Over the years, I’ve heard just about every reason why a client “needs” to buy the 40 acres next door. Let’s run through a few of them.
• “It will never come up for sale again in my lifetime.” It may be true that land does not change hands frequently. But the reality is if someone buys land at an inflated price relative to its economic value, it will likely come up for sale again sooner rather than later (most likely to cover losses, unfortunately).
• “They don’t make more land.” Actually, they do. If the economic conditions are right, land base under plow worldwide expands to meet demand.
• “Ownership is control.” Very true, but you can just as easily gain control through long-term leasing options, flex leases and the like.
• “I could use cost averaging.” While this is a viable method, the reality is purchasing land at a price above its earning capacity results in a lower return on assets overall. Think of it this way – the amount you pay for land above its economic value is really a nonearning asset. Whether you average it in or not, it will impact your return on assets (ROA).
• “It has better yield potential than what I currently own.” Did you do your homework to prove that? Or are you just thinking it will be true? Did you check soils maps, crop insurance records and Farm Service Agency records? Your assessment needs to go beyond the drive-by appraisal.
• “I need the land to support my manure management plan.” This is a major factor in certain dairy areas. Maintaining control via ownership can be an important part of an operation’s long-term risk management plan. Nonetheless, it may be worth exploring a long-term lease that you can extend annually, since that can satisfy the need for extended control without the cost of ownership.
• “It’s right across the fence.” Proximity does not always translate to good economic sense. Run the numbers; then pay attention to what they’re telling you.
• “I can’t afford to pass it up.” The real question is: Can you afford to own it?
On the surface, these could all be valid reasons to consider purchasing land. And when it comes to buying the property next to your farm, dairy producers have an advantage. The big drivers of land values are the returns on the land and interest rates. Both of those indicators have been under strain, which should suggest that land values should be declining. But according to Agricultural Economic Insights, the ratio of net farm income to real estate value was 2.5 percent in 2016 – among the lowest ever recorded. That indicates farm real estate values are high relative to the earning capacity of an acre of ground.
For dairy producers, however, there’s a third driver: accessibility for nutrients and feed. That’s why we’ve seen land values holding steady in dairy compared with cash grain farms. The closer you are to the land you want to purchase, the lower your transportation costs, which means you’ll see savings in fuel bills and wear and tear on transport equipment. Those savings, in turn, can justify paying a higher purchase price.
But income generation, above all else, should be the guiding principle when it comes to a real estate purchase, not just the investment value. That’s why from a business standpoint, your decision should focus on the following factors:
1. What is the impact on your balance sheet and your liquidity position?
There are multiple facets to this question. First, if you use cash to purchase land, you’ll need to determine whether it will put a strain on your working capital and liquidity. If so, what impact could that have on your future borrowing capability? That could be a factor if you’re considering an acquisition, or if you need a line of credit to restore your working capital.
You’ll also want to consider the impact a land purchase could have on your equity position in both the short and long term. Also, while real estate is generally a solid long-term investment, you should consider what a decline in land values would mean for your operation. Performing a stress test on your balance sheet is a good way to determine what would happen if land values fall significantly.
2. What is the impact on your cost of production?
Another question you should ask is whether a land purchase will increase your cost of production. As my colleague Barry Doerfer has pointed out, knowing your cost of production is the key to understanding which strategic decisions are best for your operation. Anything that raises your cost of production – including a land purchase – can be a drag on your earnings and your cash flow.
You can make a good argument that a short-term blow to your earnings is justified if the land will benefit your operation in the long run. But even in the short term, you’ll need to maintain an adequate liquidity cushion and solvency position to continue operations until the long-term benefit can be realized. It’s not so much whether your borrowing ability is strong today; it’s what your borrowing ability will be once the purchase is added to your balance sheet.
Knowing the answers to these questions will drive a better, more informed decision – whether the land is located next door, or anywhere for that matter. 
For more agriculture industry insights, visit the BMO Harris Bank website.
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Brad Guse
- Senior Vice President of Agricultural Banking
- BMO Harris Bank
- Email Brad Guse
