As the saying goes, they're not making any more land. But how do you decide when and if you can afford to buy it?
“Farmland is worth what it earns,” says Dale Aupperle, farm manager, Heartland Ag Group. “Unless the price is influenced by location or something else, it's going to be driven by the earnings stream off the land.”
That's what people who own farmland should pencil out and negotiate over, says the Forsyth, IL-based manager.
Frank Sollars, a Washington Court House, OH, farmer, takes a similar approach. He wants his figures in black and red ink. First Sollars calculates his interest cost/acre and adds what cash rent and real estate taxes would cost per acre. That tells him if a farm is worth buying or not.
Sollars, who farms 3,600 acres with his three sons, recently passed up buying a 520-acre, 80%-tillable farm because his calculations yielded red ink with the above formula.
“At that time I figured if I had the money to buy it outright — which I didn't — I would have gotten a 3% return over cash rent,” he says. “But if I borrowed the money and paid 7% interest, I'd lose 4%. I'm not too interested in losing 4% on $1.5 million.”
Sollars explains that by thinking about the financing cost as similar to cash rent, you'll know pretty quickly if the cost is too high. While he says owning the land is worth a premium over cash rent, it becomes clear very quickly if that premium is too steep.
On the farm mentioned above Sollars knew right away that financing the land wouldn't work.
“Nobody in the country is going to pay 7% on $3,000,” Sollars points out. “That's $210/acre. Even in Iowa and Illinois you don't pay that much for cash rent, and that doesn't even include real estate taxes.”
Each farm has its own set of particulars and those have to be factored in, according to Duane Jackson. This Argenta, IL, farmer has slowly added acres to his farm over the last 25 years.
He figures what a farm will earn based on the available information. He makes sure he sees tile maps and soil fertility information before making any decisions. “That's more important to me than yield data,” he says. “I also factor in how close it is to storage. I'll pay a premium for that.”
Jackson says he'll add to the purchase price for any land, $300-400/acre, if it has the right features — close to storage, good tile and fertility. He figures that's the maximum he'll pay over what land is worth.
While Jackson places his highest priority on location, Sollars disagrees with him on its importance.
“Sometimes the farm next door is not an investment — it's a luxury. It's like buying a Cadillac instead of a Chevrolet. You don't do that for business reasons, you do it because you want the Cadillac,” says Sollars. “If a farm's next door and I can afford it, I would forget about the economics and buy it. But if you're doing it strictly for business purposes and you're not too strong financially, you'd better be very careful.”
Because he's financially fit, Sollars will pay a $200-300/acre premium, but he bases the premium on the sheer advantages of owning land versus renting it.
“If you own the land you have the assurance that your machinery can cover enough acres to make it economical,” says Sollars. “You also have the assurance that you can make improvements and reap the benefits from those improvements. You don't have that guarantee if you rent land.”
Like Sollars, Jackson reaps the benefits of improving his land. Several years ago he bought 80 acres of what he described as a “dreadful farm.” Weedy, in a neglected drainage district and with poor fertility, Jackson doubts anyone else even thought seriously about buying it. But the 80 acres were ½ mile from his farm.
He bought it for $2,000/acre, tiled it himself for $500/acre and adjusted the fertility. He says it's now worth $3,000/acre and was a real bargain.
“There's a certain pride in being able to improve a place,” says Jackson. “I'd rather get a sore thumb and improve a farm than buy a golden glove.”
While Jackson recouped his investment by purchasing a farm in need of improvements, Heartland Ag's Aupperle says farmland is a good investment for non-farmers too.
“Farmland is a growth stock,” he says. “When you buy it you can probably count on a 5% return over time, plus 4-5% earnings annually on the value of that land. Central Illinois farmland earns 10% total return on investment.”
Aupperle says a 10% return — 5% in land appreciation and 5% in cash rent earnings — is why so many people are buying farmland. He points out that it's very attractive to equity investors bruised by low stock prices because it has low volatility; it won't lose half its value in one day.
According to Aupperle, 46% of the farmland in the U.S. is owned by people who don't farm it.
“As the price goes up by outside bidders, the return on investment drops because the income hasn't changed,” he says. “The investor is still willing to take a little less return on higher priced land because it's still better than any alternative he has.”
That increased competition for land can and often does price farmers out of the market. Still, Aupperle believes outside investors are good for farming.
“Agriculture needs outside capital,” he says. “If the average farming operation in the next few years becomes 2,000 acres, and land is $3,000/acre, that's a $6 million investment. Few farmers can pony up $6 million.”
Aupperle's advises making friends with the new outside investors and lease it from them until you can afford to buy. Because, he says, “every outside investor will need a farmer.”
Capital gains on land sales dropped when President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003 in June. According to Aaron Pasche, CPA, the bill decreases the top individual tax rates for adjusted net long-term capital gains to 10% from 20% (the rate goes to 5% from 10% for lower income taxpayers in the 10% or 15% regular tax bracket) for land sold on or after May 6, 2003. After 2007 the 5% rate drops to 0 during 2008. Both rates are scheduled to return their respective 10% and 20% rates in 2009.
It is unknown how this will affect land sales. Many land investors currently use 1031 exchanges to defer the 20% capital gains tax on land sales by rolling the proceeds from one sale into another, similar land purchase. Capital gains are deferred by having a third party hold the proceeds of the land sale, which are reinvested in different property. Pasche says the seller has 45 days to identify and 180 days to close on the replacement property.
This drop in capital gains tax may prove to be a good opportunity for some investors to take profits while giving Uncle Sam a smaller bite.
“There's so much 1031 activity in the Midwest already that there's not enough land to fill the demand,” says Royce Bryant, AFM, vice president of Capital Agricultural Property Services based in Memphis, TN. “So the demand for land is tremendous without this change in the capital gains tax. But some families may have been waiting on this to divide or sell some property. I expect that this will trigger a modest increase in land coming onto the market, but it won't be a flood.”