The three main concepts that people use to establish the “value” of land are: economic value, non-economic value and market value.
1. Economic Value
The economic value of farmland is comprised of productive value and capital gain value.
The productive value of land is determined by the land’s ability to generate a financial return. To estimate the productive value, or the return to land, all income and costs (cash and non-cash) must be accounted for.
There are four steps to determine land's productive value.
- Estimate gross income from the land to be purchased.
- Estimate all costs of production, EXCEPT for interest on the land.
- Determine the return to land (Step 1 minus Step 2).
- Divide the return to land by the capitalization rate.
- Estimating Gross Income
Gross income on the land to be valued should be based on the crop rotation to be followed using long-term average yields for the management level that applies, and the long-term market price of the grain.
- Costs of Production
Industry or government cost of production estimates do not necessarily represent an individual's situation. As there is great variation in farming practices, crop rotations, soil type and climate, producers must calculate their own expected costs. The cost of production should include an estimate of all costs associated with the land to be valued, except for an interest charge on the land investment. This would include all cash costs, such as seed, fertilizer, machinery repairs, taxes, etc., and non-cash costs, such as depreciation on buildings and machinery, interest on building and machinery investment, and an allowance for labour and management.
Where available, a farmer should use estimates based on his/her own past records and trends. An estimate for cash expenses such as seed, fertilizer and chemicals will need to be based on the condition of the land being valued and the crop rotation being planned. Other cash expenses, such as machinery, fuel and repairs, insurance, etc., can be based on the costs per acre on the existing land, with the assumption that the costs on the new land will be similar.
Non-cash costs (interest and depreciation on buildings and machinery) should be determined for the whole farm and then prorated to the additional land to be purchased. This procedure accounts for the non-cash costs on the existing buildings and machinery, plus the non-cash costs on additional buildings and machinery that are acquired as a result of the land purchase.
- Return to Land
The return to land is the gross income minus operating costs, depreciation and interest costs for buildings and equipment, and an allowance for labour and management. Interest paid on term loans should not be included in the operating costs.
Small variations in crop yields and prices can have a dramatic effect on the return to land. Furthermore, it is difficult to predict prices accurately, and yields can vary significantly in the short run. Therefore, several calculations should be made using different yield and price assumptions. The range of results provides a basis for assessing the risk involved in buying land. This is often called sensitivity analysis.
Capitalization is the conversion of future profits or earnings from the land into a current economic value.
By using the appropriate capitalization rate, farmers can estimate the value of land. The capitalization rate should be the rate of return that could be earned on other investments. A minimum rate is the earnings on a savings account, while the maximum rate would be the bank interest rate on loans.
The capitalization procedure converts future returns into today's value. For example, if the goal is to earn a six-per-cent annual return on an investment in land with an expected net income of $15 per acre, the value of the land would be $250 per acre. The capitalization formula is as follows:
Productive Value of Land =
Annual Return to Land
Productive Value of Land =
$15 per acre
= $250 per acre
Capital Gain Value
Productive value is not the only factor to consider when determining the economic value of land. Another important consideration is the amount of capital gain that might be realized when the land is sold.
To incorporate expected capital gain into the economic value formula, reduce the capitalization rate used by the expected annual rate of capital gain. For example, if the capitalization rate is estimated to be six per cent (as in the example) and the annual capital gain is expected to be one per cent, then the adjusted capitalization rate would be five per cent (6%-1%).
The formula to determine the economic value of land (with the productive value adjusted by a potential capital gain) is:
Economic Value of Land =
Annual Return to Land
(Capitalization Rate – Annual Capital Gain)
In the above example, the economic value of land is:
.06 – .01
$300 per acre
The economic value of land is equal to the productive value plus its capital gain value.
Non-economic factors affect the value of land. For example, a buyer may be willing to pay more to live in a particular community. A farmer may place more value on land that is adjacent to land already owned. Land may be of interest to some buyers because of its aesthetic value – it may be located near a river or a picturesque creek. In some cases, non-farmers may be competing with farmers for land.
Land’s "market value" refers to the price of transactions between informed buyers and sellers. It is always recommended that you hire an accredited appraiser in cases where an accurate valuation needs to be done. You can, however, get a good idea of market value by doing some analysis yourself.
The technique to determine market value is to use "comparable sales" of similar property in the same area. When doing so, it is extremely important to compare properties that are very similar in every way, and to examine the conditions and terms under which these properties were sold. It is important to obtain as many comparable sales as possible, as the more information, the more accurate the average becomes. It then becomes the simple process of calculating the average selling price, usually per cultivated acre, or per forage acre, or per grazing acre.
Here are some factors to consider when looking at comparable sales:
- Proximity is important. How close are the comparable properties to the one that is being sold? If the properties are too far away, it may not reflect your “local” market for land.
- Comparable properties should, as much as possible, have the same soil types, similar topography, and similar stones and sloughs; those things that change how much someone views a property to be worth.
- Determine the motives of the purchasers of the comparable sales. A purchaser buying land adjacent to his/her farm may be prepared to pay more.
- Improvements to property, such as buildings, make comparison of land more difficult. It is often better to use bare land sales only.
- Sales between relatives or close friends should not be used for comparative purposes because they may not reflect market conditions.
- Adjustments should be made if there are differences in the number of cultivated acres per quarter-section. In fact, as stated above, the comparisons are usually done on a “per cultivated acre” or “per forage acre” or “per grazing acre” basis.
- If the property has not been farmed properly, the estimated value should be reduced by the cost of bringing the property back to normal condition.
Another quick method for making a more general comparison is “multiples of assessment.” By using these same comparable sales, make a ratio of selling price divided by municipal assessment. This is the multiple of assessment. Take the assessment and multiply it by the ratio to get an estimate of market value.
Sources of Land Sales Information
Establishing market value requires good comparable sales data. Real estate agents might be one possible source of land sales information. Banks, credit unions and Farm Credit Canada (FCC) may also be able to supply data on sales that have occurred in a particular area. Rural municipal offices might also be able to share some information.
The source of information the industry uses is the Information Services Corporation (ISC, or the former Land Titles Office). This information must be purchased.
Factors That Influence the Decision to Purchase
1. Labour and Management Capability
2. Equipment Capacity and Requirements
3. Ability to Handle Risk
4. Tax Implications
Determining the economic value of land is one step in making a decision on whether to purchase or sell land. Economic value comes from both profits and capital gain. The next step in a land purchase decision is to compare the economic value to the current market value. This provides the means to evaluate whether renting land is more profitable than owning it. As well, it provides benchmark values that can assist buyers in establishing bid prices for land.
Lastly, the purchaser must determine if there is sufficient cash flow to purchase or finance the land. This is important even if the economic value is higher than the current market value, as the benefit of a capital gain is not available to service the mortgage unless the land is sold.