Debuble runs a mid-sized grain farm and is fortunate enough to have his son and daughter-in-law returning to the operation. The farm will need to generate more revenue, and Landon is thinking of expanding. In the last five years crop margins have been good and local land values reflect this reality. Landon purchased his last piece of land five years ago for $1,500 an acre, and hardly slept a wink for 18 months! Now he’s looking at prices of $2,500 an acre and is worried that if he doesn’t jump at the opportunity, it will be $3,000 before he knows it.
Landon called us to analyze his operation and look at whether the farm can afford to purchase additional land in order to accommodate the next generation. He fears we’re seeing a land price bubble and is worried it’s about to burst.
Rising land values
Our discussion began with why land values have risen so quickly and factors affecting the market. When we look at who’s investing in land right now, it gives us some insight into why values are so high.
First, there are large farm operations aggressively seeking further growth.
Second, there are investment companies actively seeking to invest huge capital amounts in farmland ownership. Word in the international investment community is that Canada is a politically stable country with a thriving agriculture industry and solid banking system — in other words, it is a safe place to park your money during a time of huge financial insecurity.
Thirdly, we have high-equity farm operations that made big profits in the last few years and are looking to reinvest them in land.
Finally, we have some young farmers that have really big risk appetites and have yet to experience poor margins.
When you look at that list and the fact that interest rates are at all-time lows, it’s not surprising to find financial institutions aggressively trying to lend money.
Threats to land valuations
On the other side of the land evaluation issue, three things are going to threaten current land valuations.
The first is the margin from the crop produced. As margins decrease, the money available for land payment, rent, and future growth will become limited.
The second factor is that affordability of land is being propped up by strong liquidity and record low interest rates.
The third factor is strong demand. But guess how demand will be impacted by lower margins and decreased affordability.
Unfortunately, a drop in land values doesn’t affect land to be purchased but also land that is already owned. Price decreases erase equity from a farm’s balance sheet overnight. Any time equity is erased, so are options. In many operations, lenders rely heavily on land equity in making a loan. So in times of reduced equity, low production margins, and higher interest rates, everyone’s hands are tied and assets often must be sold. This, in turn, increases the supply of land on the market and a downward spiral begins. Anyone who was around in the 1980s has seen this movie. It can happen and if you don’t believe us, look in the history books!
What to do?
So what can Landon do to mitigate the potential risk when buying land at a time like this?
Lock in interest rates on any debt that is expected to be around for any period of time. The interest rate may be higher but it may prove to be cheap in the long run.
Strive to be as efficient as possible. In times of difficulty, lenders will have a easier time working with you if you have a low operating expense ratio.
Maintain strong liquidity. This will allow the operation to withstand short periods of lower margins without jeopardizing cash flow.
Structure payments so they are sustainable and within the long-term carrying capacity of the farm.
Enrol in crop insurance, Agri-Stability, AgriInvest, and other government risk-management programs because they will also help bridge the gap when margins are reduced.
The bottom line is we may or may not experience a correction in land values. It is rare in agriculture, but it does happen. So understand your risk and focus on things you have control over. †