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Rising U.S. farm debt and the implications for farmland investors
Why are U.S. farms facing challenges?
Three consecutive years of disappointing commodity prices has led to farmer incomes decreasing year after year. Low prices for soybeans, corn, milk and beef have reduced the level of farm income and 2019 is not expected to provide a deviation from this trend.
With generally modest leverage, the farm sector still has a healthy asset base, which usually consists of farm land. However, today liquidity is more crucial with the lending policy of banks changing to more cash flow driven structures. Farmers with an insufficient cash flow will face problems sourcing new agreements for working capital or investments, even if their leverage (debt to assets) is low.
How does this impact farmland investors?
The farm sector has been characterized by consolidation for some time, with thousands of farmers leaving the sector every year. The process accelerates when there is pressure on farm income, which varies widely among farms, based on type of production but also based on quality of management. Farmers whose margins are in the industry's bottom quartile are leaving the sector by liquidating current assets and selling/leasing out their farmland. Overall, farm bankruptcies play a minor role in this consolidation trend, and current bankruptcy cases have increased from a low level. Top performing farming operations which are still profitable will see opportunities to expand.
Farmland investors who lease the land need to carefully select tenants who belong in the top performers. This ensures a stable and sufficient return even if farm margins are under pressure. Furthermore, farmland investors help provide top performing farmers new lease opportunities for them to expand.
Farm income and debt levels are under pressure
Commodity prices for key crops like corn, wheat and soybeans have come down since their peak in 2011/2012, but remain above their averages from the 1990s and 2000s. Supply has been sufficient to meet global demand and stock to consumption ratios for the major crops are high. In the absence of major crop failures in more than one major grain producing region, global supply has put pressure on farm gate prices. Yield increases can provide limited compensation. Retaliatory tariffs that have closed the Chinese market for soybeans and held back exports of milk and pork aggravate the situation, distort long-term trade relationships and redirect global trade flows. Hay crops, such as alfalfa, have been hit especially hard due to retaliatory Chinese tariffs and exclusion from USDA subsidy payment programs. In addition, a stronger USD limits the competitiveness of U.S. exports.
Farm leverage has increased over the last few years as more than half of U.S. farm households lost money. The USDA estimated that median farm income for U.S. farm households was a negative $1,553 in 2018.1 However, with a forecasted 2018 debt to equity ratio of 15.7% (2012: 12.7%) the farm sector still has moderate debt levels. Comparing U.S. farm debt to asset and equity ratios over the past 48 years, the level of gearing remains at historic lows (see Table 1).
Because most of the assets in the sector are farmland itself, the ability of the farming sector to borrow or generate liquidity is more favourable than in other industries such as manufacturing with more specialized assets, which are harder to liquidate. The results from the 2018 Iowa State University Land Value Survey echoes results from other surveys, which all showed relatively stable farmland market trend,2 leaving the agricultural sector with a solid collateral base to lend against.
A closer look at debt levels indicates the underlying strength of the overall agriculture sector, and not just in North America (see Table 2).
Acceptable leverage ratios do not take away that pressure on liquidity is rising. Banks and lenders are taking a more careful view on providing further debt, as the risk profile has increased and the regulator exercises more pressure on banks to have a close look at the ability of borrowers to repay their debt from cash flow. The U.S. farm debt service ratio, which represents the cost of borrowing (including principal repayments) relative to their cash flow, has just moved above the 48-year average in the last twelve months. This indicates that financial conditions are becoming tighter.
Recently, District Courts in some regions are reporting a doubling of Chapter 12 bankruptcies.4 However, looking more broadly across the entire U.S. farming industry, bankruptcies have been relatively minor. Farmer Mac reports 2.3 bankruptcies per 10,000 farms in the U.S. for the period from 2006 to 2016.5 In 2017, Chapter 12 filings increased 9% to 499 across the U.S. This compares to more than 2 million farms in the U.S., meaning bankruptcy rates were 0.025% in 2017. Any percentage increases are coming from a low level.6
Taking a farm by farm view – a look beyond the average
An extension of the analysis from sector level to farm level provides further insight on the farms likely to leave the sector. While the last three years have negatively impacted the financials of most farms, the impact differs widely from one farm to another. A recent study from the University of Illinois highlights the wide variation of financial results not only from one year to another but also among the top quartile vs. average, when grouped according to the operating margin (see Table 4).7
The top quartile was able to sustain a healthy profit rate over a ten-year period of 23.4%, almost double the average of 11.9%. Since 2014, the bottom quartile made a negative margin. These farms were not able to fully cover expenses, depreciation, and unpaid family and operator labour. Paulson & Lattz identified the top performers to outperform their peers on yield, prices and a number of direct cost items with some of them outperforming their competitors on a consistent basis.8
The wide variation of farm results is also seen in other regions of the globe. Cross farm bench marking undertaken in the U.K., Denmark, Germany, Canada or Australia support similar findings. Table 5 below is an example of a breakdown from Danish farms.9
While farm results can differ from one year to another depending on the type of farm (livestock, crops) and/or commodity prices, management skills are a decisive factor. Even neighbouring farms, whereby the assumption of similar soil types and growing conditions can be taken, show a wide variation of results, which hint at management decisions as one major reason for the difference.
The numbers in Table 4 and Table 5 indicate that there are farms that are not earning a positive margin and have limited ability to cope with a multi-year downturn in farm margins. In times of higher commodity prices their margin might have been sufficient, but low commodity prices make these farms a loss making operation. Higher financing cost, less access to debt, and less capital available for further investments into new technologies or expansion are likely consequences. The market drives farmers to adopt new technology if they wish to stay in farming.10 The better farmers are more likely to support the fixed costs of adoption of new technologies to increase production and productivity. We therefore need to look more closely at the role of capital as basis for growth of a farming operation.
Capital is crucial in a capital intense sector
Historically, capital intensity is seen to increase much faster in agriculture than in non-agriculture and is today higher in agriculture than in many sectors of the manufacturing industry.11 This is caused by the trend of agricultural technology adoption. In addition, farm sizes are increasing year by year, reflecting more farmers to pursue economies of scale by investing in modern equipment.12 Without a sufficient profit margin, the bottom quartile is lacking capital to further grow their business, while losing competitiveness due to not being able to invest in modern technology. Farms with more debt on their balance sheet relative to cash flows, farms that need a greater share of their cash flows to pay interest expenses, and farms with a greater proportion of variable-rate debt will likely be impacted the most by these restrictions and higher interest rates. In the longer run, this puts more pressure on under-performing farms to leave the industry and allows better performing farmers to expand.
Farmland investors need to identify top performers as stable business partners to secure returns.
Consolidation is here to stay
The historic trend of farmland moving over time from the less productive to the more productive farmer has been noted already by Areboe in 1928 and still holds.13 Between 2008 and 2018, approximately 13,000 farmers left the sector per year, which is an indicator of the ongoing change. Farmers leave for a variety of reasons including lack of growth opportunities, lack of profitability, no successor or off-farm job opportunities, or an inability to create growth opportunities for the remaining farmers. The top quartile of farmers is able to earn more and pay a higher purchase price or a higher lease compared to their peers and thereby outperform farmers from the bottom quartile when farmland purchase or lease opportunities arise.
The current pressure on farm margins increases the pace of structural change in the farming sector with the bottom quartile leaving at an increasing rate while the top quartile is left to grow. This is a reinforcement of a trend seen for a long time in agriculture.
Farmers need to analyze what amount of risk they can run for their own operation when margins are under pressure and take necessary measures to meet their obligations. With a focus on efficiency and cost in good times, farmers need to be prepared to enter a period with pressure on farm margins with sufficient working capital.
Farmland investors leasing out farmland need to analyze their tenant base to identify the top performers as stable business partners to secure returns and support their growth plans by providing lease opportunities.
1 USDA-ERS: Farm Household Income Forecast 2019, March 2019 update
2 Zhang, W.: 2018 Iowa State University Land Value Survey: Overview. Iowa State University Extension and Outreach, CARD working paper #18-WP 586.
3 BMELF, Bonn, Monatsberichte, Buchfuehrung der Testbetriebe, 2018 Statistics Canada. Table 32-10-0056-01 Balance sheet of the agricultural sector as at December 31st (Solvency Ratio : Debt) Insitut Ekonomyki Rolnictwa i Gospodarki Zywnosciowej, FADN Report 2018: Wstepne Wyniki Standardowe Polskiego, rok obrachunkowe 2017 Department for Environmental, Food and Rural Affairs: Balance Sheet Analysis and Farm Performance England, 2017/2018, Department for Environmental, Food and Rural Affairs, London, Jan 22nd 2019 Department of Agriculture, Australia: AGSURF DATA, April 2019, Farm Type: Wheat and other crop, Debt Ratio at June 30, 2017
4 Federal Reserve Bank of Minneapolis: Chapter 12 Bankruptcies on the Rise in the Ninth District. Nov 14th 2018
5 Farmer Mac: The Feed. Spring 2017
6 AgWeb: Trends show Chapter 12 bankruptcies not rising at an alarming rate. April 17, 2019
7 Langemeier, M. and E.Yeager: Operating Profit Margin Benchmarks. Departmentof Agricultural and Consumer Economics, Universityof Illinois at Urbana-Champaign, August 24, 2018
8 Paulson N., Lattz D., Habits of Financially resilient farms. Department of ACE, University of Illinois. Paper presented at the IFES, 2017
9 Danmark Statistiks: De bedste landbrug tjener også penge i nedgangstider, 2018
10 Chen, Chaoran: Technology Adoption, Capital Deepening and International Productivity Differences. Job Market Paper. University of Toronto, November 22, 2016
11 Top agrar: Landwirtschaft arbeitet sehr kapitalintensiv. Alfons Deter. Dec.20st 2018
12 Daniel Summer: American Farms keep growing: Size, Productivity, and Policy. Journal of Economic Perspectives. Vol. 28. Nr. 1. Winter 2014
13 Friedrich Aereboe, Agrarpolitik. Ein Lehrbuch, Berlin 1928, S. 321.
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A word on risk
As an asset class, agricultural investments are less developed, more illiquid, and less transparent compared to traditional asset classes. Agricultural investments will be subject to risks generally associated with the ownership of real estate-related assets, including changes in economic conditions, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties