The average value of Canadian farmland increased by 8.3% in 2021, following a gain of 5.4% in 2020, according to FCC's farmland Values Report1. Land values seem to have continued to upsurge as commodity prices rose to historical highs this spring. However, with increasing interest rates, is it still profitable to buy land?
Beyond a thumbnail estimate of gross margin multiplied by estimated yields versus interest payments, is there a more detailed way to project the level of profit generated by a proposed land purchase?
In this piece, we explore key questions and actionable steps to help you make the right decision when you consider buying land.
Key questions and considerations
To help determine the financial viability of such a capital expansion, it's crucial to learn about the assets in play. This can be achieved when using the client's own historical data to understand profitability per acre, and then lay it over the calculated debt payment requirements.
To cover the basics, consider the following questions:
- Will the asset generate revenue? (usually, this is a yes)
- Will the asset increase the productivity and efficiency of the farm operation?
- What is the expected useful life of the asset?
- Will financing be needed (again often a yes answer) and, if so, what are the proposed terms of the financing and repayment period?
After answering the provided questions comes the analysis stage. There are four general parts to the purchase analysis phase explained as follows:
1. Do you know your costs of production?
This information can be derived from the existing financial information and involves determining your variable costs and fixed costs for each crop or commodity. Some variable costs are directly related to each crop or commodity and include seed costs, fertilizer, and spray costs among others.
Other variable costs may also be indirectly related to each crop or commodity such as labor and utility costs. It should be noted that variable costs are subject to increases or decreases in relation to production.
Fixed costs may include costs like interest and property taxes. These are typically added in to figure out the total costs and calculate them on a per acre basis.
2. What are your equipment costs?
Very often, these costs can be calculated based on a formula that can become complex. In general terms, we look at the original cost, the useful life, and the residual value of the assets. These costs are often related to the amortization rates set by the producer, and they also include lease costs for equipment.
3. What are the expected increased levels of production? And what are the expected commodity prices that will be available with the increased production?
Start by itemizing your crop or commodity. For instance, when taking crops into account, we would take the crop type and multiply it by the number of acres planted and the expected price per acre.
The resulting amount will then be reduced by the per acre costs of production and equipment costs. This resulting number will be the per acre contribution margin for each crop or commodity.
We can then do a pro-forma projection of the financial contribution that the purchase will generate for the operation.
4. What will the new debt ratios be?
Finally, you'll need to know what your existing bank covenants are and determine if these covenants will change with the new financing.
With all these answers, the financial position of the entity after the acquisition can be estimated, including the calculation of the projected bank covenant ratios. With these projections in hand, a farmer will have a good idea if they will be able to sustain financing and if the purchase will increase the farm's overall profitability.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) are often important calculations here. The calculated new EBITDA for the farm will be what's available for debt coverage (interest and principal payments). This resulting debt coverage ratio will also be imperative to lenders.
With that in mind, farmers should not just aim at meeting the debt coverage requirement, but also set goals to exceed that bank requirement and increase the EBITDA to obtain maximum profitability. This could, in turn, provide a case for better financing terms and rates, making it very important considering the current inflationary market and rising interest rates.
How BDO can help
Being able to project and calculate financial information to determine if you can or should buy land is powerful for any producer hoping to expand.
Making decisions shouldn't be an obstacle to capitalizing on opportunities in the agriculture industry. With trusted assurance and accounting services, you can future proof your farm and set yourself up for success.
For more information, reach out to a BDO agriculture expert today.
1. FCC Farmland Values Report | FCC (fcc-fac.ca)