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Land Purchase and Lease Decisions--Taking the Long View

Agricultural real estate and the real estate market are different from many other types of investments. Each tract of land is different, if only in location. Each attribute of a farm can be studied by the prospective buyer, and the discounted future benefits can be recognized before purchase. Each buyer has his or her own mental calculus for assessing property value.

Farmers tend to buy land with the expectation of holding and farming it indefinitely. The mindset for holding farmland is entirely different from that for stocks and bonds. Stocks are bought and sold frequently for both capital gain and current income. If land is purchased as a long-term investment, mortgage payments have to be made from farmland income or from outside sources rather than relying on increases in land prices.

Because of these characteristics, organized markets have never developed for real estate as they have for stocks and commodities where transactions can be conducted in a matter of minutes or seconds. Thus, land values are highly subjective and influenced by nonmonetary considerations such as the desire for security and prestige. However, anyone who plans to buy or sell farmland needs to make an objective assessment of the monetary value of the land in question separate from the emotional joy of ownership.

Boom and Bust

Fora long time, many landowners, including farmers, thought that farmland always increased in value and that they could expect substantial capital gain over the years. That is what happened between 1932 and 1982, a span when hardly a year went by without land prices going up. But those who invested in farmland in the late 1970's expecting ever-increasing prices to help pay for farmland were shocked in the mid-1980's by the worst short-run decline in land values in this century.

Farmers generally have been willing to pay more than outside investors for farmland, because farmers could put their own labor return into the equity or mortgage payments. This has resulted in a current rate of return of land alone that has always been less than the mortgage rate of interest. The return rate has normally been in the range of one-half to two-thirds of the mortgage rate. This rate relationship persisted until about 1972, when inflation, interest rates, and optimism about demand for food drastically changed the picture.

In the spring of 1981, at the peak of the land boom, at least 80 percent cash downpayment would have been required in order for the land share of net income to make mortgage payments on the balance, with no return on equity. Although this made no economic or business sense, many mortgage lenders continued to make loans on "current asset" values rather than cash-flows. Such loans were frequently as high as 70-80 percent rather than the 20 percent that would have made financial sense based on cash-flows. Farm incomes did not rise as expected, and the ensuing debacle caused land prices to fall by more than 50 percent in many regions.

Most farm real estate is considered by both investors and users as a long-term investment (Photo by Tim McCabe, IL-2197)

Ownership vs. Renting

Most farmers would rather own their own farmland than rent. Ownership gives farmers a permanency that renting on a year-to-year basis cannot. Ownership may allow expansion of the farming operation in areas where renting additional farmland is difficult.

Ownership also allows greater management control over fertility, soil conservation, and building investment. And ownership confers greater prestige in the community. Theoretically the higher price not based on monetary return represents the extra value placed on ownership.

The Farmer's Advantage. Farmers have several advantages over outside investors when it comes to buying land in their area. If the new property is within a reasonable distance of the home farm, it may be legitimate for the farmer to estimate a higher land value from the use of farm machinery and labor than an outside investor could justify based on rent alone. Farmers have two other advantages: They are likely to know more about local farm productivity, and they can find out about land for sale in their region that outside investors know nothing about.

However, when a farmer buys land in the next county or another State, much of that advantage is lost. Then the farmer must make as thorough an investigation as an outside investor.

Deciding Whether To Buy. Given that a farmer is willing to pay more for farmland than a nonfarming investor and is willing to pay more for an adjacent tract than a farmer who is not adjacent, the next step in the decisionmaking process is to determine whether the farmer can afford to purchase the property and whether it is a wise investment. Self-imposed limits that affect the decision may include alternative uses of limited resources, family considerations, and the lowest amount one is willing to accept on monetary return to equity. Outside factors which impose limits include the market rate of interest, the return generated by the property, the amount a lender will loan on the property, and loan terms.

A recent survey I conducted of appraisers and brokers revealed that in more than half of all land sales, the land is purchased with cash and no external financing. In such cases, self-imposed limits are the most important.

The Financial Approach

If a farmer must get outside financing, the cash-flow generated from land or outside income must be sufficient to cover the mortgage payments. When financing is necessary, a logical decisionmaking framework is needed to place a price limit on the farm for the person making the investment. One approach I developed several years ago is called the "Financial Approach to Appraisal" or the "Financial Approach to Valuation."

Suppose, for example, that you think you have enough money to pay half in cash on a farm that is coming up for sale and your loan officer will loan the other half on a 20-year amortized mortgage with a 12 percent fixed interest rate. For the past several years, your money market funds, which you would have to draw out, earned as little as 4.8 percent, but now they've gone back up to 7.75 percent.

You contemplate what you're willing to accept for your equity if you put it in farmland. You think about the advantages of owning more land and how you could farm it with the labor and machinery you already have. You come to the conclusion that you would be willing to take your money out of the money market fund to purchase farmland even if you only got 5 percent on your equity. You might also be hoping for some capital gain, although you remember what a serious error this was for some people who bought in the 1970's. So you decide that even if your equity return dropped to zero some years, the return from the farmland had to be enough to make the mortgage payments.

To determine whether you made the right decision, use the table below.

If the expected net return would be $80 per acre after all expenses were paid, and this was expected into the foreseeable future, then the most the farmer should pay for this land would be $80 capitalized by 8.7 percent. This is the return required to pay the mortgage and produce the desired 5 percent return on equity. This would be $80/.087 = $920 per acre. Even if the farmer is willing to forego any current return on his or her equity funds, accepting the possibility of increased land value as the equity return, it would not make sense to pay more than $1,290 per acre ($80/.062 required to meet the mortgage rate).