Evaluating farm real estate decisions
Most farmers would jump at the chance to buy land when it comes available next door. Even with tight margins and shrinking working capital, there are still producers positioned to take advantage of those opportunities when they arise. Any real estate decision should be carefully evaluated before jumping in to ensure it’s the right decision for your operation.
As a financial officer with Compeer Financial, I regularly walk my clients through some key steps to ensure just that.
Weigh Financial Metrics
It’s important to look closely at your finances when thinking about taking on additional land to understand if it’s a viable business decision. We evaluate many different metrics, but we pay particularly close attention to three core underwriting standards:
- From a balance sheet perspective, we look at solvency. A well-established farmer should aim to have 50% ownership equity after the purchase. That could look different for a young or beginning farmer who likely doesn’t have as strong of equity. In that case, an ownership equity ratio of 35% may be more appropriate.
- When looking at liquidity, the working capital target is 15% or better of the operation’s average gross income; but again, a level less than that could be acceptable for a young farmer’s first purchase.
- Repayment capacity is the third core ratio that should be evaluated when making a major real estate purchase. It’s slightly complicated to calculate but it’s essentially a measure of profitability. A farmer needs to insure that there is a sufficient margin after all obligations are covered.
When working with clients to evaluate the decision on whether or not to buy additional land, we will always run anamortization schedule. A total annual payment is calculated based on a few assumptions such as estimated purchase price, down payment, loan term and interest rate.
That figure is divided by the number of tillable acres to come up with the principal and interest payments on the acres that would generate revenue. Clients can compare that amount to an approximate rental fee for a similar plot of land.
This exercise also illustrates how close the investment comes to cash flowing and to what degree other areas of the operation will need to subsidize the purchase. Once we determine the cost of owning the land, I encourage clients to plug these numbers into their cash flow budgets and be comfortable with the impact the acquisition has to their operation.
Capacity to absorb new land
In addition to evaluating purchase costs and production potential, it’s important to consider current capacity for servicing the land as this may increase your investment. Ask yourself if you have:
- The right equipment
- Enough grain storage
- Sufficient labor
If the answers to the above are no, you’ll need to look at options such as making modifications to the equipment you do have to make it more efficient and whether you are financially able to accommodate the needs the new land will bring. You’ll also want to work with your advisor so your marketing plan accounts for the additional grain you’ll be harvesting.
Evaluate quality of land
You should also add in any necessary improvement costs when building out a budget for a land purchase. The faster you can get the land up to par, the quicker the payback will be.
For example, many farmers I have worked with install drainage tile soon after acquiring their new parcel. Fertilizer is another enhancement to think about. Building up fertility can be a huge investment, and it takes time to achieve maximum results.
Conservation efforts to control erosion may also be a necessity. Understanding the land’s needs ahead of time will help paint the big picture so you can fully see the potential impact the purchase will have on your operation.
When to walk away
As much as you may want that piece of land next door, you may need to walk away if the circumstances aren’t in your favor. Whenever possible, separate the emotions from the business impacts of the decision. If the purchase is putting you in a bad financial situation or one that could cause unnecessary stress, you may need to pass on the opportunity.
There are some alternatives to consider if the land is extremely desirable. You can sell other land to get this particular piece, especially if you own a parcel that is farther from home or not performing well. Some producers opt to sell land to an investor located away from the area and renting it back from them. Maintaining those additional acres will still help with overall expansion.
Following a defined process when considering a land purchase is equally critical whether you’re beginning your farming career or have a well-established operation. The evaluation for young or beginning farmers just may be more in depth, require a bit more assistance or raise additional questions.
As tempting as it may be to jump on the opportunity to buy land next door, be sure to take time to evaluate the decision. Look at your finances, understand the capacity of your operation and recognize what other investments may be needed to improve the quality of the land.
As always, I encourage you to bring in your trusted advisors to help you look at the numbers before moving ahead.
Davison is a financial officer with Compeer Financial