Debt financing and timing of farmland purchases • farmdoc daily
Yields from agricultural land have averaged around 10%, especially when holding periods exceed 20 years. Even with this 10% average return, financing farmland is difficult because capital gains make up a large part of the total return. There is little reason to expect this situation to change in the future.
Cash rents and land prices
Figure 1 shows the average cash rents and farmland prices for the state of Illinois. In recent years, these values have been reported by the National Agricultural Statistics Service (NASS), an agency of the US Department of Agriculture. As shown in Figure 1, cash rents and farmland prices increased in 2021. Cash rents increased from $ 220 per acre in 2020 to $ 227 per acre in 2021. Farmland prices have grown from $ 7,300 in 2020 to $ 7,900 in 2021. Both cash rents and land prices are expected to continue to rise, with reports from other sources suggesting substantial increases approaching. and exceeding 20% for the year 2021 to 2022 (see agricultural doc agricultural land outlook webinar).
As with all assets, the total return on farmland has two components: current returns and capital gains. Current yields are based on the annual cash yield of agricultural land. Rent in cash is a measure of the current return on owning farmland. On a percentage basis, the current yield is equal to the cash rent divided by the price of farmland. In 2021, the average cash rent of $ 227 divided by the average land price of $ 7,900 is 2.8%. Note that this is a gross return and not a net return. Property costs must be subtracted to get a net return. A large annual expense is property tax, while other property costs such as fertility or drainage tiles are not likely to be incurred each year. According to Illinois Farm Business Farm Management, property taxes are on average $ 52 per acre in Illinois in 2020. Factoring in property taxes results in a reduction in the current yield in 2021 from 2.8% to 2.00%. 2%. Overall, accounting for property tax likely reduces current yields by 0.5%
Figure 2 shows the current yields on farmland from 1970 to 2021. A close relationship between current yields and Treasury rates is expected, as Treasury rates represent the current return on alternative financial investments (see farmdoc Daily, March 30 2018). The current yields and rates of 10-year Treasury bills follow each other closely, except for the late 1970s and early 1980s. Treasury rates rose in the early 1980s due to inflation. At the same time, land prices have increased, causing current yields to decline as a percentage of land prices. During the agricultural financial crisis of the mid-1980s, the fall in land prices again made the current yield and the 10-year rate converge, and have since largely remained strongly correlated. Over the entire period 1970-2021, current yields averaged 6%. Since 2010, current yields have averaged 3% of the price of agricultural land.
Capital gains represent changes in the value of land over time. From 2020 to 2021, land prices went from $ 7,300 to $ 7,900, an increase or a capital gain of $ 600. Expressed as a percentage, the capital gain in 2020 is 8.2% (0.082 = $ 600 change / $ 7,300). This capital gain is important to monitor from the point of view of the return on investments, but it represents in particular an unrealized capital gain unless the land is sold.
Capital gains averaged 6% from 1970 to 2020. There are time trends in capital gains (see Figure 3), which follow changes in farmland. Land prices increased significantly during the 1970s, resulting in high capital gains. In the mid-1980s, land prices fell, causing capital losses. Capital gains averaged about 5% per year from 1989 to 2004. Land prices increased in most years from 2006 to 2014, resulting in significant capital gains in those years. Land prices remained stable and fell from 2014 to 2020, resulting in low and negative capital gains.
The total yield of farmland is equal to the current yield plus the capital gain. Over the period as a whole, the total return reached almost 11%, with current returns of 5% and capital gains of 6%. There are no general upward or downward trends in total returns. However, the proportion of return coming from current return has declined in recent years as capital gains have increased.
Financing of agricultural land
Buying farmland with loan capital is economical as long as the return on assets exceeds the costs of debt. Over time, the yield from farmland has averaged 11%, and there is little reason to expect declines in the future. Currently, agricultural mortgage interest rates are between 4% and 5%. As a result, the use of loan capital to buy farmland is expected to increase the wealth of those who buy farmland over time.
However, financing the purchase of fixed assets will be difficult because a large part of the yield from agricultural land is made up of unrealized capital gains. To illustrate, take the 2021 state of Illinois values of $ 227 per acre in cash rent and $ 7,900 for the land price. A 40% down payment requirement would require a down payment of $ 3,160 in cash, with the remaining $ 4,740 funded. The annual debt payment for $ 4,740 of principal using a 20-year amortization period and 4% interest rate is $ 348. A payment of $ 348 on debt is much higher than the rent in cash of $ 227, indicating that financing from other sources will be required to cover deficits in the first few years of the purchase. To get a debt payment of $ 227, the down payment would have to be 61%, or $ 4,819 an acre.
Due to low cash positions and negative net cash after financing, young farmers often find it difficult to purchase farmland. Yields from farmland have historically been high enough to warrant recourse to debt, but financing farmland is difficult because much of the yield is capital gain. This difficulty may have worsened in recent years as current yields as a percentage of the price of agricultural land have declined.
Timing of agricultural land purchases
While the total return has averaged almost 11% from 1970 to 2021, the timing of the purchase will affect the average total return. Prices have shown trends over time. By way of illustration, Figure 4 shows the average total return for different holding periods. The blue line shows the average yield from the sale of farmland in 2021 with one purchase in any previous year on the horizontal axis. For example, buying farmland in 1970 and selling in 2021 is marked with a small circle and has a return of 11%. Buying farmland before 2004 and selling in 2021 yields relatively close to 10%. These yields were slightly lower for purchases in the early 1980s, as farmland declined sharply in the mid-1980s. Yet holding for 20 years or more, regardless of the year of purchase, has resulted in a yield close to more than 10%. Agricultural land purchased from 2012 to 2016 and sold in 2021 has a holding period of much less than 20 years. These purchases from 2012 to 2016 had yields of less than 5% because farmland prices experienced declines and then were relatively stable during this period.
Green shows the average yield of a sale in 2014 when buying in the year along the horizontal axis. Compared to a sale in 2021 (blue line), the average yield is higher because the prices of agricultural land were relatively stable from 2014 to 2020.
The red line represents farmland sold in 1987, when farmland prices were lowest in the 1980s. As can be seen, buying farmland in the 1980s and selling in 1987 would have resulted in losses. negative returns. However, buying farmland in the early 1970s and selling in 1987 would have resulted in an average yield of over 10%.
From an income generation perspective, buying farmland in 1984 was the worst possible time to buy farmland. As shown in Figure 5, a purchase in 1984 and a sale before 1988 would have generated negative returns. In contrast, a purchase during this period would have generated an average annual return close to 10% if it had not been sold before the mid-2000s.
Overall, the timing of farmland purchase affects total income. From 1970 to 2021, however, achieving total returns close to 10% was achieved by having relatively long holding periods.
Farmland has had total returns that exceed debt costs. Yet financing of farmland has been difficult due to the cash flow requirements associated with financing, and much of the income from farmland comes from unrealized capital gains. On the contrary, this situation may have worsened in recent years because current yields as a percentage of land prices have declined.
Holding farmland for relatively long periods generated returns of almost 10% from 1970 to 2021. The timing is important. Overall, buying agricultural land before the land price drops results in low returns, especially if it is not held for a long time. However, it is difficult to predict when land prices may fall.