When I started this writing project, one of the first posts was the Farm Purchase Price Budget. That was January 15, 2020. It feels like a lifetime ago right now. Given the changes to the real estate market and how dramatically everything has changed, I wanted to bring the main idea behind the post to the present.
In that post, I looked at how much land you could afford given your income. Since that part of the math is still valid and hasn’t changed much, this time, I am going to walk you through understanding how much revenue is needed to service debt for a land purchase. I’ll use the same kind of parameters as before with some minor changes as it’s now 2021. These are your parameters:
The maximum gross debt service rate for conventional mortgages is 39% and the maximum total debt service rate is 44% for a lot of lenders. There is leeway as a business but this is a good place to start from. Essentially this is the percentage of revenue that you can tolerate spending on debt repayment (interest and principal).
The interest rate will depend on several factors. If you are applying for financing without an active farm business, you’ll be subject to the stress test. As of June 1, 2021, the rate for the stress test is posted on the Department of Finance website (currently 5.25%). Look up your lender’s interest rate and add 2% to your lender’s interest rate. Whichever is the highest interest rate is the rate you will use for your calculation.
With few exceptions, you cannot finance more than 80% of the assessed value of your farm.
The Mathematics
One way to consider affordability is to look at the per-acre costs and determining how much income per acre is needed for financing. For this example, these are the facts:
The bank’s interest rate is 3.5%, which makes the stress test rate 5.5%.
Financing is based on 25 years and you need to finance $8,000 per acre.
You can either use a really long formula which is payment = P x (r / n) x (1 + r / n)^n(t)] / (1 + r / n)^n(t) - 1 where:
The loan amount (P) or principal
The annual interest rate (r) on the loan
The number of years (t) you have to repay, also known as the term
The number of payments per year (n), which would be 12 for monthly payments
Or you can use a mortgage calculator like this one or this one. The end result is that this loan has a payment of $48.83 per month. So now we know that the payment is $585.96 annually ($48.83 for 12 months), dividing it by 40% (or whatever your tolerated service rate is), gets you the amount of gross revenue you need to pay that land. For this quick example, it is $1,464.90 per acre. This leaves you with $878.94 per acre to cover costs and profit.
A Quick Note
You’ll notice in the following examples, I will be using an interest rate of 6%. The 5-year rate is 4.8% at the time of writing with a range of rates depending on the agricultural sector. Overall, building in a buffer for your interest rate is a wise idea. If the math works at 6%, then it will work for rates below that as well. Since many farms would struggle with a 1% interest rate increase, erring on the side of caution and using the stress test 2% can save a lot of sleepless nights.
Land Values
Sometimes I think the FCC land value reports should include revenue requirements per acre. Using the 2020 FCC report and I will be looking at revenue per acre needed to service that kind of debt. For all of these, I’ll use 25 years at 6% interest with a 35% debt service rate and 80% financing coverage. I’ve picked a couple of regions from several provinces:
South Coast, British Columbia - average value of $100,800 per acre - requires annual revenue of $17,690 per acre to cover a $515.94 monthly payment
Northern Alberta - average value of $3,500 per acre - requires annual revenue of $614 per acre to cover a $17.91 monthly payment
Southern Saskatchewan - average value of $2,000 per acre - requires annual revenue of $351 per acre to cover a $10.24 monthly payment
Pembina Valley, Manitoba (irrigated) - average value of $9,500 per acre - requires annual revenue of $1,667.28 per acre to cover a $48.63 monthly payment
Central West, Ontario - average value of $19,600 per acre - requires annual revenue of $3,440 per acre to cover a $100.32 monthly payment
Abitibi, Quebec - average value of $1,300 per acre - requires annual revenue of $228 per acre to cover a $6.65 monthly payment
Western New Brunswick - average value of $4,800 per acre - requires annual revenue of $842 per acre to cover a $24.57 monthly payment
Annapolis Valley, Nova Scotia - average value of $5,300 per acre - requires annual revenue of $930 per acre to cover a $27.13 monthly payment
Kings, Prince Edward Island - average value of $4,100 per acre - requires annual revenue of $720 per acre to cover a $20.99 monthly payment
This translates to a range of revenue requirements from nearly $18,000 per acre in the Vancouver area to $228 per acre in northwestern Quebec. Using a 35% debt coverage for the land leaves some room for financing equipment and operating loans. However, in some places, the odds that selling agricultural products can bring in that kind of money are slim. The revenue potential just isn’t there.
Revenue for an Entire Farm
The same approach can also be used to understand how much revenue is needed to service any amount of debt. For entertainment, I’ll use this Almonte farm currently listed on MLS (MLS 1252302). The listing price is $2,750,000 and I’ve summarized the listing as follows:
“326 acres of cropland, woodlot, barns and century brick home. Organic loam soils have grown hay and pastures for over 60 years - no pesticide or fertilizer. Property fenced with cedar rails and page wire for grazing horses and cattle. 3bed, 1bath home. Multiple old barn buildings with a barnyard consist of natural bedrock. Approx 220 tillable acres, most tile drained. Natural springs on the property. Wood for furnace cut from the property. High-speed available. 25mins Ottawa.”
Financing for this farm will be $2.2 million with a downpayment of $550,000. If the buyer gets a 25-year conventional mortgage at 4.8%, that’s a monthly payment of $12,545.99 or $150,552 per year. To service that kind of debt, at 35%, this farm needs gross revenue of $430,148 or $1,955 per tillable acre. That’s just for the property itself. If the buyer plants all 220 acres in soybeans and gets 50bu/acre at $12/bu, that is $132,000 in gross revenue. This property will require some serious creativity if a buyer wants it to cash flow.
Playing with the Debt Service Rate
Raising the debt service rate (DSR) is one option. Let’s take the Almonte option and raise the DSR to 50%, which brings our revenue requirements to $301,104 ($1,369 per acre). Still high but watch what happens when the interest rate climbs:
An increase of 1% to 5.8% brings the payments to $165,783 annually.
An increase of 2% to 6.8% brings the payments to $181,662 annually.
Both of these situations would bring that DSR over 50%, every one percent increase in interest rates is a 5% increase in the debt service rate if your revenue does not grow at the same rate. Starting out with a high DSR to make a purchase work can lead to a lot of sleepless nights over the next two decades.
Affordability
The post from January 2020 focused on how much farm property Buddy, Jane and John could afford. I had written “Buddy can afford $298,000 and John and Jane can afford $547,000. Adding down payments on top of that at the minimum 20%, Buddy can make an offer up to $372,500 and Jane and John can offer up to $683,750.” The math and how it came into being have not changed much. The land hasn’t become any more affordable though. And finding parcels in that price range has become even more difficult.
Looking at the list from the various parts of Canada, you’ll notice that the seemingly “affordable” places are in more adverse climates. They are further from the markets, typically have lower heat units and lower class land. The yields and earning potentials on those properties are going to vary greatly.
A listing like this one in Béarn, Quebec (Abitibi) includes a 4-bedroom house on 273 acres (210 acres tillable including 30 acres tiled) with some outbuilding for $545,000 is a prime example of affordability trade-off. That works out to $29,836 in annual payments (same terms as Almonte) and $85,248 is needed for annual revenue. While yields would be down compared to the Almonte listing and its location is further from all services, that kind of revenue is actually obtainable.
Always know the Revenue Potential
All of this to say, the land is getting expensive and financing an entire land purchase without a big down-payment is being a bigger obstacle all the time. There are still the odd places where the math might end up working for a start-up. The revenue potential on a property should have a major impact on your decisions. It’s when the purchase price of the land exceeds the revenue potential that trouble starts brewing.