LOAN SERVICEABILITY AND FARM DEBT TRENDS
In recent years, we’ve seen significant increases in rural and agribusiness property values.
There’s no doubt this is a positive development.
But it has also led to some unrealistic borrowing requests. Many people assume the bank will always lend 60-70% of the land’s value. Unfortunately, land value is only one part of the finance equation.
In this blog, I’ll discuss why the bank is more interested in your cash flow than your property value. Then I’ll review recent farm debt trends.
Servicing your loan
In simple terms, ‘loan serviceability’ refers to your ability to make repayments based on the size of your loan, your income and expenses. Increasing interest rates make it harder to service your loan. That’s why the bank needs to determine your ability to repay the loan, even if things change.
When assessing your ability to repay debt, the bank wants to see historical information like profit and loss statements, balance sheets and tax returns.
The importance of a cash flow budget
As noted above, it doesn’t matter how much your property is worth. If you don’t have the cash to service the loan, the bank won’t lend to you.
Lenders put a lot of resources and time into assessing the credibility of your cash flow. Putting together a realistic cash flow budget is one of the most important documents when applying for a loan or refinancing. Making something up using fairy tale figures won’t fool your bank manager or lending officer. This is one reason working with a broker can make the process so much easier.
The lender will also look at how well your historical and projected financial performance matches. If you’re borrowing to buy additional land, you’ll need to project future income from increased production. To calculate farm income, lenders will usually accept current commodity prices for the first 12 months. But for years 2 and 3 in your cash flow budget, prices would need to reflect a 5-year average.
They’ll also consider your repayments (including both principal and interest). We usually calculate this on a 15-25 year repayment term with interest rates 2-3% higher than the current rates.
Client case study (property values were not the issue)
I began working with my clients at the beginning of 2020. They’d recently taken ownership of the property after finalising their succession plan. Their land was valued at $6,000,000. In 3.5 years, the value of that land has increased by 75% and their overall business equity has increased by 15%. Their LVR (loan to value ratio) has reduced from 33% to 18%. These are great numbers which give the bank total comfort when it comes to security.
Recently, they were looking to purchase land, so we crunched the numbers. The LVR increased to 42% and equity dropped by 22% to 64%. From a security perspective, these are still numbers that the bank would be comfortable with.
But the hard work came when we had to show serviceability. We calculated 5-year averages for income and yields using their current interest rate. The cash flow projections showed they couldn’t service the loan over 25 years. While high land values have increased equity for farmers, it’s made serviceability more difficult for those looking to purchase land. It’s a real catch 22.
UNDERSTANDING FARM DEBT TRENDS
Recent Australian farm debt trends
Debt financing is important for the farm sector. It helps fund new investments and manage variable farm revenue and profits. Borrowing allows agribusinesses to buy land and fund working capital.
In recent years, increasing land prices, low interest rates and high farm incomes have improved a farmer’s ability to access debt. But as interest rates rise, the proportion of farm income needed to pay interest will increase.
Understanding farm debt trends is important for understanding longer-term changes in farm financial performance and drivers of future productivity growth.
Aggregate farm lending is increasing
Farmers across Australia use debt to buy land, plant and equipment, and fund ongoing working capital. Profitability influences long-term trends in lending to the farm sector.
In recent years, we’ve seen high levels of investment in land, vehicles, machinery and farm infrastructure. This has been funded by borrowing and has helped increase farm productivity and improve financial performance over the medium term.
A recent report from ABARES, Trends in farm debt: Agricultural lending data 2021-2022 showed that aggregate lending to the farm sector increased 9% in 2021-2022. Lending to the farm sector has increased at an accelerating rate since 2016-2017. Interest payments represented 8% of income, which was historically low and is likely to have increased in the past year due to increased interest rates.
When profitability of farming is below average, lending to the farm sector increases. When profitability is above average, lending decreases.
Access to off-farm income
One of the other factors that affects farm debt is the access to income from non-farm sources, which can increase business resilience.
In 2021-2022, smaller farms (those earning under $150,000) sourced most of their household income from off-farm sources. The bigger the farm, the lower the proportion of off-farm income.
Changes in the make-up of farm debt
As the average size of farms has increased, the average debt per farm has also increased. But size is not the only factor influencing debt.
The average level of farm debt also differs by industry due to:
- differences in working capital requirements
- farm size
- income variability.
Even within an industry, there is usually an uneven distribution of debt.
Specialist broadacre cropping farms had the highest debt (around $2.31 million per farm in 2021-22). In comparison, debt for specialist sheep farms was the lowest ($309,400 per farm).
In this period, only 23% of broadacre and dairy farms increased their debt, down from the average of 32%. 40% of farms reduced their total debt, the highest figure since 2013-2014.
Debt financing in the agricultural sector
Using debt to enter or expand operations in the agricultural sector is not uncommon. It’s an important tool to help agribusinesses manage fluctuations in revenue during the year or between years.
In Australia, debt financing is more common for larger farms (based on turnover), with a small number of large agribusinesses holding most of the debt. This is partly because they can generate enough cash flow to repay the debt.
Understanding debt-to-equity ratios
In Australia, average debt-to-equity ratios have been stable for the past couple of decades. Equity ratios are lower for bigger farms with high turnovers, as they are the major users of debt financing and are better placed to service larger debts.
Continued increases in land value and high farm equity have resulted in increased lending to the agricultural sector.
In 2021-22, the ratio of owned capital to total capital for dairy and broadacre farms was about 91%. This is the highest this ratio has been in 20 years and was due to increased land values and an increase in the proportion of farms with no debt.
Using debt to manage fluctuating farm incomes
We all know that farm incomes change because of the variability in climate, prices, the cost of farm inputs, pests and diseases. Being able to manage these risks is crucial to the success of your agribusiness or farm.
Farms can manage income variability in several ways, including holding liquid financial assets (like farm management deposits) and maintaining high farm equity.
By maintaining a credit reserve, you can avoid the costs of needing to liquidate (and then re-acquire) assets.
And while borrowing to manage risk and income variability is an option, it isn’t always the most effective or straightforward option.
Conclusion
So, while the equity most farming businesses hold has increased, this isn’t the main thing a lender will consider. Showing you can make repayments is the key to increasing your farm or agribusiness loan.
Before you decide, chat to your broker, who will help you crunch the numbers and see what will work for you.
Over to you
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