Another way to determine land values

By Gary Sipiorski The real estate market has continued to see escalating agricultural land prices.  Many reasons have led to higher dollar sales, including grain producers who have seen a number of very profitable years and now have strong cash reserves.  Low interest rates and dairy producers seeking land for nutrient management have also been compounding factors. Now investors of all kinds have entered the market to secure a hedge against inflation.  Lenders are requiring greater down payments and land purchases and yet the buying continues. When it comes to decisions on land values, the bottom-line question is – as always – do you know your total expense or your cost of production?  What are you expecting for a gross income and ultimately what is your net income? If you are borrowing money, you better be getting a higher return than what you are paying for the borrowed money.  If you are justifying your purchase of land with grain income, will today’s prices move lower?  Make sure you are stress-testing your purchase with ups and downs of expenses, interest cost and income. The cap rate Bankers, investors and appraisers evaluated asset values for years by using what is commonly called a “cap rate” or capitalization rate.  Here’s how it works:  You have an asset and the net annual income per year from that asset.  Divide the net income by the percent return you want.  The result is what that asset is worth. Here’s an example.  You have a piece of land that will give a net income of $300 after all expenses and you would like to see a 4 percent annual return.  If a CD at a bank is paying 1.5 percent, a 4-percent return is better than what a bank is paying and you might be comfortable with the risk versus the return. Now, take the net income of $300 per acre, divide by the 0.04 return, and you get $7,500.  This means a $7,500 asset is yielding you a 4-percent return. But what if you want a 6-percent return?  Now that number becomes $5,000, which means you don’t want to pay more than $5,000 for that asset. Are you okay with only a 2-percent return?  Now the number is $15,000.  This says you will be satisfied with a 2-percent return and you can justify paying more for the asset. Using the cap rate Let’s run through an example.  Say you’re planting corn and soybeans on a 50:50 rotation.  You’ve estimated your net profit per acre at $350 for corn and $180 for soybeans.  This gives you an average profit per acre of $265 for the two crops.  Divide that by your 4-percent return and you get $6,625 per acre of land. Now let’s add your milk cows and youngstock into the picture.  Your cows average 24,000 pounds of milk at $20 cwt, earning you $4,800 annually.  In addition, let’s assume a 33-percent cull rate at $1,000 per head is earning you $333.   Assuming half of your calf crop is bull calves, you’re averaging $75 per cow for sold bull calves.  That yields a gross income of $5,208.  If you estimate your total farm expense rate at 80 percent, you’re earning a net profit of $1,042 per cow.  If you assume you need three acres per cow and calf, dividing this profit by 3 yields a net income of $347 per acre.  Finally, let’s divide that by your 4-percent return and you get $8,675 per acre value based on your milk cows. With land purchases, you obviously shouldn’t make your decisions based on emotions only.  Using the cap calculations strategy will help put some logic into a potential purchase.  Make sure the future cash flow is stress-tested with a 15-percent drop in land values and/or a 15-percent drop in gross income when adding in the potential land purchase.  Don’t bet the farm on something you cannot financially handle. The original version of this article was printed in the “Money Matters” column of the April 25, 2012 edition of Hoard’s Dairyman. About the author:  Gary Sipiorski is the Vita Plus dairy development manager.  He grew up on his family’s dairy farm in eastern Wisconsin and attended the University of Wisconsin-River Falls.  Sipiorski spent 17 years with Citizens State Bank of Loyal and worked his way up to president and CEO.  In 2008, he transitioned to his current role at Vita Plus and continues to serve on the CSB board of directors.  In addition, he served on the advisory committee on agriculture and industry for the Federal Reserve Bank of Chicago.  He is also an advisor for the Professional Dairy Producers of Wisconsin and a regular contributor to Hoard’s Dairyman and other agricultural publications.