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Land

• Land encompasses all natural resources such as soil, minerals, and water.   In this course, the focus is on using land to produce agricultural products (including native grass).
• The economic return to land is rent.

• Selected North Dakota statistics from Census of Agriculture
• Total cropland and harvested cropland in 2007:  27,527,180 acres and 22,035,717 acres, respectively; some of the difference can be accounted for with
• Conservation Resource Program (CRP) in 2007:  3,434,036 acres
• Fallow in 2007:  598,516 

• Compare these 2007 acreages to 1987 data:  5,894,262 acres fallowed and 467,650 acres of CRP (the CRP program was enacted by Congress in 1985 and was just starting to enroll acreage in 1987).
  • These several statistics are enough to raise the question of "what is the impact of technology (i.e., less fallow) and social concerns about land use (created CRP)." 
  • How much land will be in production if Congress allows CRP to terminate and owners are free to return the land to production?  What might happen to total production?  What might happen to commodity prices?  What might happen to farm profitability and land values?  Is the global demand for food enough to offset the impact of bringing (returning?) more U.S. land into production?
• Text: Kay et al. Chapter 20 Land -- Control and Use (pp. 347-370).
• This course does not address production issues such as soil fertility, erosion, pesticide application, range management, crop rotation, or tillage practices.  Those topics are addressed in plant sciences, soils, range management, and other production courses.

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Valuing Land

• A common question when discussing land is "how much should I pay for land; what is its value."
• Link to NASS page with North Dakota land values
• What relationship, if any, does there appear to be between land values and rental rate?

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• Valuing an asset -- the value of an asset (e.g., land) is the "present value of its future earnings."
• Restated, the value of an acre of land is its potential profit over its useful life.  This definition also is referred to as capitalization or capitalizing the land's future earnings.
  • Valuing land is similar to valuing other assets that will generate income in the future; that is, the value of the asset is the total of the present value of future income.
  • PV = FV/(1 + i)^n
    • This formula illustrates the concept of discounting; for example, discounting future earnings to present value; review Kay et al, Chapter 17, pp. 278 - 283 for a refresher on discounting.
  • An asset that will last two years and generate $40 of income each year has a value of $74.38 (assuming a 5% annual discount rate). That is, the first payment that will be received one year from now has a present value of $38.10; the second payment will be received two years from now has a present value of $36.28.
  • A simple spreadsheet can perform the calculations.

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• Should a real discount rate or a nominal discount rate be used in completing the calculations? That depends on the assumptions being made about the future income.
• If the analysis is being prepared on the assumption that the future income will be impacted by inflation and that impact is NOT represented in the projected future earnings, a real discount rate should be used. For example, the $40 annually is the projected future income before considering inflation. This assumption further assumes that the future income and discount rate will be equally impacted by inflation.
• If the analysis is being prepared on the assumption that the impact of inflation is already incorporated into the projected future income, a nominal discount rate should be used.
• Review Time Value of Money.

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• Because land has a long useful life, the number of years of future income can be extended far into the future.
  • A short-hand way to capitalize earnings is V = R/d; where V is the value of the asset, R is the average annual net return, and d is a capitalization rate.  This method is referred to as income capitalization; see Table 20-1 on page 355 of text for an example.
    • This calculation (formula) is valid only for assets with infinite (or at least, very long) useful life, such as land.
  • This capitalization formula also assumes that the future earnings will not vary from period to period (e.g., year to year).
  • A better approach for valuing land may be to project future income for each year the property is expected to be owned. This includes projecting a value for the land at the time it will be sold or transferred.
    • This approach can be calculated with a spreadsheet.
    • This approach does not eliminate or simplify any of the assumptions about the future; it only makes them more apparent.

Several of these considerations require additional discussion.

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• Future Earnings

  • An enterprise analysis can be used to calculate "return to land" by 1) determining revenue, costs and accounting profit, and 2) imposing an opportunity cost for all owned assets except the land.
    • Do you see the relationship between Table 20-1 and an enterprise analysis?
    • Does Table 20-1 include opportunity cost of labor, management, and risk?
  • What factors will influence future earnings?  Quantity of future production, price of the product, quantity of inputs, cost of inputs; imbedded in these projections are assumptions about inflation, technology, demand, and other similar considerations.
  • A challenge is incorporating into the analysis the variety of products and inputs involved in operating the land. 
  • Another challenge is projecting future earnings.
    • Link to NASS page with index of prices paid by farmers (page 15 of pdf file).  All prices and costs do not change at the same rate.
  • A third challenge is estimating the future resale value of land.
  • Again, a spreadsheet may be a way to consider this range of factors.  

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• Present Value

• Value of an asset is calculated by capitalizing its expected future earnings or income for its useful life:  V = R/d.
  • Capitalizing involves discounting future earnings to present value.
• What factors influence d (the discount rate)?  Inflation?  Cost of capital?
• What assumptions are being made in Table 20-1; more specifically, what assumptions are being made when using a capitalization formula (such as V = R/d)?  Are those assumptions always valid?
  • The assumption of no variation in earnings has already been identified  

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• Profitability v. Feasibility

• Do not overlook the difference between profitability and cash flow; compare Tables 20-1 and 20-2 in Kay et al.

• Be certain to recognize the difference between 1) earnings or profit and 2) cash flow.
• Is the value of an asset based on its projected profit or projected cash flow?

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Land Ownership

• Benefits and disadvantages of owning land
  • Owning land offers the security of knowing it is available; it is a means of accumulating equity; the owner has the decision making authority; and it can be a source of pride
    • There are limits on how land can be used -- physical limits; legal limits (e.g., zoning ordinances, environmental regulations)
  • Owning land generally requires more cash than leasing land; land often provides a relatively low rate of return; land usually is subject to property taxes that must be paid by the owner.

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Leasing Land

• Lease
  • Common types of lease arrangements -- cash rent, share-crop or share-livestock, variable cash lease
  • Characteristics of alternative lease arrangements -- level of risk!
  • Negotiating a lease agreement -- landowner's considerations; tenant's considerations
• Benefits and disadvantages of leasing land
  • Leasing often requires less cash than ownership; is an opportunity for the business operator to collaborate with the landowner; offers flexibility to add or remove acreage from business
  • Leasing land is less certain than ownership; leased land is not a means to accumulate equity
• What determines the rental rate for land?  What role does enterprise analysis have in reaching a lease agreement?  What role does communication have in reaching a lease agreement?  What role do goals have in reaching a lease agreement?  What role does opportunity cost have in reaching a lease agreement?  What role does risk management have in reaching a lease agreement?

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Composite Cost of Land

Land can pose a unique issue when determining production cost because its cost varies depending on whether it is rented, owned without debt, or owned with some debt. An example may clarify the issue.

Example. A farmer owns 60% of the land used in the business. It has a market value of $500 per acre, but the land debt averages $220 per acre. The farmer pays 10% of the principal each year plus 9% interest on the remaining balance. The property tax is $7 per acre. The remaining land in the business (40%) is leased for a cash rent of $45 per acre. The farmer could invest cash in a non-farm investment and earn an annual return of 6%. To assure a proper rotation, the farmer uses both rented and owned land in the enterprise being analyzed.

With this information, the land cost can be calculated as follows:

1. Rental rate times the portion leased is the land cost attributable to leasing (variable cash),
2. Property tax times portion owned is some of the land cost (fixed cash) attributable to owned land,
3. Amount of land debt per acreage times the interest rate times the portion that is owned is the interest costs attributable to land ownership (fixed cash),
4. Principal that must be paid on land debt times the portion that is owned is a fixed cash outflow but not a cost, and
5. Opportunity cost is the foregone interest income on the equity in the land times the portion that is owned; this is a fixed non-cash cost.

Table 1. Calculating Land Cost for Profitability and Cash Flow

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Alternative Uses for Land (or any real property, such as a building)

• The answer to this question is different for every tract of land, whether you own it or lease it.  What we need to accomplish with this discussion is to assure you are able to analyze the information you gather about the land's opportunities.  Thus we also need to consider what information you need to gather for your analysis and what information you do not need to gather.  We also need to consider "where do I find that information I need for this analysis. "

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Government Regulation of Land

• Controlling land -- private control and public regulation.
• What role does government regulation of land use have on the operation of farm land?
• land use regulation (zoning, waste management plan)
• voluntary federal government land use programs (conservation compliance, CRP, EQIP)
• Voluntary government programs -- conservation reserve program (CRP), conservation compliance, highly erodible land (sodbuster), wetland (swampbuster)
• Mandatory government regulations -- zoning, Endangered Species

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Summary of Key Points

• Enterprise analysis and opportunity cost of owned assets except land provide the foundation of determining both a rental rate and the value of land.
• Capitalizing projected future return to land is the basis for valuing land; capitalizing involves 1) using an enterprise analysis and opportunity cost to project future earnings, and 2) discounting the future earnings to present value.
• Again, the difference between profitability and feasibility (cash flow) need to be recognized in analyzing whether additional land advances the business owners' overall goals.
• Opportunity to expand owner equity and opportunity to manage risk also should be considered in deciding whether to add land to the business operation.
• Managers need to recognize and carefully consider the long-term assumptions incorporated into an analysis of whether to acquire additional acreage. Technology, government policy and market opportunities are some of the assumptions.