Andrew Gawith from Gareth Morgan Investments looks at the return on investment in farming and blames the banks for lending on overpriced farms and inflating land values.
He argues if bank lending was based more on ensuring farms income returns, matched the cost of capital this may create a more robust and vibrant farming sector.
In the adjusting period this would cause a huge amount of pain for those retiring or exiting the industry.
What he does not explain in this article is family farm succession which often allows farms to inject young blood at discounted land values.
These agricultural investment return issues are not unique to NZ, but need to be solved as farming needs youth and energy to generate better profits and production
One of our most important industries, agriculture, appears to be one of our least commercially rational writes Andrew Gawith in the NZ Herald. The idea that businesses should generate a return sufficient to cover the cost of capital doesn't seem to apply to farming. Why does this situation prevail and what changes would need to occur to bring a little more sanity to this important sector?
There are two earnings streams from farming: the income return and the capital return.Typically farmers and their funders (mainly the banks) focus solely on the ability to service the debt raised to fund the business.So let's say the farm is worth $2 million and the bank lends the farmer $1 million, then all the bank is interested in is whether the farm can generate a net profit big enough to meet the interest payments on $1 million. Interestingly, farming is the most popular business for banks to lend to. While other areas of economic endeavour are starved of capital, banks have very nearly drowned farming with debt. The ease with which farmers can get capital has helped push up the price of land.
Now banks are generally reluctant to force a sale - they don't want to spread panic and undermine the value of their collateral. So why do farmers take such big risks for such pathetic income returns? The answer: capital gains. The value of farmland has risen even faster (10.7 per cent a year) than housing over the past 20 years. That's a very healthy return given there's no tax to pay. Farming may not be as commercially inept as it first seems, but it is speculative.
A portfolio of world shares over much the same period would have yielded a real post-tax return of between 4 per cent and 5 per cent a year. The rationale for investing in farms becomes clearer and stronger, but heavily dependent on rising land prices. Given land's credentials as collateral, banks are unlikely to abandon farming as a major lending market, though there's some evidence they have pulled their heads in a bit over the past year or so.
The value of farm land is also underpinned by an impressive track record of productivity growth.Another factor likely to stimulate land prices is the rise in demand for food from the rapidly developing countries such as China and India and the growing world population - it's expected to increase by about 50 per cent over the next 40 years.
Capital returns seem likely to remain the mainstay of total earnings for farming but the industry is vulnerable to falls in land prices (which is happening now).A combination of falling farm equity and pitifully low income returns quickly make farming an unattractive banking proposition. More focus by banks on ensuring income returns at least match the cost of capital would help shift the balance between income and capital returns as farmers would find it more difficult to get funding for over-priced farms.
We welcome your comments below. If you are not already registered, please register to comment
Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.