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Land equity shock test

Land equity shock test

This summer at seminars with agricultural lenders, I frequently encountered similar questions regarding negative margins. Lenders indicated that one or more of their customers have  negative economic margins and poor cash flow.  Working capital is depleted and the only reserves left are in land, machinery and livestock equity.   

Of course, the asset value of machinery and livestock continue to decline, but is the only equity remaining for use in a refinance. Lender after lender, the description of this situation became eerily familiar. Ultimately, each lender wanted to know, “How long can we continue to finance this customer with current land equity?”  Well, while this situation may be familiar, each customer is different and there are several variables to consider. 

First, producers and lenders together need to discuss the maximum “loan to value” ratio of credit extended on real estate.  It is important to remember that lenders will examine other financial factors in determining the maximum loan to value level such as, profits, cash flow and liquidity. This year, the range was 50 percent to 85 percent of the appraised value of the asset. Of course, this depends on the area of the country,  quality of the assets and the internal loan policy at the lending institution.  Still, others will place a dollar limit on credit extended for land. In the Midwest region of the country, the $4,000 to $6,000 per acre range is normally the maximum level even if land is selling in the $12,000 to $15,000 per acre range. 

The Example

Imagine a 1,000 acre farm with an appraised value of $6,000 per acre or $6 million in total value.   

Let’s assume the lender’s internal loan policy dictates a maximum loan to value level of 70 percent.  The maximum borrowing capacity would be $4,200 per acre which is 70 percent multiplied by $6,000. This farm also has debt against the land of $1,600 per acre or $1.6 million total. Subtract the debt amount of $1,600 from the borrowing capacity of $4,200 which gives an excess reserve of $2,600 per acre.  For the entire farm, total debt of $1.6 million subtracted from borrowing capacity of $4.2 million results in a total of $2.6 million in reserves. During the year, this farm lost $260 per acre as a result of lower commodity prices for a total loss of $260,000. If these results persist, the equity would be drained in one decade ($260,000 divided into $2.6 million), given the lender’s internal loan policy. 

Assets- Market Value

Appraised Value

Loan Maximum

Borrowing Capacity


Equity Excess Reserves

Land Value $6000/ac


X    70%

= $4,200,000


= $2,600,000


Burn Rate: Land Equity Reserves= Excess Reserves= $2,600,000 = 10 Years

                                                            Earnings Loss        $260,000


As further exploration of this example, what if the land values declined by 20 percent? This would result in a value decrease of $1,200 per acre or $1.2 million, which makes the new per acre value $4800.  In this case, the equity drain would be reduced to just under seven (6.8) years, instead of ten.  Additionally, with the new total farm value of $4.8 million, the maximum loan to value ratio of 70 percent allows up to $3.36 million in extended credit, if maximum level is approved. 

Assets- Market Value (20% decline)

Estimated Value

Loan Maximum

Borrowing Capacity


Equity Excess Reserves

Land Value $4800/ac


X    70%

= 3,360,000


= $1,760,000


Burn Rate: Land Equity Reserves= Excess Reserves= $1,760,000 = 6.8 Years

                                                             Earnings Loss       $260,000


It may be easy to see this as an example, but perhaps more difficult to regard as a possible reality.  However, if the economic reset continues, land values increasingly decline, and especially if the farm accumulates losses, land equity could be completely depleted.  Often, producers utilize land equity as their retirement fund, which in this example would be extremely problematic.

As the refinance season and lender review period approaches, it is extremely important to think through cash flow scenarios and available options regarding assets and equity.  This may be the time to start crucial conversations with your lender, partners and family members regarding limits, and how long and how far to continue the business.   Navigating the economic reset is difficult, but the real challenge is to simultaneously safeguard for the future.     

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