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Is Now the Time to Buy That Land Next Door

Date: 
Author: 
Paul Dietmann
Interests: 
Grain, Dairy, Swine, Beef
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Survey data from the Federal Reserve Bank of Chicago shows that Wisconsin farmland values have increased every year since 1988, with the exception of a 3% dip in 1991.  In 12 out of the 29 years between 1988 and 2016, the year-over-year increase in values was 10% or more.

While the red hot farmland market has cooled in recent years to a 2-3% annual increase, values appear to have gotten ahead of farm profitability.  The US has experienced four straight years of declining net farm income--and 2018 will potentially end up being a fifth down year—while land values are still rising.

Despite data suggesting that farmland might be overvalued, if a parcel of land that a farmer can see from their porch happens to come up for sale, he or she will likely want to buy it.  Should they buy it?  Could the purchase be justified?

If farmland followed a rational, disinterested market based on purely economic considerations, the short answer would likely be no. 

Let’s say the neighbor is asking $5,000 per acre for the land.  Even if the farmer was able to pay cash for the parcel, the current expected return on land and the operator’s labor from growing corn or soybeans is approximately $150 per acre.  If we consider the value of the operator’s labor to be $50, the return to land is $100, which yields a 2% return on investment.

If the farmer financed 65% of the land purchase, the interest expense in the first year of ownership would be approximately $185, resulting in a cash loss on the land even without considering the value of the operator’s labor.

Granted, agriculture is a cyclical business and we are arguably in the trough of the cycle.  The results we received in late 2017 will likely be different this year and the year after.

So, how does a farmer justify this sort of purchase when the numbers don’t look good?
First, the opportunity to purchase adjacent land may only appear once in a farmer’s lifetime.  Buying land isn’t like buying publicly traded stocks.  A farmer doesn’t have the luxury of simply waiting until the land’s market price falls into their target range before purchasing.  If the deal isn’t done soon, it may never happen.

Second, even if the return on investment is likely to be low or negative, it might still be better than the cash return from renting the land.  The land in our scenario above might rent for $250 or $300 an acre.   The net cash flow that results from renting it could be worse than from owning it.

Third, a land purchase typically doesn’t take place in isolation from the rest of the farm operation.  The land is co-mingled with all of the other land owned by the farmer.  Some of those acres may have been inherited, other land might have been purchased in the early 90s for $1,500 per acre, and much of the land may have no debt against it at all.  When the new land is thrown into the mix and everything is averaged out, the purchase may have negligible impact on the overall operation.

Fourth, even with multiyear periods of significant declines in land values such as during the 1980s, land has generally gone up in value over time.  The farmer’s equity tends to increase over time as the land becomes more valuable and the principal balances on loans are paid off.  Wealth created in the form of equity on a farm balance sheet isn’t exposed to tax liabilities until assets are sold, if they are ever sold.  This adds to the enticement of buying land as a long-term investment even when the short-term economics don’t support the decision.

If you’re an established farmer who is determined to buy the neighbor’s land right now, proceed with caution.  Maintain an overall farm debt-to-asset ratio below 50% after closing on the land purchase.  In other words, don’t carry more than 50 cents of debt for every dollar of assets on the farm balance sheet.  Maintain an adequate level of working capital too.  Net working capital (current assets minus current liabilities) should be a minimum of 15% of the farm’s annual gross income.  Diversify a bit and invest some money each year outside of the farm for retirement purposes.  Seriously consider selling marginal or more distant land to free up funds needed to acquire land closer to home.

Young and beginning farmers are in a particularly challenging position, given current land values and farm economy.  Their money should be invested in assets generating the strongest cash returns, which probably wouldn’t include land right now.  If a young farmer is determined to buy land, consider limiting the purchase to a small acreage, keeping total real estate debt at a level a person might have with a single-family home.  Don’t become over-leveraged by buying land with little or no down payment.  A high debt-to-asset ratio puts a beginning farmer in an extremely vulnerable position.  Don’t let the urgency to buy land jeopardize your farming career.
 
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