There is currently much talk about the value of agricultural land and the fact that land prices seem to have decreased during 2017. The drought was certainly the major contributing factor in the decrease of land value, as not only more farms came onto the market, which increased the supply, but the demand was also stagnant during this period.
When it comes to the purchasing of agricultural land, there are two distinct factors that contribute to the final decision: The productive value of the land and its ability to increase in value. Since productive value is in the most instances not enough to cover the repayment of the land, the increase in value should make up the difference.
The value of agricultural land has, however, decreased this year, and this begged the question whether the purchasing of additional farm land over the last number of years was really that good a decision? To try and answer this question, we should look at the difference between an asset, investment and consumption to determine in which category agricultural land falls.
The three differences
To determine the difference between the above-mentioned terms, I would like to start with the definition of each. According to Investopedia these terms can be defined as:
- Asset: “A resource with economic value that will provide future benefit.”
- Investment: “An item that is purchased with the hope that it will generate income or will appreciate in the future.”
- Consumption: “When the cost is higher than the combined benefit of the income generation and appreciation.”
There are, however, also other definitions for the said terms. For example, the famous Robert Kiyosaki, writer of the book “Rich dad, poor dad”, defines an asset as anything that puts money in your pocket. The house you live in is an asset, according to Investopedia, as it will provide a future benefit (once you have paid off the mortgage). But, according to Kiyosaki, the same house is not an asset, as it does not provide you with extra income.
When you compare the Investopedia definitions with each other, it is clear that an asset can also be an investment, while a bad investment can also be considered consumption. This means that an asset, bought as a bad investment, can easily become consumption.
Classification of agricultural land
A comparison of agricultural land to the above definitions, brings to the surface some interesting facts. A farm can definitely be an asset, as it has economic value and may provide future benefit from production income as well as an appreciation in value.
Since a farm can generate production income and appreciate in value, it can also be considered an investment if the production income and value appreciation is more than the total cost involved. But a farm can very easily be a bad investment or consumption, as it might well happen that the production income is not enough to cover the cost – this may even cause the land to depreciate in value.
Whether a specific farm is classified as an asset or consumption, I believe, is based on its classification as a good or bad investment. A good investment brings an asset to the table, while a bad investment leads to consumption.
Good or bad investments
A good investment generates income or appreciates over time, while a bad investment costs money or depreciates over time. The time factor is very important as a certain investment may have been a very bad investment from one year to the next, but over a five- or ten-year period it may have been an excellent choice.
Figure 1 shows the details of R1 million that was invested on the FTSE/JSE All Share Index at the beginning of 2006. Over ten years until the end of 2015, the investment realised an average annual appreciation of 15,5% per year, making it a good investment choice. Year one showed appreciation of 41,2% followed by 19,2% in year two.
This very same investment showing excellent growth for the first two years, suddenly became a bad investment in year three with negative growth of 23,2% and a decrease in value of approximately R400 000. Years 2011 and 2015 can also be considered bad investments as the appreciation of 2,6% and 5,1% was less than inflation and interest rates in both these years.
The example of the FTSE/JSE proves that the time factor is very important with regard to the classification of an investment. Another factor to consider is the purchase price of the investment in question. No matter how high the returns or appreciation may be in some instances, the purchase price may have been so high that the returns and appreciation will not justify the investment.
To decide whether your farm was a bad investment or not, we should consider the price you paid for the land and the returns over time and maybe benchmark it against the JSE instead of taking only the decline in land prices during 2017 into account.
Was your farm too expensive?
As mentioned earlier, the price of agricultural land is driven by two factors: productive value (income potential) and market conditions. To calculate the value of land according to its income potential is quite simple – it is a function of the annual net farm income (NFI), annual living expenses (LE) of the farmer, expected return (ER) in percentage per year and the additional capital (AC) requirement for machinery or livestock:
Yet the calculated value of the land is often lower than the actual market value, and the difference between the land value and the purchase price should be justified by the appreciation of the land value over time. The influence of demand and supply, and thus the associated market value, is much more difficult to determine, as it depends on the market conditions at a given time.
As no two farms are exactly the same, it is impossible to use a certain farm, or the average price of agricultural land, as an example of a good or bad investment over a given period. You, as the owner of land, can, however, compare the price that you paid to its current market value, in order to determine the status of your investment. In my opinion, considering that the value of farm land is said to have increased by approximately 18% per year over the last ten years, chances are that you have a good investment.
The other factor that must be remembered is that you also get a return on your investment from your production income. Considering the combined effect of the appreciation in value at 18% per year and a return on investment of only 5% per year, there are very few other assets that performed so well as an investment.
Food for thought
Although the value of agricultural land may have decreased over the last year due to market conditions, this is nothing new when it is compared to other investments. It is never easy to see the value of your investment depreciate, but it is usually the result of a cyclical occurrence.
The current decline in the value of agricultural land should not scare you off from the long-term plans that you had for your business, and it might even be an opportunity to further increase your economies of scale in terms of land. – Frikkie Maré, UFS
For more information, contact Frikkie Maré at MareFA@ufs.ac.za.