We’ve all heard the phrase “Cash is King.” Considering the volatility in today’s agriculture economy, access to working capital is essential to viability. When you are adding owned acres to your operation, cash for a down payment can ensure your real estate purchase is sustainable. In this article, we examine how your down payment on a land purchase impacts cash flow.
Let’s say a farmer wants to purchase 160 tillable acres at $7,500 per acre, for a total cost of $1.2 million. The farm currently consists of 1,840 acres, some of which are owned and some of which are rented. The farm has annual gross income of $1.2 million and working capital of $800,000. Before the purchase, the farmer’s annual fixed asset costs (including real estate payments, machinery/vehicle payments, cash rent, lease payments and real estate taxes) are $322,000 a year. When you divide this by the number of acres farmed, you have fixed costs of $175 per acre.
- 1,840 acres, combination of owned and rented
- Gross farm income = $1.2 million
- Working capital = $800,000
- Fixed costs before purchase = $175/acre
If the farmer has adequate collateral, he or she can borrow the full $1.2 million. At an interest rate of 4.9% over 30 years, the annual payment on the loan is about $77,800. Real estate taxes for the land add an additional $3,200 to the farmer’s annual costs. When you divide these additional costs over the full 2,000 acres, it results in a cost increase of $26.50 per acre, bringing the new fixed cost to $201.50 per acre.
- $1.2 million loan
- 30-year term
- 4.9% interest rate
- $77,800 annual loan payment
- $3,200 annual taxes
- Increase in fixed costs of $81,000 per year for a new fixed cost of $201.50 per acre
Now that we know the lay of the land, we can look at what the farmer expects to produce, including on the newly acquired acres. If we estimate yields of 200 bushels of corn per acre with an average selling price of $3.50 per bushel, gross revenue per acre is $700.
Let’s say that the cost to raise the crop (variable expenses, such as seed, fertilizer, insurance and fuel) equates to 57% of gross income, which is $800,000 or $400/acre. This leaves the operation with revenue of $300 per acre to cover real estate taxes and payments for machinery, land, cash rent and leases.
But we haven’t yet considered family living expenses. If the family relies on farm income to pay for their lifestyle, these expenses have to be factored into the land purchase decision. In this instance, the farmer needs $80,000 ($40/acre) of farm income to support his/her family. This reduces per-acre revenue to $260, but the farmer still has enough to cover the additional expense of the land purchase.
The farmer may choose to finance the entire purchase rather than use cash for a down payment. Even with the loan payments, the operation will have a positive cash flow. If long-term interest rates are lower than operating loan rates, it may make sense to maintain a higher level of liquidity and skip the down payment.
Now let’s reduce the yield per acre to 180 bushels of corn at an average selling price of $3.50 per bushel. Gross revenue drops to $630/acre. If all costs remain the same ($400/acre for inputs and $40/acre for family living), the farmer now has $190/acre to service fixed costs – which is less the farmer’s after-purchase fixed costs of $201.50.
It might appear that the farmer can’t afford the land. However, the financial picture changes if the farmer makes a down payment to reduce the annual loan payment and better align the operation’s fixed costs per acre to its revenue of $190. Remember, this operation has $800,000 in working capital and this cash might be well used for a down payment that allows the producer to expand at a sustainable cost.
The farm’s current fixed costs are $11.50 higher than anticipated revenue. Multiply this difference by 2,000 acres and the farm needs to reduce its annual payment by at least $23,000 (roughly 28%) to be sustainable. If the producer puts down $350,000 (slightly more than 29% of the $1.2 million purchase price), the new annual payment is $55,225, plus $3,200 in real estate taxes -- or $58,425.
Adding our original fixed costs ($322,000) to the new annual payment ($58,425) brings our total annual fixed costs to $380,425, or $190.21 per acre.
In the second scenario, the operation should be able to handle the land purchase. However, the farmer may want to explore options for reducing input costs and/or cutting back on family living expenses to provide some extra flexibility. When revenue and expenses are this close, a large, unexpected expense could make it hard for the farm to maintain positive cash flow.
The good news is the farm still has access to $400,000 of working capital, which is 33% of the operation’s gross farm income of $1.2 million. As a best practice, an operation should aim to have at least 25% of gross farm income available in working capital at a given time. For a $1.2 million operation, this equates to about $300,000 available to handle emergencies and deal with market volatility.
The answer to the question “How much cash should I put down?” is not always a simple one. Factors such as working capital, cash flow, operating expenses and debt all influence the affordability of a real estate purchase. It’s important for buyers to fully understand their financial position before making such an important decision. Solid record-keeping matched with basic financial acumen skills will help you evaluate opportunities and allow you to make tough decisions a little easier.