Investors need to understand a farm’s dual role as a business and a property investment, explained Prof Nicola Shadbolt, an associate professor in farm and agribusiness management at New Zealand’s Massey University, at the 2009 SA Large Herds Conference. She gave advice on making investment decisions in these tough times.
Investing in farmland is complicated, as it isn’t always easy to calculate the returns generated. Cash is a fact, but non-cash values are conjecture. Investing in land may be profitable in the long-term, but isn’t always feasible on a cash-flow basis. It’s often the time frame of the investment that non-farming investors find unacceptable.
Some investors and rural professionals feel farmers aren’t clear in their investment decisions, and too influenced by lifestyle factors to decide rationally. But have they missed the big picture? And don’t all investors suffer similar emotional bias?
Articles on investing in farmland tend to focus on either the returns (profitability) or the cash flow (feasibility), but not both. Some rural professionals even use the terms “profitability” and “cash flow” interchangeably. It can also be misleading to consider only annual profitability for a long-term investment, such as farmland, due to the volatility of annual profit and the nature of farming returns.
The average returns on assets and equity from owner-operated farms have been volatile over recent years. Deciding to invest, based on returns in good years, could result in unpleasant surprises later, while investors might regret not investing based on low returns in poorer years. Investors have to understand this volatility in farming returns.
The positive impact of gearing can be seen in years when return on assets exceeds cost of debt or interest rates, and increased returns on equity results. Its negative impact is seen when return on equity is negative.
It’s helpful to split the farm into two businesses – the property business and the farming business. These are often, but not necessarily, linked. In the first, success is measured by changes in asset values over time and driven by smart purchase and sale decisions. In the second, success is usually measured as return on equity, reflecting effective, efficient and sustainable operation of the resource base.
Historically, “property” has out-performed “farming”, but its returns have been three times more volatile. While property had huge success over the last decade, there were still years when property values dropped.
The only way to get a true measure of the value of a farm and its overall returns is to sell it, which is rather irreversible. It’s riskier to rely on increasing capital value in the future than on receiving cash flow in the present. With the higher risk of this strategy, the returns should also be higher.
For those who’ve farmed for the last 10 years or more the overall return has been satisfactory, provided something near current value can be realised if they sell. A farm investment’s overall profitability is the sum of its farming and property businesses. The farming business delivers primarily a cash result – the property business doesn’t. Farming is commonly described as “asset-rich, cash-poor”, suggesting liquidity difficulties and persistent cash flow problems. The problem in land investment is therefore liquidity, not profitability.
The first indicator of a liquidity crisis is erosion of working capital, or a cash deficit. The mix of assets will determine the business’ ability to respond to such crises. Those with liquid assets or cash reserves are in the better position. Debt may be raised to address the crisis, but there’ll be less scope to do this over time as the ratio of debt to equity increases, or credit reserves are depleted. In recent years this hasn’t been a constraint as asset values have increased faster than debt.
If a farm business needs to run a cash deficit for a while, it must determine which trigger-points will indicate that it has to quickly unravel itself from its commitments to protect investments. Some of these triggers have been overlooked in recent months, and there’ll be large equity losses as farm land prices adjust.
In New Zealand, a common short-term response is not to reward farmers for labour and management. Another, “passive equity”, where all or part of the equity receives no cash return, or no or limited dividends are paid. Here equity holders need to be patient and accept this investment is for long-term growth, or equity generation, rather than income, or cash generation. Many successful New Zealand farming families have understood this.
Long-term investments, often spanning generations, must be able to tolerate short-term variation in returns. Farmers’ debt level will reflect farmer and banker expectations and respective attitudes to risk. Cash surpluses are driven by amount of debt, “passive” equity and lifestyle expectations, plus profit levels. – Lloyd Phillips.
E-mail Prof Nicola Shadbolt at [email protected]. |fw
