“When you see that ad in the local paper for land for sale, there are six things you need to consider before you pick up the phone,” says Jacqueline Gerrard of Backswath Management.
1. Carrying cost: “Think of this as your interest or opportunity cost,” says Gerrard. “In other words, what will it actually cost you to own the property?” For a farmer purchasing land at $2,500 per acre which is 100 per cent financed at five per cent interest, the carrying cost of owning that land is $125 per acre for the interest only. However, it still costs you money even if you paid the full amount upfront. That’s because you could have been using that money as an investment. Even if you had it deposited at two per cent in the bank, you’d still have earned $50 an acre.
2. Leverage versus cash: Cash is still most definitely king, and there’s always a way to make money with money, unless you have to borrow it. When you start to accumulate some interest-earning cash reserve it may be wise to do the math carefully before you make an investment decision you might regret. “One million cash in the bank earning two per cent interest will give you $20,000 per year,” says Gerrard. “If you took that million in cash and invested it in 400 acres at $2,500 per acre and you make a net profit of, let’s say, $100 per acre, you will make $40,000 per year. But if you need to borrow a million at five per cent interest, it will cost you $50,000 to make $40,000 per year, and we are only talking about the interest cost here.”
3. Weighted average cash outflow for capital: Farmers may sometimes try to justify the cost of new land by averaging it over the whole farm (including land that they already own or are paying for at a lower cost than the new land). This gives a cost per acre that is weighted against the full land base of the farm and it may be higher or lower than current land rental rates in the area.
4. Net operating profit: This is a figure that will vary from farm to farm and is one that you absolutely must know. Take your accrued financial statements and calculate what your net profit (after all expenses) is per acre.
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5. Return on investment: Each farm operation is different so each producer will need to calculate what he or she is going to be able to make as a return on his or her investment in new land expressed over the whole farm operation. “If you know you are going to make $100 per acre net profit on the new land at a cost of $2,500 per acre, that gives a four per cent return (i.e. $100 divided by $2,500), but the whole farm return may be different,” says Gerrard. “You need to determine how the new asset fits into the whole basket of assets on the farm.”
6. Additional costs of expansion: Consider any additional costs of expansion that might be necessary as a result of purchasing new land, such as machinery, bins, barns, technology or land improvements. These costs will factor in to the overall return on investment and the net operating profit of the farm.
Depending on the circumstances of the farmer and the availability of land in the area, the answer to these questions might best be weighed by asking another question. Would it be cheaper to rent land? “You really need to think about what the answers mean,” says Gerrard. “Does the purchase of new land push you past rental costs? Is the carrying cost higher than rental? Is it a good addition to what you already have? And we are only talking about the productive capacity of the land; remember you will never capitalize on the land itself unless you sell it.”
Farmers will often make the point that there isn’t any land in their area to rent, adds Gerrard. But true as that may be when they are looking at a land purchase, they should also consider whether it’s really worth paying three times more than the current rental rate (or whatever it pencils out to be).
The “what if?” questions should be the next ones you ask, says Gerrard. “What if interest rates went up, what would the effect be? What if profits went down? Can you always rely on that $100 per acre net profit or whatever you calculate it to be on your farm?” she says. “When you want to capitalize on your purchase, who will you sell it to? Is there a possibility you may be selling it one day to your kids and if so, it may not be possible to get the cash out that you are hoping to get for your retirement.”