At Farm Future’s Ag Finance Bootcamp this past January, I did a presentation on “cashing in equity.” This is still a hot trending topic especially the past couple weeks.
Many of you might wonder, why am I hearing SO much about equity right now?
Equity -- the difference between what your business is worth (your assets) minus what you owe on it (your debts and liabilities) -- has always been an important factor in assessing the financial condition of a farm operation. But with cash being depleted rapidly in this current economic environment, equity is where many turn to next.
First let’s discuss the difference between equity (more specifically, real estate equity in this post), working capital, and assets. Assets are the things you own that have value such as real estate. Working capital is your operating liquidity which is calculated using your current assets. Today we will be referring to long term assets (real estate) equity, your long term assets less your long term debt.
When cash flow and ability to repay are strong, equity still matters, but not as much is often required. Now with ability to repay calculations coming in at 1 to 1 or breakeven, ag lenders are asking for more equity, and some are not willing to lend as much as in prior years.
For example: In the past let’s just say Bank ABC had required 25% down payment on land, so they finance 75% of the purchase price. Now that the markets are the way they are, Bank ABC has tightened up on how much they will lend. They will now only finance 65% of the purchase price of land.
They are aware that land prices might be hit with the depressed commodity markets and are attempting to protect themselves from being “collateral deficient.” So, they want more equity up front.
Equity equals borrowing power
This is why equity is so important right now, because equity equals borrowing power. If you do need to purchase or replace something for your farm and can’t put up the 35% they now want, you could use that equity as a supplement. When you are cash poor the equity in your assets gives you the borrowing power you need. It can also provide a small bit of “peace of mind” when you know that you have that cushion to fall back on.
Equity also is important in the event you do not hit the 1 to 1 mark and do not breakeven. If you are short paying back your line of credit you have to clean that up in some way. Unfortunately it is not simply wiped away. We wish!
In the event you have to take out a loan to cover this shortfall you will need collateral for the loan. Since you are not buying anything that could serve as collateral (you are just covering the shortage), you will have to use an asset you already have. That asset will have to have enough value to stand for the loan it currently is held on, along with this new one.
In the past I have encountered farmers who could afford the payment on a shortage loan, and the payment fit into the plan for next year fine. Then when we would look at the collateral for the loan, there was no equity to be found.
Even though they could afford the payment on the loan they were still in big trouble because they had no equity or not enough equity for the bank to be comfortable doing the loan. This is a tough position to be in.
FSA was able to help in some cases with their guaranteed loan program, thank goodness. Unfortunately, sometimes it doesn’t work out, and that is a hard pill to swallow. They had a good plan for the next year, but what stopped them was equity position.
I know you can’t gain equity overnight. This is a fact. Also, it is even harder in these current times to gain additional ground on your debt payments. It is hard enough to make the regular payment, much less to pay more!
My advice is to think about this for the future. When the markets improve, work on building that equity cushion if you don’t have a very substantial one. Consider a more aggressive amortization if you know you can afford it. Chip away at that principal balance.
To those who have a solid equity position – good for you! Protect that equity and think very hard on what you cash it in on. It is necessary to cash it in at times but remain aware of how much you are leaving and if you are comfortable at the reduced level. Real estate equity is not a piggy bank! Cashing in equity isn’t a decision to be made without proper analysis. However; sometimes you need to have your assets go to work for you when cash is not an option. When it is time for them to go to work, they will need equity to get their job done.
Protect your equity and use it like a weapon that only gets fired when absolutely necessary.