I’ve been advising farmers at kitchen and boardroom tables for 30 years and have been involved in many discussions about land purchases.
The price being contemplated was usually well in excess of the productive capacity of the land in question and yet it has continued to increase in price almost without a break.
Common pitfalls have become apparent over the years, including these seven deadly sins:
1. Putting land ownership ahead of everything else: Typically this means putting it ahead of profit, but on occasion even relationships have played second fiddle. Neither is the right strategy, as those with failed businesses, dreams and relationships can attest. Ultimately it is profit that pays for land. Unless you are lucky enough to have capital or income from outside of farming, your first priority is increasing profits to a level that permits the purchase of land. Get it right and profits grow at an increasing pace and land purchases become easier. Get it wrong, and the business is starved of cash, growth slows and land purchases become harder.
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2. Buying poor land: Land will be with you a long time, so make sure it’s the right land for you and that it will treat you well. Land prices these days reflect scarcity more than quality. The price difference between good and bad land seldom fully reflects the productive difference. If you must buy bad land, and sometimes you do, don’t commit sin No. 3. Be pragmatic about its longevity.
3. Emotional involvement with fixed assets: Just as doctors are counselled not to become emotionally involved with their patients because it leads to bad medicine, farmers should avoid becoming involved with their fixed assets because it can lead to bad business. This is a lot to ask in the case of land, but those who successfully keep it under control run better, more profitable and ultimately larger farms than those who don’t.
4. Over-aggressive debt repayment: It is rare to encounter farms in difficulty because of too much debt, but those in trouble because of bad debt structure (too much repayable too soon) are countless. Be practical about your capacity for debt repayment on all purchases but especially land and especially when you are young. Maintaining cash flow and liquidity are critical success factors on every farm.
5. Fixed versus variable rates: The painful interest rate lessons of the 1980s still lead to an over-estimation of interest rate risk 30 years later. The decision should be based upon many factors, starting with an objective understanding about whether there is a lot of debt and including a strong understanding of the balance sheet and the income statement to achieve an appropriate stance on interest rate. Staying abreast of Canadian monetary policy is good way to make proportionate and rational decisions about rates.
6. Losing sight of how you make money from farming: Farmers make money from controlling farming assets. Control is distinct from owning. Although it is nice to own farming assets, the assets themselves could care less who owns them. They respond instead to your management. Generally, optimizing the assets maximizes your ability to convert management into profit which, in turn, maximizes your ability to buy those assets. The paradox for young farmers wanting to own lots of land is that they have scarce financial resources and so should not try to own any land that they are not given. Instead, all financial resources should first be directed toward maximizing the assets they control. That accelerates business growth, which accelerates asset purchase.
7. Trying to buy it all: The belief that land comes for sale only once in a lifetime leads to a certain amount of desperation to buy any and all land that comes for sale within a certain radius of the home farm. This predisposes farms to overpaying, buying the wrong land in the long term and sometimes not being able to afford the right land when it comes for sale. This sometimes occurs because sin No. 3 has been committed and the “wrong” land cannot now be sold. Set your strategic goals, make your rules and stick to them.
Land ownership also has its virtues, and without a doubt it has performed excellently as an investment. Owning a good solid land base within your whole farm is a key long-term strategy for stability and equity growth, which ultimately helps in the leverage process when raising debt to finance land.
As a result, land ownership is to be recommended, but it can remain out of reach for a long time without the means to generate the profits and the cash to pay for it.
With the right business model and the right capitalization of the business, it becomes possible in your 30s to make the sort of profits most farmers don’t make until their 50s. Being prepared to challenge the paradigm can be rewarding.
Consider a young farmer with $250,000 of cash available to invest. Land costs $2,000 per acre to buy and $60 to rent.
If the young farmer opts for a land ownership model, he can probably leverage that cash with debt, up to $375,000 of buying power.
With money allowed for working capital and $250 per acre for equipment, he can farm about 160 acres.
In a fully rented model, he would need more working capital per acre and could probably leverage at only half the rate and so would have $312,500 available to go farming. Nevertheless, he could farm 560 acres this way.
The land will generate the same gross margin of $250 per acre whether it is owned or rented, but profit per acre in the owned model will be higher at $110 than the rented model at $76.
However, because of the larger number of acres in the rented model, the farmer makes more than $42,000 of net profit compared with $16,500 from the farmer who buys.
Ask yourself this: who will pay for the next quarter of land the quickest?
