Examining the source of farm equity

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I spent a short time working as a commercial lender in a small, rural bank. As a new lender, I was encouraged to grow my loan portfolio. With that goal in mind, I perhaps was a little too eager to approve any loan request that walked through my door. Fortunately for me, my boss was a seasoned lender and was able to guide me toward making wise credit decisions.

At one point, a farmer approached me about a loan request and brought in his financial statements for me to examine. I looked at them and was impressed with his net worth. He had experienced cash-flow issues during the past few years, but his net worth position helped overcome the cash-flow issues.

I put the loan package together and presented it to my boss, but she quickly noticed a problem. I was using market values to calculate net worth. The farmer had a tract of land that bordered prime recreational land. Based on the current economic conditions, the land was valued extremely high. Basing the value of the land on agricultural values vs. recreational values, the farmer’s strong net worth quickly disappeared. I realized then the importance of understanding sources of equity, or net worth.

The most basic accounting equation, which underpins the balance sheet, is assets minus liabilities equals net worth, or owner’s equity. Net worth is an indicator of wealth and financial position. However, net worth is complicated because of the problems caused by changes in asset values.

To understand this better, it is helpful to identify the composition of net worth. Net worth is composed of three pieces. The first piece is contributed capital. This can be thought of as the money invested in the business by the owner. The second piece is retained earnings. Retained earnings is defined as the accumulated net earnings of the business that have not been withdrawn or distributed. The final piece is valuation equity. Valuation equity is the change in asset values often defined by the difference between market and cost values.

This quick accounting 101 lesson was necessary to illustrate one of the threats facing farmers. Farmers have been able to strengthen their balance sheet, thanks to favorable prices and growing conditions combined with sharp increases in land values. Researchers at the Federal Reserve Bank of Kansas City have noted that the U.S. farm balance sheet is the strongest it has been since the 1970s.

As we look at the current situation, land values have increased dramatically throughout the Midwest. Average land values in North Dakota went from $670 per acre in 2007 to $1,910 per acre in 2013. We also have seen farm assets go from an average of close to $1 million up to $1.9 million. At the same time, the average producer’s liabilities have stayed relatively constant.

During the past few years, farmers also have seen a dramatic change in net worth. The average net worth went from $600,000 in 2007 to just more than $1.3 million in 2012.

The question becomes: Is that change in net worth driven by changes in asset values or retained earnings? In 2007, the average net farm income was $192,200. In 2012, the average was $367,317. With this increase in farm income, have farmers been putting those earnings back in the farm or has the change in net worth been driven by appreciating farmland values?

My colleague Frayne Olson and I have analyzed data from 1998 through 2012 to help find the answers. We divided the data into two time periods: 1998 through 2006 and 2007 through 2012. The shift that occurred in agriculture in 2007 would provide a reference point.

Based on our results, farmers during the most recent time period (2007 through 2012) are relying more on retained earnings to build net worth than asset revaluation. In other words, most farmers have been using their earnings wisely.

Perhaps a partial explanation for this change could be lenders shifting focus to earnings-based decisions vs. asset-based decisions. The 1980s farm crisis illustrated the dangers of asset-based lending decisions. Although proper assets must be in place to justify a credit decision, lenders also are requiring sufficient earnings/cash flow to secure credit.

So what does this mean for the future? What happens if land prices fall? What happens if prices do not rebound? I wish I had a crystal ball and could forecast the future accurately. Although I am unable to forecast the future, I believe that we can agree that commodity and input prices will continue to be volatile, which highlights the need for sound financial management.

The hope is that farmers, lenders and researchers can use the lessons from the 1980s financial crisis and the recent agricultural boom to help avoid any future crises.

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