We recently had calls from two very distinct farm clients, opposite in nature, but both asking the same question. “Should I buy that land that’s in the paper for tender or let it go?”
Their situation is not unique. Good crops and good prices in last five years combined with extremely low interest rates have pushed land prices to an all time high. Local farmers that didn’t buy land two years ago at $2,000 dollars an acre don’t want to miss out this year. Those that did buy made a profit, and are hungry for more.
Johnny Cash is 58 years old, owns 2,500 acres, a decent line of equipment and carries next to no debt.
Lee Vergdupdabutit is younger and started farming five years ago. He farmed through some of the most profitable times in the area and has poured every cent of profit back into leveraging more growth on the farm. For the significant risk he has taken in the past five years he has been well rewarded but it has also left him with very high payments, marginal working capital and not a lot of breathing space. Without experience to tell him differently, he feels his present financial situation is reasonable and sustainable. He has had no difficulty sourcing credit — with strong past income statements and high values placed on land, creditors are generally supportive of his operation.
It is pretty well understood in the area that the land for which both farms are bidding will sell for $3,000 per acre or higher.
Cash has accumulated significant cash and liquid investments with mediocre returns of less than three per cent. This capital is considered passive capital by CRA — the interest he earns on these investments is taxed at around 50 per cent. If this capital was invested in the land and he achieved a net margin of $150 per acre, Cash would receive a return of five per cent on his investment, taxed at his current corporate rate. Cash’s risk lies in the potential future depreciation of land value, due to rising interest rates and/or falling net margins per acre. He would only realize this risk if he was to sell this land at a low price. This risk can be mitigated through his strong financial position and long term ownership of the land.
Vergdupdabutit, on the other hand has a totally different but equally valid set of risks. He has very little capital to invest in the purchase and thus he will need to finance most, if not all, of the purchase price. His motivation has been to make more money through growth and efficiencies gained through economies of scale. The reality is that if Vergdupdabutit achieves the same return of $150 as Cash is expecting, Vergdupdabutit’s interest cost alone at five per cent would be $150 per acre and he would pay property taxes on top of this. These two figures only address his cost, without giving any consideration to the cash he would need to make the principle portion of the payment. The only other motivation for Vergdupdabutit is that he believes that long term interest rates are an outstanding value currently and he thinks inflation will make the payments on this land very affordable 10 years from now. His risk is that if margins decrease or his interest term renews into a higher interest rate environment, the land will become tremendously unaffordable and strain his entire operation. The fact of the matter is that agricultural margins are not tied directly to inflation.
The moral of this story for industry professionals is that it is very important to understand people’s motivations for purchasing land when helping them evaluate their risks and opportunities.
For farmers, the moral is that, in today’s market, people are investing in land for a multitude of reasons. There is a wide spectrum of motivations and a vastly different set of risks than we’ve seen in the past. †