There is an old saying in rural America: Farmers don't want to own all the land in the county, just the land that touches their property. With hot demand for farm commodities and the need for additional ground to spread nutrients from growing dairy herds, that folksy statement which mixes both the business and the emotion of land ownership has quite a bit of truth to it.
In this month's Money Matters column, Gary Sipiorski tackles the issue, "Stress test potential land purchases," on page 600. He shares point-blank advice. Based on his four financially-based examples, today's large run-ups in land prices simply don't cash flow.
Until recently, many agricultural finance experts haven't been overly concerned about comparisons drawn between today's bullish land prices and those from the early-1980's land bubble. Today's conventional wisdom suggests most recent purchases have been funded from cash flow. In fact, current USDA data still shows that both real estate and nonreal estate debt is dropping compared to a year earlier. However, those survey estimates are now in conflict with what lenders see.
Two separate surveys by commercial banks and the Farm Credit System indicate real estate debt is growing. For all new farmland purchases, 20 percent of the financing came from a cash down payment, 30 percent with a pledge of existing equity, and the remaining 50 percent with new debt, reports the Kansas City Federal Reserve Bank.
How do you separate emotion from reality when evaluating the question, "Should you buy more land?" We want to echo Sipiorski's sage advice, "You and your lender will have to justify what you can afford to pay for land. Make sure you can cash flow your new total debt. Stress test your cash flows with a 30 percent land value drop, and use at least a 7.5 percent future interest rate."
Two key messages are found in that advice: Low interest rates and high returns are driving land prices. What happens when one or both turn against buyers?
Three decades ago, there were many among us who thought land prices couldn't fall. Unfortunately, those who strongly believed that concept made purchasing decisions without factoring in potential market corrections. Some of those same conditions exist today. Prepare for worst case scenarios and you may be able to weather a land value drop and interest rate storms.
This editorial appears on page 598 of the September 25, 2011 issue of Hoard's Dairyman.