Take home messages

• Assuming management performance is assessed on profit generation, the better the management the greater the capacity to expand.
• Interest cost must primarily be covered by the profits generated from the operations of the business.
• The view of the purchaser towards future capital growth should be clear as this will assist in setting the purchase price.
• The risk profile of the business operator making the land purchase plays a big role in the amount that can be paid for land.
• While profits remain high the ability and willingness to expand will also remain high.

Introduction

It is impossible to be prescriptive about the amount that a farm business operator can pay for land due to the range in factors that dictate the outcome. This is part of the reason that there is such disparity in land prices in the market. The factors that affect the amount that can be paid for the next agricultural land purchase include:

• The profit that can be generated inclusive of the level of scale efficiency that will be achieved.
• The additional level of debt incurred and the capacity of the prospective purchaser to cover the associated cost of debt.
• The risk profile of the purchaser.
• The expectation of return on investment.
• The view of capital growth.

Profits

The amount of profit or earnings before interest and tax (EBIT) that can be generated is important because the cost of debt (interest) is typically serviced from profit. The greater the level of profit generated the greater the capacity to service debt. In other words, the better the management (assuming management is assessed on profit generation), the greater the capacity to expand.

Increasing operating scale should provide a marginal benefit to the business where the existing level of efficiency is below optimum. This occurs because the existing overhead cost structure is spread over more productive units. This should result in the expansion area generating a higher marginal profit than the existing operation.

Whole farm profitability, which is a measure of resource efficiency, is calculated by dividing profit by the market value of all assets under management. The measure of whole farm profitability is operating return which is usually expressed as return on assets managed.

Typically, land accounts for the majority (greater than 80 percent) of the value of assets under management in farm businesses. High levels of farm business profitability are therefore dependent on good profits at market values for land and other assets. A reasonable means for valuing land is to consider the comparable sales of farmland in the district and adjust for infrastructure differences. The valuation should be close to what the market will pay for land should the farm go to sale in the very short term.

Debt

Bank debt is the most common and typically the lowest cost means of funding additional land purchases. Many in the agricultural space appear to be pushing external sources equity as an alternative to debt but the reality is that the cost of equity will be higher than the cost of bank debt. The reason for this is that the return expectations of external equity sources are typically higher than bank interest costs.

Debt creates wealth for users where the returns from its application exceed its cost. The returns generated from purchasing land come from the operations on the land (operating return) and ownership of the land (capital return). The combination of these returns must exceed the cost of the debt to create wealth.

The ability to service (pay for) the debt is the other important component to its use. The capital gain of agricultural land is variable and relatively illiquid which means that it is unable to be converted easily to cash. This means that the interest cost must primarily be covered by the profits generated from the operations of the business. Finance coverage or interest cover ratio is a financial ratio measuring the number of times that interest costs are covered by profit (EBIT).

While it is desirable to have high interest cover ratios over the whole business (greater than 3:1) there will be times when it may be acceptable to be below this target. Expansion is one of those times due to its capital intensive nature. Further, as land purchases don’t usually meet the needs of the purchaser perfectly, there may be a need to extend borrowings beyond a level that would usually be considered comfortable.

Off farm income can also go some way to assisting with debt servicing and can be particularly useful when seasonal factors drive low farm returns.

Capital growth

Capital growth has contributed substantially to the growth in net asset value of those who have purchased land since 2000. The average capital gain of long term benchmark clients in the Holmes Sackett database is nine percent with a range from five percent to over fifteen percent. The view of the purchaser towards future capital growth should also be clear as this will assist in setting the purchase price.

Risk profile of the purchaser

The risk profile of the business operator making the land purchase plays a big role in the amount that can be paid for land. An acceptable level of interest cover to one operator may provide an unacceptable level of discomfort to another. Understanding the limits and working within those limits to be able to sleep at night will also differentiate the price paid between competitors in the land market.

What has changed?

Figure 1 shows land values, livestock profits, crop profits and interest rates indexed since the year 2000. An index takes the value at a point in time and expresses the relativity of the change in value over time. The index shown in Figure 1 uses three year rolling averages thus the year 2000 includes also the 1998 and 1999 years.

Figure 1. Index of land values, livestock profits, crop profits and interest rates (Source: Holmes Sackett).

The key outcomes from the index follow:

• The compounding rate of growth of livestock profits is 15%. This rate of change is partly due to livestock profits coming from a very low base.
• The compounding rate of growth in crop profits is 7% - well below those of livestock.
• The compounding rate of growth in land values is 9%.
• The compounding rate of growth in interest rates is -1.2%.

The combination of solid growth in livestock and crop profits in combination with low interest rates are all contributing to increased demand for land. While profits remain high the ability and willingness to expand will also remain high.

Contact details

John Francis
john@holmessackett.com.au