity gains as well as a better tailoring of products to meet the demands of the highest returning markets.

One might argue that farmers are under enormous pressure, because of the low income returns, to achieve big productivity gains simply to stay in business. Productivity gains are eventually translated into farm prices.

Another factor likely to stimulate land prices is the rise in demand for food from the rapidly developing countries such as China and India and the growing world population - it's expected to increase by about 50 per cent over the next 40 years.

An obvious example (obnoxious to some) of this pressure has been attempts by Chinese interests to buy farmland and invest in downstream processing in New Zealand.

Upward pressure on land prices is evident in many other countries: British and US agricultural land prices rose between 90 per cent and 100 per cent over the past decade, well ahead of sharemarkets.

The rise in land values over the past 20 years may, of course, largely reflect financial deregulation and falling inflation. Lower funding costs (interest rates) have made it easy for purchasers of land to pay more.

The downswing in interest rates has now played out - the best that can happen from here is that interest rates stay low. Higher interest rates are more likely, and that would most certainly cramp land price inflation.

Capital returns seem likely to remain the mainstay of total earnings for farming but the industry is vulnerable to falls in land prices (which is happening now).

A combination of falling farm equity and pitifully low income returns quickly make farming an unattractive banking proposition. More focus by banks on ensuring income returns at least match the cost of capital would help shift the balance between income and capital returns as farmers would find it more difficult to get funding for over-priced farms.

That in turn might create a more robust and vibrant farming sector.

Farming may not be as commercially inept as it first seems, but it is speculative. The financial benefits are almost entirely dependent on capital gains (rising land prices); income is puny and unreliable.