Article
Farming 101 teaches the importance of land ownership to leverage returns
Published: 11/07/2018
Since the passing of the parliamentary motion to review section 25 of the Constitution there has been an explosion of views on land reform, land tenure regimes and state ownership of land. From these debates it has become clear that there are diverse views on the value of land and its role as an instrument of financial security and leverage. – Wandile Sihlobo and Prof Johann Kirsten *Written for and first published on Business Day on 9 July 2018
Since the passing of the parliamentary motion to review section 25 of the Constitution there has been an explosion of views on land reform, land tenure regimes and state ownership of land. From these debates it has become clear that there are diverse views on the value of land and its role as an instrument of financial security and leverage.
Some positions, such as that of the EFF, support the principle of an end to private ownership of land and propose instead common property ownership. For this to be workable the state would have to implement a leasehold system over all land and run an effective land administration system and strong legal system to protect the security and tradability of the leasehold. However, as shown in many parts of Africa, Asia and Latin America, this is not easily guaranteed.
There are clearly divergent ideological positions on land as an asset and its role in a market-based economy – such as that of South Africa – that is an integral part of the global economy. A number of questions arise: what are the financial implications for the South African financial and agricultural sectors if different tenure options are followed? What happens to the financial sustainability of the companies or family businesses that own land? What are the implications for farmers?
Most market-based economies that permit land ownership and attach a value to land consider it to be a financial asset – something that can be traded for profit and the proceeds used to acquire assets of a different nature or that can be used as collateral to secure loans and finance the farming enterprise. This principle informs the behaviour of any financial institution and entrepreneur and plays an important role in the assessment of the financial performance of farms to evaluate investment decisions, calculate the repayment ability of a specific enterprise and assess affordable debt levels and overall sustainability.
The following are basic facts and concepts extracted from the first-year agricultural economics text book Finance and Farm Management, published by Standard Bank, to counter some of the irresponsible statements on land values and land ownership that have emerged over the past few months:
Most farm business in South Africa are family farms and are run as sole proprietorships. The sole proprietor will typically use own and borrowed capital in the business (as sole proprietor the farmer accepts full responsibility for making all decisions and is personally liable for any farming losses or claims against the business). This means there is an incentive for the farmer to work hard, since he or she shares in the success of the farming business and will be the ultimate loser of wealth in the case of failure. In addition to sole proprietorships, farm businesses can be structured as partnerships, companies, trusts and co-operatives.
In sole proprietorships the owner is responsible for all aspects of financial management. In the case of larger farm businesses there is sufficient turnover and financial responsibilities to warrant the appointment of a financial manager. Financial record-keeping is a fundamental part of sound financial management. The correct valuation of the balance sheet is first priority.
Typical farm assets in the balance sheet include land, fixed improvements (orchards, irrigation systems, buildings, kraals, dams, fences, sheds); breeding stock, other livestock, machinery and equipment. This implies that land can in fact be only a small part of the total asset value of a farm business.
Regarding the value of the land as one of the assets of the farming business, a first step is to classify all land available to the farm business in terms of ownership. There can be own land (title deed, private property), rented or leased land (land owned by someone else or the state) and land used for sharecropping.
Land is only an asset if it has value and is tradable. Thus, even "owned land" is only considered an asset under the correct circumstances, ie the guarantee of private property rights. Without this, individuals do not have a secure bundle of rights to land, which includes, naturally, the right to transfer land or rent it out. However, a long-term (99 year) tradable leasehold could be entered in the balance sheet as an asset.
When valuing land, one should draw a distinction between dry-land crop cultivation (crops, pasture, orchards and plantations), irrigated land (orchards, crops, pastures), natural grazing, farm yard and waste land. This distinction, with a further distinction for arable land between high, medium and low potential, also indicates that 1ha of land is not the same anywhere in the country.
The land potential, and thus the income-earning potential, not only affects the farm size necessary for a full-time livelihood but also the value of the land. That is why regions with high potential, such as irrigated farm land, have smaller farm sizes that support full-time large businesses. Naturally, the land values are much higher than those in the dry western parts of South Africa, where animals on low-potential natural grazing are the dominant farming enterprise.
The value of farm land under freehold tenure can be established using the agricultural value (income capitalisation) method or the market value (based on transactions of comparable pieces of land in the region).
The return on investment in land includes not only the annual income from the land but its appreciated value over time. The market value is therefore almost always higher than the agricultural value of farm land. There will, however, be no market value for land if land cannot be sold.
Throughout the recent discourse in South Africa there seems to be an aversion to the principle of using land as collateral to access finance. There seems to be some misunderstanding of the risks facing lenders that extend loans to individuals to acquire assets or inputs. There is no guarantee, given the risks inherent to agriculture, that individuals will repay the borrowed funds. So what guarantee does the financial institution have? What happens if the asset is not used to produce an income stream from which the monthly or annual payment can be made?
Using the land as collateral forces the owner to work hard and effectively to ensure that the annual commitments are made, since the lender will be able to sell the asset to recover the loan if the lender does not pay.
The collateralised asset therefore facilitates access to finance as it reduces the risk of default and losses for the lender. Borrowing money can furthermore make financial sense since it provides an opportunity for leverage and growth of the enterprise.
The use of farmland as collateral to access finance has distinct and crucially important benefits, including increasing returns. A basic principle taught to students of accounting, economics and finance is that of positive financial gearing, a principle that simply holds that "the income generated from the loan’s application should be more than the cost of the loan". For example, if the loan has an interest rate of 10% one should endeavour to apply the loaned funds to an activity in which the potential benefit is more than 10%.
Assume a farmer plants soya beans and makes a return after overheads and before tax of R2 000/ha (value of total crop minus production costs and labour). If this farmer has 100 ha it implies earnings before interest and tax of R200 000 (R2 000/ha x 100 ha). Assume he paid R10 000/ha to acquire the land, paid in full with own funds. This implies an investment of R1m (R10 000/ha x 100 ha). He thus made a 20% annual return on his R1m initial investment, (R200 000 from R1m).
Assuming the farmer only contributed 50% own capital and took a 50% loan, the farmer’s own contribution is R500 000, which with a bank loan of R500 000 makes up the R1m paid for the 100 ha of land. The farmer produces the same crop and makes his earnings before interest and tax of R200 000, but must now pay R50 000 interest (simple straight-line once-compounded 10% for R500 000 loan). This gives the farmer earnings before tax but after interest of R150 000.
At face value it seems the farmer is worse off by R50 000, as he only makes a profit of R150 000 versus R200 000. Yet his return on capital is now 30% (R150 000 earnings before tax on R500 000 own capital).
This is more complicated, more difficult to manage and higher risk for the farmer, but also represents a better return.
Overall, in the event of nationalisation of land the potential beneficiaries will not be able to build wealth without assets, as illustrated above. Therefore, the proposed system will not enrich anyone but rather be a nightmare for the state to administer – as has already been witnessed with the difficulties with managing the current land programmes.
• Wandile Sihlobo is head of agribusiness research at Agbiz (Agricultural Business Chamber) and Prof Johnn Kirsten director of the Bureau for Economic Research at Stellenbosch University.