November 17, 2010
By: Mike Walsten, Pro Farmer Editor
In today’s competitive environment, controlling farmland through ownership and long-term leases is increasingly cited as essential to controlling business risk. Yet rapidly rising land prices bring farmers’ perennial question of “How can I buy land when it doesn’t cash-flow?” to the forefront.
The answer is that land usually does not cash-flow when purchased because the rent (profit) earned from the ground doesn’t cover the loan payment. “But over time, rent (profits) grow while loan payments don’t and eventually the land cash-flows,” says Terry Kastens, Kansas State University Extension agricultural economist. That said, the key to reducing risk is to put down as much cash as possible and pay off debt as soon as possible.
The chart shows two different loan structures: In B, the buyer put down 40% of the purchase price, so the $60 rent just covers the $60 interest payment. By year 2, rent growth allows for a bit of principal payment, and even more the next year and so on. The loan balance is zero by year 17. In loan structure A, the down payment was only 15%. At purchase, the $60 rent does not cover the $85 interest payment.
Even though asset value grows the same in both cases, it takes much longer for the loan balance to start dropping in loan structure A. In fact, since rent is insufficient to cover even the interest in the first few years, additional financing is required. Eventually, rent exceeds interest, allowing for principal payments. The loan is paid off in 34 years.
Kastens adds, “Although not easily seen in the chart, the debt-to-asset leverage ratio is falling throughout the time period in both cases. But the risk with 85% loan is much greater than the risk with the 60% loan: Even a modest drop in growth, say from 4% to 2.5%, will lead to loan default at some point, whereas the 60% loan would still cash-flow at a growth rate as low as 0%.
“Regardless, each year that goes by where rent is greater than interest reduces the risk of ownership. Put another way, each year it gets ‘easier’ to make principal payments. Hence, it is often stated that ‘if you can make it through the first few years, you’re home free,” Kastens observes.
Be realistic in your forecasts of increased rent (profit) as well as the likely rise in the land’s value, Kastens advises. By his calculations, that means an annual increase of 4% to 5% in land value and perhaps 2% to 3% in rent (profit) growth per year.