Lesson 6 Financing Considerations
LAND VALUE
AND PURCHASE
Prepared by: Michael D. Duffy, extension economist, Iowa State University, Ames, Iowa.
Lesson 4: Financing Considerations
Overview
This lesson examines one of the more fundamental issues in the land purchase decision: financing. How the purchase is financed can make the difference between whether or not a purchase can or should be made.
There are two methods for financing a purchase: Debt capital or Equity capital. As their names imply, debt capital is the use of borrowed funds and equity capital is the use of funds contributed by the purchaser. Most land purchases involve a combination of these two forms of capital.
Interest Rate
Before discussing the use of capital in greater detail, some terms and concepts need to be defined and explained. Interest is one of the major components in evaluating financing. Interest represents the charge for using borrowed funds. For equity capital the interest is the opportunity cost of using the money to buy land instead of using it elsewhere. For example, an investment could be made in bonds or certificates of deposit which would earn interest. This interest given up could be the charge used for the equity capital. Because it is equity capital, any rate could be used. But remember, even though it is equity capital, there is still a cost to using it.
A variety of interest rates could be charged for borrowed funds. Some loans have fixed rates, some variable, or they may be variable with a maximum interest rate. The interest paid on borrowed funds for business purposes is tax deductible. Therefore, the effective rate of interest for debt capital is the interest rate on the funds times one minus the tax rate. For example, if a farmer has a marginal tax rate of 20 percent, a loan with 7 percent interest would have an after-tax effective rate of 5.6 percent (.07 (1-.2) =.07 x .8 = 5.6).
It is not feasible to outline in this lesson how a lending institution sets the interest charged. In general, the rate charged reflects the cost of funds, operating costs, profit and risk. This is why different institutions charge different rates and may even charge different rates to different customers.
Length of Time Considered
The second major consideration in financing is the length of time considered. For borrowed capital, the time is set by the length of the loan. Although any length of time could be used for equity capital, generally the same length of time as the loan is used. This makes computation and comparison easier.
The time period considered affects the cost of financing in several ways. The primary way is through the concept known as present value. Present value is a method used to account for the fact that a dollar today is worth more than a dollar tomorrow. In other words, the future is discounted because of uncertainty and deferring the use of the funds. There could be inflation, death or whatever reason, but the fact is a dollar today is worth more than a dollar in the future.
The formula for determining present value is:
|P.V. |= | F.V. where: |
| | |(1 + i)t |
|P.V. |= |present value |
|F.V. |= |amount of the future payment |
|i |= |interest rate |
|t |= |length of time until the future payment is received |
The interest rate in this formula is also known as the discount rate. That is, how heavily the future is discounted. Since the length of time is the exponent in the divisor, the longer the time, the lower the present value. The following is a simple example problem.
What is the present value of $2,500 to be received three years from now with 10 percent interest?
|P.V. |= | $2500 |
| | |(1 + .1)3 |
| |= |$2500/(1.1 x 1.1 x 1.1) |
| |= |$2500/1.331 |
| |= |$1878.29 |
Present value tables are available for various interest rates and time periods. These tables are usually for a future payment of $1 or $1,000 so the present value of any amount of payment can be calculated simply by multiplying the payment amount by the factor from the table. Tables are also available that give present value factors for a series of equal payments. Both of these kinds of tables are useful in analyzing financing with different interest rates and maturities.
Consider the following situation:
Suppose a farm can be purchased on contract for $100,000 with 10 percent down and a $90,000 contract amortized over 20 years at 8 percent interest. If the buyer values his equity capital at 10 percent, the present value of the contract purchase would be $88,047. This was calculated by determining the annual payment required by the contract ($9,167.40 using a loan payment amortization table), discounting these 20 payments to present value at 10 percent interest (using a discount table) and then adding the $10,000 down payment. This means that purchasing this farm on these contract terms would be equivalent to buying it for $88,047 using all equity capital.
Sources of Financing
There are several sources of financing available for land purchase. One source of financing is 100 percent equity. No borrowed funds are used and the interest rate and length of time can be chosen by the individual.
Another source of financing is owner financing. In this case, the current owner of the property provides all or part of the financing for the purchase on an installment sales contract. Such arrangements are common in Iowa. The terms of the financing and payments can be very flexible.
Borrowing from friends, relatives or other individuals is a third source of financing. As with owner financing, the terms can be very flexible and arranged to suit the parties. Here too, competent legal advice is crucial. Be sure to have everything in writing. In 2001, individuals held 18 percent of the real estate debt in Iowa.
Borrowing from a lending institution is the most common source of financing. Over three-fourths (82 percent) of the US farm real estate debt is owed to lending institutions.
There are several lending institutions available to farmers. Interest charges, length and types of loans, etc., vary substantially. Be sure to shop around for credit and carefully review what is available.
[pic]The Farm Credit System (FCS) is one of the lending institutions. One of the unique features of the FCS is that borrowers are also owners. A requirement of the FCS is that the borrower must buy stock. About 35 percent of the real estate debt is held by the FCS.
Another source of long-term funds is the insurance companies. Several companies loan investment funds. In 2001, insurance companies held 12 percent of the Iowa farm real estate debt.
The Farm Service Agency (FSA) will also make farm ownership loans. In addition to certain requirements, the FSA has a limit on how much an individual can borrow. The FSA also operates a guarantee program. In this program, the borrower obtains a loan from another institution, but FSA will guarantee the loan. Approximately 3 percent of the real estate debt is financed through the FSA.
The State of Iowa, through the Iowa Agricultural Development Authority, will subsidize interest rates for certain long-term loans in its beginning farmer loan program. Eligible applicants secure a loan through a commercial lending institution. The State then subsidizes the interest on the loan with the subsidy passed along to the borrower. The loan is financed by selling tax-free bonds, hence a lower interest rate.
Secondary Mortgage Market
The Farm Credit Act of 1987 established a secondary market for agricultural land loans. This is the so-called “Farmer Mac” program.
The secondary market will allow local banks and others to enter the land lending market by pooling loans and selling them. The idea is that pooling of loans will help spread the risk which should make more credit available at lower interest rates. A similar service within the state of Iowa is offered by the Iowa Bankers Mortgage Corporation.
Types of Financing
There are two primary types of debt financing for farm purchases: mortgage loans and installment land contracts. If the seller desires a cash transaction and the buyer either does not have sufficient cash for the purchase or does not wish to utilize 100 percent equity financing, a mortgage loan will usually be taken on the property. In this case a loan will be obtained from one of the sources stated above. The seller receives full payment and the buyer gets a deed to the property. The loan would normally be secured by a first mortgage on the property. Although not a common practice, the buyer could assume an existing loan that the seller had on the property if allowed in the loan terms. The seller is usually still liable for the loan until paid but has no ownership interest in the property. If there was good equity over the existing first mortgage, the buyer could possibly obtain a second mortgage loan for part of this equity.
If a seller is willing to provide financing for the land purchase, he could deed the property to the buyer and take back a note and mortgage for part of the purchase price. Another alternative is to sell on an Installment Land Contract, also called Contract for Deed. Under this type of sale the seller retains legal title with the buyer getting possession and a beneficial ownership interest. Upon fulfillment of the contract terms the buyer receives a deed to the property. Terms of the contract are crucial to both parties and both should have legal representative in drafting it. It is advisable to have an escrow agent, such as a bank or law firm, hold the signed deed until the contract has been fulfilled. Payments may also be made through the escrow agent. Having an escrow agent avoids many problems that arise if the seller were to die before the contract was fulfilled and had not signed a deed.
One of the main differences between a contract and a mortgage is what happens in case of default. Contracts normally have a forfeiture provision that allows the seller to retain all payments made and take the property back shortly after the default. If this provision is exercised the seller has no further remedy against the buyer even if the value of the property is less than the remaining contract balance. Default under a mortgage can result in bad actions depending on the term of the mortgage.
Repayment Plans
The loan or contract repayment plan is critical to the cash flow of any purchase financed at least in part by debt capital. The three primary types of payment schedules are: amortized, fixed principal plus interest, and graduated payment. All three can either be fully paid during the term or have a balloon payment.
With a fully amortized loan, as the interest amount decreases, the principal amount increases giving the same annual payment during the term of the loan. For a fixed principal schedule the annual payment is a given amount of principal plus accrued interest on the outstanding balance. The total payment decreases each year by the interest on one year’s principal payment. If the loan is to be fully paid during the loan term, the annual principal payment is the total loan divided by the length of the loan.
Graduated payment schedules normally have increasing payments after the first three to five years but are not common in farm real estate financing. They may be used in cases where the buyer expects to have greater income and cash flow in future years. In some graduated payment schedules the beginning total payment is less than the accrued interest and the principal balance actually increases in the first few years.
If the payment schedule has a balloon payment, the annual payments are based on a loan with a given term, say 20 years, but the remaining unpaid balance is due in the balloon year, perhaps the 10th year.
Remember, carefully evaluate all loans, particularly if there is a balloon payment. Things can be dramatically different when the balloon payment is due. Evaluate how to proceed when the balloon payment comes due and be prepared for it. May be able to refinance the balance.
Table 1, Repayment Schedule Comparison, shows the differences in payments between an amortized loan and a fixed principal loan both of which have a 20-year term and 10 percent annual interest. The sum of total payments is greater for the amortized loan, but the required payments in the first several years are considerably lower. Both payment schedules have the same present value if discounted at a 10 percent rate. If the payments are discounted to present value at a lower interest rate, the amortized loan has a higher cost or present value, and at a higher interest rate it will have a lower present value than the fixed payment plan. Since more principal is paid at the beginning under the fixed principal schedule, any required balloon payment would be less than with the amortized loan.
Summary
The importance of financing in the land purchase decision cannot be overstated. Which method or type of financing is available, can determine whether or not a purchase can be made and if it will succeed.
When examining the need for financing, several key aspects must be determined: How much of the purchase will be financed with debt and how much with equity capital? What is the cost for both debt and equity capital? What are the terms of the loan (length of time, payment schedule, etc.)? What are the other important considerations, such as stock purchases, servicing and origination fees, insurance requirements, etc.?
All of these questions must be answered. Simply looking at how much will be borrowed and the interest rate is not enough.
Commercial lenders have a variety of loan programs available. Carefully evaluate all of he programs that would apply.
When entering into any long-term arrangements, be sure to get competent legal advice. This is especially true for contracts and other arranged borrowing agreements.
Too often people think only in terms of the purchase price when making a land purchase. How it is financed can be every bit as crucial. Careful evaluation, planning and comparing alternatives takes time, but that time spent can save thousands of dollars and years of grief.
Table 1: Repayment Schedule Comparison
($100,000 loan repaid in 20 annual installments at 10% annual interest rate)
|Amortized Loan | |Fixed Principal Loan |
Year |
Interest |
Principal |Annual Payment |Remaining Balance | |
Interest |
Principal |Annual Payment |Remaining Balance | |1 |$10,000 |$1,746 |$11,746 |$98,254 | |$10,000 |$5,000 |$15,000 |$95,000 | |2 |9,825 |1,921 |11,746 |96,333 | |9,500 |5,000 |14,500 |90,000 | |3 |9,633 |2,113 |11,746 |94,221 | |9,000 |5,000 |14,000 |85,000 | |4 |9,422 |2,324 |11,746 |91,897 | |8,500 |5,000 |13,500 |80,000 | |5 |9,190 |2,556 |11,746 |89,341 | |8,000 |5,000 |13,000 |75,000 | |6 |8,934 |2,812 |11,746 |86,529 | |7,500 |5,000 |12,500 |70,000 | |7 |8,653 |3,093 |11,746 |83,436 | |7,000 |5,000 |12,000 |65,000 | |8 |8,344 |3,402 |11,746 |80,033 | |6,500 |5,000 |11,500 |60,000 | |9 |8,003 |3,743 |11,746 |76,291 | |6,000 |5,000 |11,000 |55,000 | |10 |7,629 |4,117 |11,746 |72,174 | |5,500 |5,000 |10,500 |50,000 | |11 |7,217 |4,529 |11,746 |67,645 | |5,000 |5,000 |10,000 |45,000 | |12 |6,765 |4,981 |11,746 |62,664 | |4,500 |5,000 |9,500 |40,000 | |13 |6,266 |5,480 |11,746 |57,184 | |4,000 |5,000 |9,000 |35,000 | |14 |5,718 |6,028 |11,746 |51,157 | |3,500 |5,000 |8,500 |30,000 | |15 |5,116 |6,630 |11,746 |44,526 | |3,000 |5,000 |8,000 |25,000 | |16 |4,453 |7,293 |11,746 |37,233 | |2,500 |5,000 |7,500 |20,000 | |17 |3,723 |8,023 |11,746 |29,210 | |2,000 |5,000 |7,000 |15,000 | |18 |2,921 |8,825 |11,746 |20,386 | |1,500 |5,000 |6,500 |10,000 | |19 |2,039 |9,707 |11,746 |10,678 | |1,000 |5,000 |6,000 |5,000 | |20 |1,068 |10,678 |11,746 |0 | |500 |5,000 |5,500 |0 | | |_____________ |_____________ |_____________ |_____________ | |_____________ |_____________ |_____________ |_____________ | | |$134,920 |$100,000 |$234,920 | | |$105,000 |$100,000 |$205,000 | | |
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