Andrew Watters: Dairy farm prices in tune with earnings

Home owners, sitting on a near tripling of house prices over the past 20 years, are largely immune to warnings that the housing market is overheated.

Latest property market statistics showing rising prices are met with glee, such as: "If we bought now we would only be able to afford to buy in Henderson", and,"our Ponsonby villa is now worth twice the price we paid".

If there is one measure that is likely to puncture homeowner hubris, it is housing affordability. On these measures New Zealand's housing market looks overheated. The 10th annual Demographia International Housing Affordability Survey released this year rated New Zealand housing prices as "severely unaffordable".

House prices in the major metropolitan centres were on average 5.5 times the median household income of just over $60,000, the survey said. Auckland was the seventh most unaffordable market out of the 360 markets surveyed worldwide, with house prices equal to eight times the median household income.

The measure resonates with homeowners because it establishes a link between the value of the asset and the homeowner's earnings. Many homeowners in the wealthier suburbs of Auckland now recognise they could not afford to service the mortgage they would need to buy the house they occupy.

Dairy farmers could be forgiven for feeling similarly smug. Over the calendar year 2013 dairy land prices have risen by 10.1 per cent and by more than three times over the past 20 years.

But at this point dairy land prices and house prices part company. Statistics that link land prices to earnings are still in dairy farmers' favour. According to an ANZ analysis, land prices to milk pay-out prices - the revenue generated by that land - have averaged 4.95 times since July 2013, well below the 20-year average of 6.3 times.

This figure was calculated using this year's record farm-gate forecast of $8.40/kg of milk solids (it has lifted since to $8.65/kg). But use a more subdued $7.25 per kilogram of milk solids and the long-run average land price multiple of 6.3, the numbers still add up.

Indeed, ANZ suggested there was scope for average land values to head towards $41,000/ha over the coming year from the average of $38,267/ha in the three months to December 2013.

ANZ then considered the alternative measure of cash rates of return on the capital invested in the land to adjust for rising costs. It estimated cash returns now stood at around 8 to 10 per cent - the highest level since the early 2000s. Compare this with rental yields in Auckland's eastern suburbs of just 2.3 per cent.

If new dairy farm investors accept the long-run average 5 per cent return, then land values are fairly priced but could start to move into overvalued territory, ANZ said.

Whatever conclusion you draw, dairy farm values are clearly aligned with the earnings capability of the land.

That said, a 5 per cent cash yield on the value of a farm is probably still not sufficient to entice the next generation of young dairy farmers on to the land. They also want a steady rise in earnings seen over the past 20 years to continue.

There is good reason to believe this remains the case. Over the past 20 years the agricultural sector has led growth in productivity across the economy. Between 1992 and 2012 per cow production has increased by 40 per cent from 259 kgMS to 364 kgMS. Production per hectare has increased 57 per cent from 653 kgMS to 1028 kgMS.

Looking forward, it is clear that the potential for these productivity gains remains. New Zealand's top dairy farmers - using pasture-based systems - are achieving 450 kgMS to 500 kgMS per cow. All of this of course must be achieved while lifting environmental outcomes.

Meanwhile, demand, and particularly demand from China and the Asean region, is showing no signs of slowing.

Goldman Sachs vice-chairman Mark Schwarz recently noted: "For the foreseeable future ... I think there's going to be tremendous demand for New Zealand products, in China alone."

New Zealand benefits from China's increasingly wealthy and still-growing population, as well as limited domestic supply growth. To ensure food security, scarce land is dedicated to the staples of human consumption. Water, abundant in New Zealand, is in short supply in China.

These demand factors could add up to dairy prices rising on average 1 percentage point ahead of the rise in general prices in the New Zealand economy over the next decade. And this rise, coupled with the dairy sector's long-run productivity growth of 2 per cent, suggests dairy farm values can rise as much as 4 per cent to 5 per cent a year over the next decade.

This is not a one-way-bet. Can the Chinese economy successfully rebalance from an investment and export focus towards consumption? Will the abolition of European dairy quotas result in over- production? These are valid questions, but even in the face of these unknowns, the numbers look good.

Andrew Watters is an executive director of MyFarm, which manages $550 million worth of dairy farms on behalf of investors.