Silicon Valley Bank invested cheap money in better-yielding long-term assets (bonds) while ignoring long-term cash flow implications. Outside land investors sought the same by seeing a return (rent) better than money in the bank.
Land is an asset akin to a bond. Land purchased in the past decade yielded 2% to 3% versus idle cash that yielded 1% in a bank — a no-brainer. Land prices exploded to levels twice that of a few years ago.
Acid-test ratios show if you have sufficient short-term assets that can be converted to cash to cover short-term liabilities. Here’s a simple formula to determine a new value of land under increasing interest rates versus a previous interest rate.
Value2 (n) X Interest rate R(n) = Value (o) X old interest rate R(o). Letting V(o) = $7,500/acre, Ro = .03 interest or rate of return (ROI); V(n) = unknown value; R(n) = new interest or ROI. New R(n) is often referred to as opportunity cost meaning a new opportunity exists for a different asset yielding a different ROI.
V1 = $7,500
R1 = .03
R2 = .07
V2 = unknown
Solving for the equation V2:
Receiving a 7% ROI (assuming $225 rent stays stable) means an investor can afford to pay only $3,214 per acre for the same land that cost $7,500 three years prior. The investor either requires new rent of $525 per acre or looks at an interest-bearing security paying 7%.
If land needs to be sold for working capital or service existing debt, the new value has depreciated significantly in theory. A bank holding a 60% loan on the $7,500 purchase now has a problem if that loan asset is required to be marked to market price on the books. (Just like the borrower who owns more than it is worth.)
If the land loan was a five-year term requiring refinancing, interest rates better come down in five years. Land purchased three, five or 10 years ago that needs refinancing is likely under water requiring more assets either cash or other asset with value.
Land bought for $7,500 per acre three years ago had a re-sale value of about $11,000 to $12,500 per acre — even nine months ago. Plugging in $12,000 with rent at the old rate of $225 per acre is only a 1.875 ROI, not a good comparison to an alternative.
With gross income dropping $300 per acre, odds are increasing rent will be difficult. One could argue old rent should have been $350 but even that would only be .0292 % ROI. Doing “what if” calculations doesn’t change what the radical change in interest rates potentially has on assets.
