Lesson 1: Land Value Trends and Other Considerations



LAND VALUE

AND PURCHASE

Prepared by: Michael D. Duffy, extension economist, Iowa State University, Ames, Iowa.

Lesson 5: Feasibility of Land Purchase

Overview

This is the final lesson of the course. Previous lessons have looked at the land market in general, how to use soil information, appraisal techniques, and financing considerations. This lesson looks at the feasibility of a land purchase. The discussion focuses on three measures or levels of feasibility: cash flow, return to management (profit) and present value.

One of the purposes for this course was to provide a means for evaluating land purchases. At the end of this lesson is a blank data sheet. If you would like an analysis for a particular tract of land following the procedures outlined in this lesson you can use this data sheet and for the computer spreadsheet: “Cash Flow Feasibility of Land Purchase”

Introduction

The feasibility of a land purchase depends on the individual and their financial situation. Cash-flow feasibility simply means does the cash income generated exceed the cash expenditures?

Some farmers will make a land purchase even with a negative cash flow if they have other income to support land ownership.

The return to management (profit) from a purchase is another measure of ownership feasibility. The return to management is the

expected return after both operating and fixed costs as well as an investment charge for the equity capital used have been covered.

Finally, the present value is another measure of feasibility. Is the present value of the net income from the investment greater than the asking price? For some farmers, comparing price to value can be a major determinant in the purchase decision.

Remember there are many reasons people buy land. These include:

-security

-pride of ownership

-increase efficiency

-realize returns from improvements

-hedge against inflation

Initial Assumptions

Any estimation of land values involves several assumptions. In the next few paragraphs the basic assumptions used throughout the remainder of this lesson will be discussed. As much as possible discussion will follow the subject farm presented in Lesson Three, except no buildings will be used in the example. The size of the land purchase under consideration is assumed to be 80 acres with 90 percent tillable. The percent of tillable acres is important because they will provide the income stream necessary to

support the land purchase. The asking price is $1,300 per acre. The total investment or purchase price is $104,000.

In our example, 15 percent or $15,600 of the purchase price will be financed from equity capital. The remaining 85 percent or $88,400 will be financed with borrowed funds.

The interest rate on the loan is 7 percent. The charge for the use of equity capital will be 5 percent. Remember, even though the equity capital does not have a direct interest charge, there needs to be an opportunity charge in order to reflect the cost of using equity capital for the land purchase instead of some other investment. The weighted average cost of capital is 6.7 percent, the 15 percent down at 5 percent plus the 85 percent borrowed at 7 percent. Finally, it is assumed that the payoff period for the loan is 20 years, with annual payments.

Weighted Cost of Capital:

|15 |x .05 |= 0.75 |

|85 |x .07 |= 5.65 |

| | | 6.7 |

Throughout this lesson, income tax will not be included in the examples used. Although this is an important consideration, income tax management strategies and individual circumstances make this a very complicated issue to be included in the discussion. Rather than adding to the complications all outcomes will be discussed on a before income tax basis.

Estimating Income

One of the first steps in estimating income is to determine the crop rotation that will be followed on the land. The next step is to estimate the average yield and expected price for each crop to be grown. It is important to use more than a single yield and price estimate. The method utilized in the lesson estimates the impact on expected returns from average, optimistic or pessimistic yield and price assumptions. The three levels of price and yield estimates provide a measure of risk analysis. Other methods for risk analysis are available, however, this method is the most straightforward.

A corn-soybean rotation is used in our risk analysis example. The average corn yield is assumed to be 120 bushel per acre with an average price of $2.00 per bushel.

For soybeans the average yield in the example is 42 bushel per acre with an average price of $5.25. To get the optimistic and pessimistic yields, a 15 percent adjustment was added to or subtracted from the averages. A 30 percent price adjustment was used to estimate the optimistic and pessimistic price levels. Table 1, Crop Rotation and Price/Yield Assumptions, summarizes this information.

|Table 1: Crop Rotation and Yield/Price Assumptions |

| |Crop 1 |Crop 2 |

|Crop Rotation: |Corn |Soybeans |

|Yield: |

| Optimistic |138 |48 |

| Average |120 |42 |

| Pessimistic |102 |36 |

|Price: |

| Optimistic |$2.60 |$6.83 |

| Average | 2.00 | 5.25 |

| Pessimistic | 1.40 | 3.68 |

Table 2, Expected Gross Revenue Per Rotated Acre, shows the expected gross revenues per rotated acre using the assumptions discussed above. For example, the optimistic/optimistic cell shows a $344 gross return per crop acre when both optimistic yields and prices are used. The gross revenue amounts shown are the revenues generated from one-half acre of corn and one-half acre of soybeans. Table 2, shows the tremendous variation in gross revenues possible in agricultural production. The range in gross revenues are from a high of $344 per rotated acre to a low of $137. This is a $207 per acre difference from the most optimistic to the most pessimistic return per rotated acre.

|Table 2: Expected Gross Revenue Per Rotated Acre (Average of All |

|Crops) |

|Yield/Price |Optimistic |Average |Pessimistic |

|Optimistic |$344 |$264 |$184 |

|Average | 300 | 230 | 161 |

|Pessimistic | 256 | 197 | 137 |

Expected Expenses

There are three areas of expenses to be considered in the land purchase decision. The financing expenses have already been discussed in lesson 4. The second area of expenses are land ownership expenses. Real estate tax is the major category in this area. For this example, real estate tax of $15.50 per acre is used. The assumption of $500 other ownership cost is also used. Examples of other ownership costs would be for insurance or repair of fences, tile lines, and terraces.

The third area of costs are the crop production expenses. Table 3, Estimated Crop Production Expenses Per Acre, shows the crop expense assumptions used. Note that most of the costs will be variable but some are fixed. The fixed costs are used in the return to management analysis.

|Table 3: Estimated Crop Production Expenses Per Acre |

| |Corn |Soybeans |

|Fixed Machinery |$38.00 |$19.00 |

|Variable Machinery | 41.00 | 14.00 |

| | | |

|Seed |$26.00 |$18.00 |

|Fertilizer | 48.00 | 26.00 |

|Pesticide | 30.00 | 30.00 |

|Insurance | 5.00 | 3.00 |

|Miscellaneous | 7.00 | 7.00 |

|Labor @ $8/per hr. | 21.00 | 20.00 |

|Total |$216.00 |$137.00 |

The costs listed in Table 3, reflect today’s costs. Remember that these estimates should try to reflect an average over the next 10 to 20 years and some cost increase should be expected. As a general rule, try to be accurate, but it is better to error higher on the expenses side and lower on income.

Cash Flow Feasibility

To estimate cash flow feasibility, first estimate the total cash inflows. In the example, multiply the number of rotated acres by the estimated gross revenue per rotated acre shown in Table 2.

The cash outflows would be the loan payment, real estate taxes, other cash ownership costs, and the variable expenses listed in Table 3. For this example, labor is assumed to be a fixed cost to reflect owner/operator labor.

Cash Outflows

|1. Debt payment | | |$8,344 |

|2. Crop expenses | | |$9,180 |

|3. Real Estate taxes | |$1,240 |

|4. Other cash ownership expenses |$500 |

| | Total Cash Outflow | |$19,264 |

Table 4, Net Cash Flow Per Acre, shows the various net cash flows for this tract of land before income taxes. This table was constructed using the assumptions outlined previously. Note the variation in cash flows depending on the various yield and price assumptions.

|Table 4: Net Cash Flow Per Acre |

|(before income taxes) |

|Yield/Price |Optimistic |Average |Pessimistic |

| | | | |

|Optimistic |$69 |($3) |($75) |

|Average |29 |(33) |(96) |

|Pessimistic |(10) |(64) |(117) |

Three of the nine situations in Table 4, indicate a positive cash flow. In other words, before income taxes, this land purchase would cover cash costs for less than half of the yield/price assumptions used. Each buyer has to evaluate the outcomes from this table for themselves. Which are the most likely outcomes? What happens to the farm business if the worst case comes true? Questions like these need to be evaluated before making the land purchase decision.

Return to Management

The return to management from a land purchase is also referred to as the economic profit. In this analysis all costs are accounted for including the opportunity cost of equity capital.

Computing the return to management (profit) involves three steps. First, take the net cash flow amount and add back in the debt payment. In the example, the annual debt payment is $8,344. This amount is divided by the 80 gross acres for an average debt payment of $104 per acre. Second, from this amount subtract the fixed costs shown in Table 3 (fixed machinery and labor at $44 per gross acre). The third step involves subtracting the land investment charge which is the cost of land ownership. The investment charge is figured by multiplying the total investment of $104,000 by the weighted average cost of capital (6.7 percent) and dividing that amount by 80 acres. The equation is as follows:

Return to Management = Cash Flow + Debt Payment – Fixed Costs – Investment Charge.

($60) = ($33) + $104 - $44 - $87

or

Gross Revenue-all crop production costs-investment charge.

The negative $60 in the above equation is the expected management return for the average yield price situation. Table 5, Return to Management Per Acre, shows the return to management from the various yield/price assumptions used in the land purchase example. Note that only two of the nine situations show a positive return. Before evaluating Table 5, the buyer should reflect back on the labor charge used (is it adequate), the cost of equity capital used, and other assumptions used. If these charges are satisfactory, then evaluating Table 5, is similar to the cash flow evaluation. The values in Table 5, range from a profit of $41 per acre to a ($144) loss. This is a difference of $185 per acre. How this range is evaluated becomes an individual decision.

|Table 5: Return to Management Per Acre |

|Yield/Price |Optimistic |Average |Pessimistic |

| | | | |

|Optimistic |$41 |($30) |($101) |

|Average |2 |(60) |(123) |

|Pessimistic |(38) |(91) |(144) |

Present Value of Net Income

A third way to look at the feasibility of a land purchase is to estimate the present value of net income from this investment. The present value of the net income provides an indication of the per acre value of the land today. Because most land is bought to be farmed and not to be resold, the present value formula becomes the annual net income divided by the discount rate. The discount rate used in this assumption is the weighted cost of capital or 6.7 percent.

To estimate the present value of the net income, take the return to management, Table 5, and add back in the investment charge. The investment charge is added back in because this charge ($87 per acre) reflects the cost of land ownership and not the cost of production. This net income amount is then divided by the weighted average cost of capital.

|P.V. |= |Mgt. Return + Investment Charge/ |

| | |Discount Rate |

|P.V. |= |($60) + $87 |

| | |.067 |

|P.V. |= |$27 = $403 |

| | |.067 |

Table 6, Present Value for Net Income, shows the present value per acre of the net income generated from the land for the various yield price assumptions. The calculated present value is higher than the $1,400 per acre asking price in one of the nine situations. Under the average yield price situation, the present value is approximately $400. Again, different individuals will view the outcomes in Table 6, differently. The negative present value in the pessimistic yield price situation is only possible because of the negative net income. Negative present values are not relevant.

|Table 6: Present Value of Net Income Per Acre |

|Yield/Price |Optimistic | Average |Pessimistic |

| | | | |

|Optimistic |$1,916 |$851 |Negative |

|Average | 1,327 | 397 |Negative |

|Pessimistic | 737 |Negative |Negative |

Different land value theories have been proposed that would add other components to the present value. The alternative theory used most frequently, particularly in the 1970s, says that the present value of the land should also include the value of expected growth in land values. This theory assumes, however, that the land is bought only as an investment and that at some point in the future it will be resold. Most farmers do not buy land to resell it, they buy land to farm it. In Lesson 5, only the present value of the net income generated from crop production was considered.

Another major factor omitted from this analysis was the government programs. No one knows what these programs will be so they were simply left out.

Changing assumptions will drastically alter the results presented here. Changing the percent down to 100 percent (cash purchase) increases value by almost 25 percent. Similarly changing interest rates and terms impacts values.

Conclusion

Analyzing the land purchase discussion involves assumptions and individual preferences with respect to risk and risk-bearing ability. The analysis is a detailed process that must be carried out to avoid mistakes. In this lesson, we have examined three alternative methods to determine the feasibility of the land purchase.

Cash flow is the first step in evaluating the purchase. In our example, Table 3, the average yield/price situation shows a ($33) per acre cash flow. The range in the cash flow, however, is over $180. The buyer must determine whether this average situation is adequate and determine whether or not the risk is acceptable. Some buyers will purchase land that will not cash flow. In that case, they must have other income to cover the shortage or else it is only a matter of time before they are broke.

The return to management (profit) is a second measure of feasibility. In our example, Table 4, the average yield price assumptions show a negative return to management of ($60). The buyer must ask if he is willing to work for less return per hour and/or accept a lower rate of return on his investment. Is the return acceptable or one that can be tolerated? Many buyers are willing to purchase land with a negative return to management because of the land ownership factor. They are willing to work for less to say they own the land.

The final evaluation of the land purchase is the present value. The example in this lesson showed a present value per acre of $397 (Table 5). This was far less than the asking price, but still may be acceptable because of the buyers’ attitude toward risk, the chance for an increase in land value, anticipation of government programs or other intangible factors.

There is no single answer to the question, “Is this a fair price?” An analysis on a single factor of cash flow, return or value could give quite different results. All of the factors must be evaluated together. Only with careful analysis and the individual factors can it be determined whether or not a particular tract of land is a good buy.

This lesson and the preceding lessons have shown the factors that should be considered in a land purchase decision. Several assumptions have to be made. Make them carefully and do not become a foolish optimist or too pessimistic, but be realistic. Remember there are no quick answers or substitute for careful analysis.

LAND VALUE

AND PURCHASE

DATA SHEET: Feasibility of a Land Purchase

Name: ______________________________________

A. General Information:

1. Number of Gross Acres _________ acres

2. Percent Tillable Acres _________ %

3. Price Per Acre $__________ /acre

4. Total Land Cost $__________

5. Equity Capital Furnished (down payment) _________ %

6. Debt Capital Needed (borrowed funds) _________ %

7. Equity Capital Charge _________ %

8. Debt Capital Charge (interest rate) _________ %

9. Number of Years for Analysis _________ years

10. Real Estate Taxes Per Acre $__________ /acre

11. Other Ownership Costs (total) $__________

B. Expected Crop Rotation and Yield/Price Assumptions:

| |Crop 1 |Crop 2 |Crop 3 |Crop 4 |

|1. Crop Grown* |__________ |__________ |__________ |__________ |

|2. Acres |__________ |__________ |__________ |__________ |

|3. Yield Assumptions: |__________ |__________ |__________ |__________ |

| Optimistic |__________ |__________ |__________ |__________ |

| Average |__________ |__________ |__________ |__________ |

| Pessimistic |__________ |__________ |__________ |__________ |

|4. Price Assumptions: |__________ |__________ |__________ |__________ |

| Optimistic |__________ |__________ |__________ |__________ |

| Average |__________ |__________ |__________ |__________ |

| Pessimistic |__________ |__________ |__________ |__________ |

|*Corn after soybeans, corn after corn, soybeans after corn, etc. |

Estimated Crop Production Expenses Per Crop Acre:

| |Crop 1 |Crop 2 |Crop 3 |Crop 4 |

|1. Crop Grown |__________ |__________ |__________ |__________ |

|2. Fixed Machinery |$_________ |$_________ |$_________ |$_________ |

|3. Variable Machinery |__________ |__________ |__________ |__________ |

|4. Seed |__________ |__________ |__________ |__________ |

|5. Fertilizer |__________ |__________ |__________ |__________ |

|6. Pesticides |__________ |__________ |__________ |__________ |

|7. Crop Insurance |__________ |__________ |__________ |__________ |

|8. Miscellaneous |__________ |__________ |__________ |__________ |

|9. Labor |__________ |__________ |__________ |__________ |

|Send to: |

|Mike Duffy |

|Department of Economics |

|478E Heady Hall |

|Iowa State University |

|Ames, IA 50011 |

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