By Dick Haney
At the risk of sounding like the Saturday Night Live character Debbie Downer, there is a potential evil that lurks among us; it is how we leverage equity in our operations to buy more agricultural farm land. I think it would be useful to examine the similarities between Las Vegas and financial land management. I know Las Vegas is a little different, but I want to examine them in terms of how assets are valued and the attitude toward leverage.
The city of Las Vegas is an entertainment and gambling mecca that was carved out of the desert. It is complete with fountains and bright lights and one who visits has the opportunity to engage in all sorts of activities in an environment that once was a series of sand dunes complete with poisonous snakes and other objectionable reptiles and insects.
When Sir John Palliser surveyed western Canada he identified a triangle that has as its€™ endpoints roughly from Regina west to the Rocky Mountains and north to Calgary. He deemed it unsuitable for Agriculture. My hometown, Picture Butte is located in this area but with the advent of irrigation it now produces bountiful crops and there are many bright lights that mark out the intensive livestock feeding operations in the area. We have rattle snakes and black widow spiders and our share of gophers as well.
There are those that would argue that some days it€™s as big a gamble to be in the cattle or hog production business and they are very similar to gambling at times.
But, that is not where the comparison ends. Las Vegas is going through one of the most horrific real estate meltdowns in the history of the United States. Residents were convinced that the merry go round would never stop turning and there was only one way for real estate to go and that was up. Turns out that was a very invalid assumption. In a very short period of time, real estate prices fell catastrophically and with that came the inevitable foreclosures and employment issues. The U.S. economy tanked and people stopped coming to Las Vegas. But you say that would never happen in Picture Butte? I would put forward the thesis that it could for the following reasons.
Land prices are based on the need to spread the manure emanating from intensive livestock operations and not on productive capability of the land itself. This artificial price for land is not unlike land prices near major urban centers. Prices have no connection to agricultural production, but alternative uses call the tune. In my father in law€™s time, his rule of thumb was that if you couldn€™t pay for a piece of land with two years of production, then the deal was not a good one. How many years of production are needed to pay for land in this day and age? Irrigated land trades for 5000 an acre and even grass trades for upwards of 1500 in the foothills of the Rockies, and this isn€™t even close to some Ontario farm land prices.
In the heady days prior to the recession, people extracted equity out of their houses to purchase consumables. In short, individuals levered their capital assets to purchased items of no lasting value i.e. trips, cars, boats and entertainment. It was short term happiness for long term debt. In the red meat industry, the past number of years have been tough ones. In order to keep going, fixed assets (land) have been borrowed against to stay in the industry, with the producer hoping to get to the other side of difficult times. But in this time period, we have seen land prices rise, and that rise has had little to do with productive capability.
Here€™s where the shell game part of the equation comes into play. Let€™s say hypothetically that I own four quarters of land. I want to purchase an adjacent quarter. I can€™t make the land pay for itself, but it is close to my operation and we all think that land only comes available once a generation, so I want to buy it. Presently my land is valued at say 4000 an acre, but this piece of land is being sold for 5000 an acre. I have sufficient equity in the existing operation and so I purchase the land for 5000. So now when I value my farm I add the additional 1000 per acre to the existing land that I previously owned. My land base before the purchase was valued at 4000 times 640 acres or 2.56 million. But now I have 800 acres total valued at the new sum of 5000 per acre or 4 million gross with the added debt of 800000 for the purchase of the new quarter. The net effect is that I now value my land to a net of 3.200,000. So, by expanding my land base and increasing debt loads I have increased my wealth on paper by 640,000. Now I literally could take my new found 640000 equity to the bank and leverage the new equity to borrow more money. If I€™m lucky or perhaps unlucky, my bank has as one of the facilities available an instrument that is known as the €œPeter Pan Plan€ In other words, I only have to keep the interest portion of the debt current to be in good standing and the principle reduction payments are in €œNever Never Land.€ I submit that this phenomenon is how Agriculture has kept going in that last number of years. In short by leveraging equity participants have kept in the game. Productive capability has increased, but not at the same rate that land values have.
This pyramid scheme can continue until as Bernie Madoff found out, the merry go round stops. When land prices fall there is a world of hurt waiting. Welcome to the world of what financial institutions antiseptically call €œSpecial Loans.€
And now for the rest of the story. Take the previous example where the 5000 per acre purchase was made. Say your neighbor was having financial trouble and put his land adjacent to yours on the market. Because of prevailing conditions, that land sold for 3000 instead of the 5000 used in the example. This might be a simple supply and demand situation. There could be more land on the market than others wish to purchase, or capital to make purchases is not readily available. The gross value of your property is now not 2.56 million, but 1.92 million. That would be a 25% downturn in the value of land in your area. This is something we have experienced historically, although not often. Presently, Banks will loan approximately 75% of appraised value of your land base for mortgage purposes. I use this number at the risk of over simplification. In this example through nothing you€™ve done personally, a downturn in the global price of property has put your business at risk. Your margin of equity safety has just disappeared. It€™s in even worse shape if you leveraged the additional 640,000 in the previous example. The old banker saying €œYou€™ve got enough dirt you won€™t get hurt€ doesn€™t fit this scenario and you find yourself having one of those not nice conversations that we all seem to have with our financial institutions from time to time. And as we all know when things get bad they sometimes get really bad with the spinoff effects of Agricultural Credit policy globally tightening. The next act of this drama is that we experience the death spiral as sickness of this sort is infectious and the more that are below the line the easier it is to be caught up in the disease as it feeds off itself.
In short, I submit that we are on very unstable ground. It€™s like passenger jets that fly in the rare air at 30,000 ft. In the thin air at that level you can go like crazy but those jets fly at a speed that is uncomfortably close to their stall speeds, In other words if they lose power and slow down for any reason they will drop out of the sky like a rock. The jets don€™t have to stop, they just have to slow down and lose momentum. Kind of like what will happen in Agriculture if the price of land drops and upward momentum is lost or worse is in fact negative.
For those that say this will never happen: It can and it did in the mid eighties in our area when interest rates became a moon shot. Land prices dropped precipitously in a very short period of time. It has happened in Las Vegas in the past twenty four months. I€™m not saying it will, I€™m saying it could and if it does, there could be a producer parade or two that gets rained on and it won€™t be pleasant.
What about those folks who are trying to farm close to the GTA in Ontario, or in the Balzac area of Alberta for example? Land prices in those areas are totally out of sight and reach of the Agricultural Producer. There are two schools of thought about this situation. First one can continue to farm land that financially makes no sense to do so and put any ideas of expansion on hold or damn the torpedoes full speed ahead and attempt to compete with those who want to use this land for other endeavors with far higher returns. What many times happens is that one is forced to pull up stakes, albeit with his jeans full of cash and ply one€™s Agricultural trade somewhere else, further from an urban center where land is cheaper. Not a very palatable idea for someone whose family has been on a given tract of land for a number of generations.
Nobody said that this business was easy, but I submit it is getting more and more difficult each day to play this Agricultural game with the high stakes that now exist. One thing I know for certain, it is not for the faint of heart. So as in Las Vegas pull up a chair, put your stack of chips in front of you, wait for the flop, the turn, the river card consider the risk and decide whether or not you want to fold, be all in or somewhere in between. But remember just like Vegas there are Bankers in this game and, all Bankers whether in Vegas or agriculture seem to have the same sense of humor when the table is running against you.