To buy or not to buy at these high prices? Use some arithmetic and your attitude toward risk to make the land purchase decision on your farm
We had an interesting discussion with Peter Paytumuch the other day. Peter was deliberating over whether or not to buy a quarter section of land that was up for tender beside his farm. Paytumuch knew that the quarter was going to sell high, but had no idea how to evaluate whether the purchase price made sense.
Peter has farmed for 25 years and only paid $1,000 per acre for the land he purchased 10 years ago. He anticipates this next parcel selling for $3,000. Even at six per cent interest, his interest and property tax costs on the land he bought earlier were $70 per acre; his total land payment was $97/ac. Rent for that same acre was $45/ac.
Now with land at $3,000/ac. and interest at 4.5 per cent, Paytumuch’s interest and property tax costs would be $145/ac.; his total land payment would be $230/ac. Rent is now currently hovering around $100/ac.
Two components to land purchase
We began our discussion with Paytumuch by talking about the two components of a land purchase.
Land cost is the first component. This part of the purchase cost includes the interest and property taxes. This cost is higher than the cost of rent — this higher cost includes a premium for the security of ownership.
The table shows the premium Paytumuch was facing. Comparing the interest and taxes cost ($70 per acre) to rent costs of $45 per acre leaves Paytumuch paying a 56 per cent premium for ownership.
The payment of this part of the land cost component of the purchase should flow directly from the income from the acre of land.
Real estate investment is the second component of the cost. This portion includes cash for the principle payment. Cash flowing the principle payment is essentially a forced saving plan. The payment of this part of the cost of land doesn’t need to come directly from this purchase, but can come from other sources — on-farm or off-farm.
This investment in real estate carries with it a reasonable expectation of appreciation in value.
Three main components have contributed to the rapid appreciation in the price of farmland:
Very positive margins achieved in typical grain operations;
Extremely low interest rates (lowering the land cost component of the purchase price);
Strong equity in many areas (increasing farmers’ ability to raise the real estate investment component of the purchase price).
For Peter Paytumuch, this purchase could pose a significant risk to his existing business, due to the sheer magnitude of the dollars being invested combined with the long-term nature of a land purchase decision.
After reviewing the operating efficiency of Paytmuch’s farm, with accrued statements, we estimated his average operating expense ratio at about 58 per cent. (This is the percentage of every dollar of revenue that goes toward paying for operating costs. To calculate your operating expense ratio, divide your total operating expenses — not including interest or depreciation — by your total revenues).
Paytumuch had an average gross revenue per acre of $480.
Using these figures, it would appear that the fixed charge carrying capacity for the farm is $201/ac. (This is the amount of per acre revenue that can be used to cover fixed costs, once operating costs are paid. In this case, with $0.58 of every revenue dollar paying operating costs, Paytumuch has $0.42 left over from ever dollar of revenue to pay for fixed costs. That’s $480/ac. x 42 per cent, or $201/ac.)
Paytumuch has $201 per acre to put toward fixed charges; the total payment for the new land would be $230/ac. His farm would only need to subsidize the purchase of this new land by $29/ac.
This payment deficit may not differ significantly from what the farm was expected to carry when he made his last purchase 10 years ago.
This calculation assumes that Paytumuch’s gross revenue and efficiency margins (operating expense ratio) will continue as they have in the last five years. If either of these deteriorate because of sinking commodity prices or rising input costs (yeah right, when has that ever happened in agriculture), then the ability of Paytumuch’s farm to carry its obligations could be jeopardized.
A long-term look
Looking back through time, we think it’s fair to say that land affordability has always challenged cash flow and today is no exception. If commodity prices continue to stay strong and genetic advancements continue to drive yields upwards, land at $3,000/ac. may be considered a bargain in five years.
On the other hand, this purchase carries significantly more risk than the purchase Paytumuch made 10 years ago because of the size of the obligations. If crop production margins erode, eventually land rent in the area will decrease, and you’ll be paying a higher premium for land ownership. How will your business mitigate this risk? Strong liquidity? High equity? Diversified income sources? Alternate land use market? There is no one right answer for every situation but you had better have one good mitigating factor or the risk you assume with a land purchase today might jeopardize what you have worked the last 25 years to build.
The moral of the story is that, as with any strategic business decision, your goal should be to match your business growth and achievement goals with your risk appetite. If you make decisions with careful evaluation of risk, potential return, and mitigating factors, you’ll make the right decision. If your purchase decision is based solely on the price the neighbor paid and whether or not the bank will lend you money, you may be driving down a busy highway with a blindfold on, just waiting for what happens next. †