A lender answers four frequently asked questions about farmland values, real estate bubbles and borrowing determinations.
By Greg Steele, AgStar Financial Services, Dairy Lending Specialist
Q. Given the rapid increase over the past few years in land value and cash rental rates, how is the limit for lending on farmland determined?
A. AgStar has developed a lending approach which looks at the whole operation. Our approach considers the production of the land being financed as well as the producer’s yield history. Other standards that measure equity, working capital, repayment capacity and the loan amount as a percent of the collateral offered are also taken into consideration. While not a dramatic change to our underwriting philosophy, this is evolution in our process to align loan standards to be relevant with current market conditions.
Q. Given the increased market price of land today, is there a dollar limit per acre that AgStar is able to lend?
A. AgStar looks at each opportunity to lend as a unique situation. When it comes to what a financial institution may lend per acre, there are a lot of factors that come into consideration, such as productivity of the land — which can vary by location — and the financial strength of the borrower. At AgStar, we’ve developed an approach to land values based on a formula which uses an analysis of historical data from several sources in order to project a value we believe can be sustained throughout agricultural cycles.
• Our baseline value was calculated on the following long term assumptions: $10.50 beans, $4.50 corn. Land value should equal approximately 25 times the rental value.
• Additionally, the long term assumption is that rental rates should be about 34% of gross revenues.
• Due to the variability in land quality and make-up (tillable/irrigation etc.), a set dollar per acre is not an appropriate, long-term approach to real estate lending.
• Based on this approach, if a parcel of land generates $1,000 of revenue/acre, you could expect the rental rate to be at approximately $340/acre. If you run the land value calculation on this same land at 25 times the rental rate, the land value could be expected to be $8,500 acre.
Q. Does AgStar think there is a farmland real estate bubble?
A. That is a fair question and one that deserves some thoughtful response. AgStar doesn’t believe we are on the verge of a real estate bubble. There will likely be a correction at some point, but we don’t know when or how much. We consistently monitor certain metrics to signal if a bubble is on the horizon, which could increase the chance of correction. Some of these metrics include:
• Farm debt to asset ratio
• Availability of export markets
• The existence of a farm safety net (e.g. government payments and crop insurance)
• Increasing interest rate environment
• Land not being rented and cash rents not being paid
AgStar is committed to real estate lending. We are dedicated, and we will be there long-term riding out challenges and volatility to help clients succeed.
Q. How can a producer be prepared for a possible correction in land values?
A. Sound risk management plans and maintaining a solid level of equity capital remain critical to withstand a correction in real estate values. Risk management has proven itself as a key tool to determine how to build profit margins for long term financial success.
In summary, AgStar believes:
• Real estate lending and purchases should be based on long-term, sustainable land values and evaluated as part of a producer’s entire operation, including production expenses.
• The sustainable value is tied to the production of the land being financed as well as the producer’s proven yield history.
• A sound margin management approach will provide stability in the event of a land price correction
• The benefit to the producer is about buying the right land to maximize production.
Greg Steele is vice president of agribusiness capital with AgStar Financial Services, ACA. His focus is working with commercial dairy operations that have grown and expanded their business. He provides expertise in the area of finance, business planning, and accounting. Contact Steele at (612) 963-7941 or firstname.lastname@example.org. For more insights on markets, risk management and other topics that impact your operation, visit AgStarEdge.com.