* Demand for farmland remains strong despite drought * Farm income hurt by rising feed, fuel prices on drought * Livestock operations, other farmers take out more loans By Christine Stebbins CHICAGO, Nov 15 Average farmland prices in the U.S. Plains states jumped as much as 25 percent in the third quarter, setting new highs as demand remained strong, the Kansas City Federal Reserve said on Thursday. But the rate of gains slowed down from the torrid pace of the past two years, the Kansas City Fed's quarterly survey said. "Drought conditions had little effect on the demand for farmland, and bankers expected sales to remain solid even with a seasonal upswing in the number of farms for sale after harvest," according to the survey of 241 regional bankers. The survey, along with reports from the Chicago and St Louis Fed banks also expected on Thursday, is a closely watched gauge of the U.S. farm economy. Farmland is basic collateral for most farmer loans. The KC Fed district stretches across the major wheat, corn and cattle states of Colorado, Kansas, Nebraska, Oklahoma and Wyoming along with parts of New Mexico and Missouri. "Lenders continued to lower average interest rates on both farm real estate and farm operating loans to attract borrowers in an extremely competitive lending environment," the bank said. The bank said the drought hurt farm incomes in the July-September quarter as escalating feed and fuel prices pushed production costs higher, boosting demand for farm loans. Sky-rocketing land values have stirred banker fears about the possibility of a ruinous farmland bubble like the one seen in the 1980s U.S. farm crisis, when over-leveraged farmers lost their land as interest rates jumped. But farmers are carrying much less debt today, thanks to record incomes in recent years. "It's still a hot market," Jason Henderson, chief economist for the KC Fed, said in an interview. "I think people are expecting prices to hold at least until the first part of the year," he added. "Right now what we are seeing is the demand is still very strong, even though there is more land being put on the market," Henderson said. "Land value gains continued to accelerate faster than cash rents as annual rental rates increased an average of 12 percent for both cropland and ranchland in the third quarter," the KC Fed said. Non-irrigated cropland values climbed 24.4 percent from the third quarter of 2011. Irrigated land values were up 21.9 percent and ranchland prices appreciated 14.3 percent. But compared to the second quarter, cropland values moved only 3 percent higher and ranchland appreciated about 2 percent. "Farmland values rose further during harvest, though gains were more modest compared with the surge seen during the past two years," the KC Fed said. The big corn and cattle state of Nebraska posted the biggest jump in land values, with non-irrigated farm land prices up 30.2 percent from a year ago. Kansas saw the strongest gains in irrigated farmland values with prices up 25 percent. The drought -- the worst to hit the United States, the world's top food producer and exporter, in more than 50 years -- will continue to stress farm incomes in the months ahead, the Fed and bankers said. "As drought conditions intensified during the summer, pastures dried up, feed costs soared with grain prices and income at livestock operations slumped," the Fed said. "The sharpest income declines emerged in cattle feedlot and hog operations. Bankers expected high crop prices and crop insurance payments to support crop incomes." One banker in western Nebraska said: "Drought is lowering breeding stock numbers by 10 to 15 percent due to culling and lack of feedstocks. The economic impact of the drought will be felt more in 2013 than in 2012." Bankers expected further farm income declines in the fourth quarter as drought conditions persisted in the district. They were also concerned that drought would continue in 2013, forcing more livestock producers to cut herds with grain prices high. Lower farm income reduced farmer capital expenditures, which was expected to remain slow in the fourth a quarter, bankers said. Some bankers said farmers awaited election results and tax policy decisions before making significant purchases.