The affect of land values on farm expansion decisions
Author: Eric Nankivell (Farmanco) | Date: 25 Jun 2019
Take home messages
- Land values have increased sharply, this may affect your expansion options.
- Be sure of your strategy and assess options carefully.
- Present your case well to potential financiers.
Background
There has been a sharp increase in land values across most areas of Australia’s southern cropping zones.
This has been a good reward for those who own land – typically adding between $2 million and $3 million to the average value of a farming business over the past three years.
However, it is not all good news. While our profitability in dollar terms is unchanged, our buying power is affected and our Return on Assets Managed (ROAM) is falling due to this rise in land values.
What this means for the farming business in terms of its range of options for expansion or consolidation is explored in this paper/presentation.
Land value trends
Land values have been trending upwards for a long period of time (Figure 1) and will continue to do so as land availability declines and farm businesses continue to grow in scale.
While land values have historically been on the rise, there have been periods of higher growth followed by corrections or long flat periods. Examples of periods of corrections include:
- Early to mid-1980s in response to the high interest rates.
- Late 1980s and early 1990s in response to the wool market crash.
- Mid 2000s, in some areas, following the millennium drought.
Figure 1. Average annual growth in farmland median prices over 20 years (Source: Ag Answers Report, Rural Bank).
Figure 1 shows the long-term trend for land values in the past 20 years. This is the Internal Rate of Return (IRR) i.e. the rate that had to have been achieved per annum to arrive at today’s land value, given a known start value.
This shows the longer-term trend without amplifying the variation over this time. This has been reasonably consistent across Australia, with stronger returns in eastern Australia compared with the rest of Australia.
Figure 2 demonstrates an example of a specific analysis of the land value trend over 23 years at Culcairn. In simple terms, it is a record of all land sales within a reasonable proximity that have been sold since 1997. In this location there has been no obvious decline in land values post the millennium drought. There has been a doubling of land values in the past three years and a long-term IRR of 8.6%. Of note, however, is the long period of stagnant values between 2005 and 2015. If land value trends were looked at between 1997 to 2015, the IRR would only be 5.5%. The last three years alone have added over 3% per annum to IRR in this locality. Timing is everything!
Figure 2. Case study of the land value trend over 23 years at Culcairn.
Profitability unchanged
What has changed in terms of the profitability of the business through this improvement in wealth:
- Productivity?
- Long term prices?
- Reduction in variable costs?
- Cheaper depreciation?
- Fall in the cost of living?
Whether any of the above characteristics change in response to the purchase of land is questionable. The only glimmer of a possible reduced cost is in response to the possibility of lower interest rates.
What HAS changed is the business’s ROAM which has fallen from an industry average of approximately 4.5% to approximately 2.5%. This might be a blessing in disguise, as corporate investors are still talking target headline ROAM rates of 4.5% to 5%, so they may be less active in the market with a ROAM rate of approximately 2.5%, allowing much needed space for family farms to continue to grow their scale.
Effect on options and opportunities
The farming business has a range of investment options to consider and the mix of these options is affected by the change in land values.
Firstly, it is important to recognise that the increase in land value has not really changed investment options for larger scale businesses with equity greater than 90%. There is nothing really to stop them from continuing to buy land.
In general, with increased land values a business’s capacity to borrow for expansion is reduced. This generally increases the attractiveness of options such as smaller land purchases and gearing through lease and sharefarming.
There are a wide range of options/opportunities including:
- Sitting out of the market and focusing on other productive improvements.
- Buying smaller parcels.
- Buying a larger parcel but selling a less profitable one (trade).
- Leasing to help give you scale and leverage to repay debt.
- Sharefarming to help give you scale and leverage to repay debt.
- Buying off-farm investments until land becomes available.
- Seeking investor capital to own land or share ownership.
In order to make sure that your decisions fit your objectives, it’s important that you engage your consultant and write a business plan to clearly articulate your business’s objectives and strategy.
Most likely options for rural landholders:
- The main option for most businesses will be to sit back and establish whether we are in a rural land property bubble. Of course, the risk here is that you miss out on a good opportunity to purchase land and the values continue their long-term rise without a hiccup.
- Buying smaller parcels of land and taking on less risk. This however can be difficult. Many businesses have geared up to handle the logistics of a substantial step-up in scale – taking on only half the land area at the same cost doesn’t quite give you the same economic advantage. But this is a sensible and pragmatic option.
- Trade into a block of land that has a good strategic fit for the business and out of a block of land which is on the extremities and is not as profitable. This can be a clever move for a business with a clear understanding of its strategy and direction.
- Leasing becomes a more attractive option with rising land values. If you do not have enough capital to scale up OR if you must pay too much for a smaller block, then leasing a property will help give you the capacity to repay debt quickly. The downside is that land to lease is hard to come by (people are chasing it) and landowners who are prepared to lease out their land still think that they can get a 4.5% to 5% Return on Investment. We have already established that the profitability has not changed!
- Sharefarming is difficult to find for the same reason as leasing. However, there are significant tax benefits for a retiring farmer to take on sharefarming. By sharefarming, the retiring farmer may be able to retain their Primary Production status, which can help manage taxation over the period heading towards retirement. Also, the outgoing owner would need to decide where to invest the money from the sale of land. Many retirees would be much more comfortable retaining their equity in their farm, which has been very good to them over their career, rather than looking to alternate investments such as shares, residential assets or cash. Tip: Equate sharefarm agreement to a lease.
- Off-farm investment offers potentially a counter-cyclical investment (Figure 3). Residential values are falling at a time when farmland values are rising rapidly. Shares are likely to show good annual performance by comparison to very low inflation and interest rates. Perhaps an investment in the residential or share sectors will prove to be a good counter-cyclical opportunity? In making this decision, you need to be very sure what your longer-term investment strategy is and that you are making an investment in something you are comfortable with in terms of the risk profile. It’s important to seek good specialist advice.
- Seek investor capital to own farmland that you can lease over the long term. This is a strategy that has worked in the past. There have been a few more city investors prepared to step out into farmland ownership with good leasing relationships. As mentioned earlier, these ‘corporate’ investors have a reasonably high expectation of returns and they are currently finding it difficult to equate land value to the lease rate.
Figure 3. Performance of off farm investments from 1988 to 2018 (Source: Vanguard).
Present your case
- Equity is only one measure used when considering land acquisition.
- For all banks the main measure is the ability to repay. This is assessed using a Year in Year out (YIYO) budget with the basic industry assumption that the business needs to show repayment of debt in full over 10 years, given average years.
- Of course, it is rarely the intention to repay the debt in full. As the business grows and debt is repaid, the business will look for other opportunities often before the debt is fully repaid. However, the underlying principle is that the business ‘has the capacity’ to repay the debt at any point in time, given average seasons.
Be sure to work out the business’s ability to repay debt and present it to your financier with your assumptions. This one-page analysis of the business (example provided in Figure 5) will quickly help you identify if there are any warning signs in your proposal, allowing you to address and mitigate these concerns with your financier.
Figure 4. Calculation of a ‘Year in Year out’ budget for two example farms (Farm 1 and Farm 2).
Farm 1 (Figure 4) shows YIYO target maximum levels for individual costs as a guide to identifying areas of strength, weakness or opportunity within the farm business. If you were to perform at these target maximums however, then there would be no profit to repay debt.
Farm 2 (Figure 4) shows individual costs as percentages of income in line with Farmanco’s “Profit Series” (benchmarking service) which indicates that the average farm can comfortably handle farm net debt at a similar level to farm income.
Conclusions
There are a lot of options available if you are still looking to grow the business, but beware. With rising land values some of these options have become riskier for your business – e.g. outright purchase - so be prepared to work out your numbers carefully.
Engage your consultant to do a business plan to clearly work out your longer-term strategy so that the decisions you make now keep this in focus. Business plans are still part-funded in NSW by the Rural Assistance Authority (RAA) for approved businesses.
Finally, your financier is likely to be a little warier of giving you advice given the fallout from the banking royal commission enquiry. Make your financier’s job easier by doing your due diligence and presenting your case well.
Useful resources/references
Australian Farmland Values 2017 Rural Bank publication
Vanguard 2018 investment chart
Farmanco 21st Edition Benchmark Report
Acknowledgements
This presentation was commissioned by the GRDC Farm Business Updates and the author would like to thank them for their continued support.
Contact details
Eric Nankivell
Farmanco, Suite 1/485 Swift Street, Albury
0428 914 263
enankivell@farmanco.com.au
@Eric Nankivell @Farmanco
www.farmanco.com.au
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