In my previous article last month, I asked “Are we valuing rural land correctly?” and examined from a commentary viewpoint the income and capital disconnect of an investment in rural land.
The positive public and industry response to that article, from important stakeholders, was very pleasing. A big ‘thank you’ to all who engaged in the debate. I hope it changes practise to a more robust model, so investors are protected, and I am still open to any further comment.
In this article I wish to address the topic of “What is a ‘Living Area’, and does the concept have currency today?”
Whether it is as relevant today as when the concept was coined, back when larger runs were being broken-up for Soldier Settlement Scheme blocks, and in more recent times, the ‘Brigalow Scheme’ in Queensland, is a point of conjecture.
The problem of State Governments not sub-dividing land appropriately is not recent. I quote from an article found in the Sydney Morning Herald from December 5, 1929, where the Forbes Branch of the Farmers and Settlers Association had this to say,
“… I have read that the Government is going to cut-up the “Cowal East” country into 1200 acre lots. It is only grazing country, and I do not think the area will be large enough. Though in some areas it will carry large numbers of sheep, there would be many other years when it would not be able to make enough, to make a living on 1200 acres. It is better to have one comfortable man on 2400 acres, then two strugglers on 1200 acres each. Members present, expressed the opinion that those who were sent to inspect closer settlement lands were not competent to judge what a living area should be…”.
Maybe it is time to have another look at this problem.
In my observation, the earlier experiences of larger properties being broken-up into an area too small to allow a margin-of-safety, seemed to cease with the Brigalow Scheme in Queensland; though there are some exceptions to the rule.
As my grandfather consecutively lost multiple large areas to soldier settlement and other reasons, in 1912, 1922 and again in 1928 respectively, he replaced some land during the mid-Twenties, by buying leases next-door (which had been resumed from other large runs), where the ex-soldiers had finally just given up and walked away, because the area was too small to make an economic living. These areas had been considered a ‘living-area’ by the government of the day, and the Valuer-General, to satisfy policy.
The point is they were far too small then, at 10,000 acres of Downs country and 24,000 acres of solid Gidyea scrub respectively, to be able to support a grazier and his family, for shepherding sheep.
In fact, they over-stocked the country so hard in the end, trying to make a go of it, some patches of dirt on these leases did not recover for nearly 40 years; and even then, only after new methods were implemented.
This was a position they were forced into, and usually not by mis-management, because the fellows who drew the ballots for each were from the land, and understood the seasons, and the risk; or so I believe.
There is a property in Central Queensland of over 40,000 acres. It is made up, I beleive, of a large number of gazetted farms, where it was considered that this country (obviously seen in better times by the Surveyor-General’s representative, who must have sent back a glowing report), if broken-up to these small parcels, would produce a bumper-crop each year.
However, the seasons, like Lady Luck, are fickle. Common sense prevailed, and the property was not broken-up, but the sub-divisions are there today for all to see.
I believe that everyone has forgotten how to price risk, including the banks, as risk and return go hand-in-hand.
The question must be asked, “How much inherent risk is involved in operating a beef grazing enterprise?”. If you invest in something, surely you want an appropriate return to your labour and capital?
Is it time that the strategic planning process for the future of sustainable grazing/farming in Australia, be taken out of the hands of the Government of the day (though they should surely administer it), and be vested in an appointed ‘Board of Trustees’ drawn from the very Lands being administered?
Is it time for the ‘in-vested interests’ (i.e. those with ‘hurt-money’ on the table), and others (usually without capital in the game) with different agendas, to put their cards on the table?
Is it time for the ‘Green Agenda’ to put some ‘common-sense’ back into the debate, as the current situation is heading towards being unworkable?
A Living Area Defined
I believe a ‘Living–Area’ is that area inside the boundary fence of a lease, that when the resources are put to their best economic use, will bear a fruitful harvest, giving an annual production, which will be both profitable, in an economic sense, and sustainable; understanding that the land must be managed as a steward would, for future generations, and with a margin-of-safety, considering the waxing and waning of seasons.
It is not a ‘subsistence-level’ concept; it is a sustainable business model.
Production ability, and profit, should be starting point.
In my opinion, the starting-point should be ‘what area will be required for that type of country (ie vegetation and soil) in that region to produce an economic profit, for each type of produce, and in a sustainable measure’; and not just to focus on the arable area, as a template.
This is because properties right next door to each other may have different natural resources, and by definition, different abilities to produce similar quantities of the same type of raw material. You need to have a mechanism to compare each, or else you are trying to compare apples and bananas.
It is important that current prices being received for agricultural production are not seen as the benchmark, but used as an input into a sustainability index; such that a long-term (say 10-year) quarterly moving average of prices for that product is established, so that seasonality and other factors may be recognised, and accounted-for when decisions are made.
This data should be readily available to the public, so they may observe trends, and break-outs above and below the long-term trend-line. Maybe this data is already available from Meat and Livestock Australia (MLA) and/or ABARES? My point is that decisions need to be made using long-term data, which shows the direction of trends; and not just the current data.
Everything in rural agri-business is driven by world supply and demand, and economic cycles; not just the local scene.
On the other hand, the grazing or pastoral manager must not hold stocking levels constant over time, because best animal husbandry practice is driven by the amount of rain in the gauge, and the amount of grass (read energy) produced.
As an aside, cotton-farmers plant their crop based upon the water already in the dam; not what might happen, and they are a much more sophisticated branch of the farming game than the grazing industry. These farmers really understand their risk profile, and mitigate where they can; for example, by making the dams deeper to conserve water that may otherwise be lost to evaporation (1” to 2” per day, over any surface area, as an average over the year), and by hedging their prices on the ASX, via Futures Trading and options.
Managers should implement ‘best practice’ management systems and processes, that allow for a radical sell-off, if appropriate.
For example; in the northern NSW, Queensland, Northern Territory and Kimberley cattle regions, I believe (as Australia is the driest continent on Earth, and one with a predominantly summer rainfall pattern, and with some country in these regions, specifically in the northern regions, referred to as ‘six-month country’), that cattle producers should be using controlled-joining for eight weeks only, in September/October, to calve in July/August (whilst there is still quality ‘hayed-off’ grass available, and with some protein remaining), with branding occurring in late September/October/early November, before it starts to get hot and wet. The turn-off is then available to meet the market in late February, if necessary.
If the expected rainfall does not eventuate, then numbers may be lightened-off without affecting income too much, as the grazier has options; and they may be sent to a feed-lot to ‘finish’ if necessary.
Ideally you should have recorded at least half your annual rainfall by the EOM-January, and 80pc by EOM-February. If not then the strategy is to off-load, to make room for the next generation coming through; as the cows need adequate nutrition and sustenance when pregnant; a rising plane of nutrition, if you will.
Therefore, manage resources well to maximise production; understand risk, and profit will follow.
However, if the property will not support you and your family in an economically sustainable fashion, because it has appropriate resources inside the boundary fence, then maybe you should not make the investment in the first place.
What Economic Return does a Rural Family Business Require?
The Economic Return to Labour and Capital is defined as the reasonable income to be earned by an appropriately qualified person in their next best alternative use (in this case skilled managers being employed off-farm), plus a return to capital employed (not including land resources, as we are looking at the leased farm in this example).
We will calculate the minimum economic return required, as follows:-
Return to Labour: Husband $86,000 Wife $54,000 Plus Super @ 9pc $12,600
- Totals $152,600
Return to Capital: Land $NIL Stock on Hand (Cattle) $1,939,938 Plant & Equipment $400,000 Improvements $800,000
- Totals $3,139,938
- @ 25pc Opportunity Cost (ROI) $784,984.50
- Total Return to Labour & Capital (e) = $937,584.50
To achieve this expected return on investment, before taxation and cost of funding, we shall reverse-engineer the process, to see what land area is necessary to achieve these economic goals.
How much is an Economic Profit or Return to Labour and Capital?
I believe that an Economic Profit (before Interest and Taxation) of $152,600 plus a 25pc Return on Investment (not including Land Value), should fall out the bottom of a set of financial statements for each farm/grazing unit, as a minimum, due to the level of risk in the venture, to be considered an economically viable property; or a ‘living area’, if you like.
As an investor, a grazier should expect no-less than his city counterpart, who (investing in a business with similar risk attached), is able to measure an appropriate return to labour and capital compared with similar risky investments. Always remember, as risk increases, so should the expected return on capital employed; and vice versa!
For example, Break-Even and Cost/Volume/Profit Analysis shows us the following, for a leased 64,000 acre property (with a sustainable carry-capacity of 1:14 acres), running a self-replacing herd of cows (with joining rate at 3.0pc), where weaners (80pc) are grown and fattened (to turn-off at <18-months), and mortality is 1.50pc. This is a traditional, set-stocking rate model.
In this model, ceteris paribus, the calculations and assumptions are:- The accounting break-even selling price is $522.75 per head, for 1693 head; and assuming we are 60km from the sale-yards. The accounting breakeven volume, for the same cost structure, is # 776 head of cattle at $1,078.03 each.
The most that might be paid for this property, at that cost structure, risk and revenue, is an intrinsic (read ‘full’) value of $3,944,392 (which equates to 4.1963 – times EBIT, or a cap rate of 23.83pc, to reflect the risk involved). The prudent price will be less than full value, and with a higher ‘cap-rate’.
This further equates to $61.60 per acre WIWO for the enterprise value, as a going concern. An interesting number, no? An appropriate multiple of sustainable EBIT to derive the Enterprise Value for an SME with a similar risky, yet profitable, business model, based in the city, will be between 2.5 and 4.5 times EBIT; depending on due diligence. A long way from the corporate Price Earnings Ratios (PER’s) of 9 to 18 – times.
Rent equates to around 25pc of revenue for the lessee. Rent equates to around 11.5pc for the owner, which is a reasonable commercial rental yield. The owner and the lessee are being adequately rewarded for the level of risk being taken. The number of breeding cows is roughly # 2,000, to achieve this outcome. The turnover is $1,824,984. The employees, including manager, number four. There is one further contractor employed during the mustering rounds. There are NIL supplementary feeding rations.
Therefore, I deduce that it does not matter the number of acres held, as cattle carrying capacity varies from 1:4 acres to 1:80 acres (or even more), depending where the property is situated.
It is the dollar turn-off available from the production of the parcel of land that is paramount, and I believe that a minimum of #2,000 breeding cows, or sheep equivalent (at a ratio of 1:7 sheep), is appropriate in the grazing regions, to make an economically sustainable income, year-in and year-out, also to continue to invest in the farm infrastructure so growth may continue.
There is also the ability to be able to invest off-farm and to diversify and build financial strength in the balance sheet. A healthy business requires less hand-outs from government, because by definition and fact, they are sustainable!
I also conclude that depending upon sustainable carrying capacity for a region, vegetation or soil type, the size of each property should be based upon this number of 2000 breeders. A calculation may then be made using the Adult Equivalent (AE) for beef cattle, or Dry Sheep Equivalent (DSE), stocking rates for a certain property, applying against ‘normalised’ production prices available, as discussed above, to then derive a sustainable operating profit.
In this way, due to profitability and scale (regardless of the season or prices), we shall return to the days when the grazier, and farming management processes, were long-term, and you could plan for thirty years, or at least a generation or two.
The social fabric of the western communities revolved about families, because the farmer/grazier made a decent living from the production, and took a stewardship view of the land by employing people; rather than short-termism, where the farmer is a virtual ‘serf’ to someone, and the rural communities are dying for wont of people.
The farmer/grazier may be considered a ‘serf’ because there are few economically profitable farming entities in Australia (read Pareto’s 80/20 rule); usually being because he is usually under-capitalised and viewed by the bank as having a virtual Non-Performing Asset status almost immediately, due to debt levels and faltering seasons; and hopes to ‘just get out alive’ by receiving a ‘suitable’ price from the next fellow. The pattern then becomes set.
Besides, and rhetorically speaking, who has the 40pc minimum deposit now required by the banks and other financial institutions, for an $8,000,000 investment; or a $4,000,000 deal for that matter? Obviously the lenders see the whole business as very risky! Maybe the investors should too, and price the asset going-in, appropriately.
What is Economic Quantity (#) for a Given Target Profit.
If the formula for Break-Even analysis (where by definition, profit equals zero), is:-
Profit = ((Selling Price per Unit – Variable Cost per Unit) x Quantity Sold) – Fixed Costs.
Therefore, to calculate the minimum turn-off (Q) required to achieve a target economic profit of 25pc above accounting profit, where the other variables are ‘known’, will be as follows:-
1.25 x (939,970) = (1,077.96 – 53.28)Q – 794,811
0 = 1,024.68(Q) – (794,811 + 1.25(939,970))
0 = 1,024.68 Q – 1,969,733.50
Q = 1,922 head of Sale Cattle.
Therefore, at 85pc expected weaning, equates to 2261 cows.
This, I believe, is the minimum breeder number required to make an economic living from this business, and to be able to pay taxes and funding costs of further off-farm investments, to mitigate the risks of being invested in the ‘bush’.
The ‘living area’ is therefore, whatever area is required to run # 2261 breeding cows.
To sum up
1. The starting-point to assessing a ‘Living area’ should be the long-term sustainable profits able to be procured from each property, bearing in mind that to make a profit year-on-year, you have to be able to make a margin greater than costs. In the ‘bad’ years there should be a pool of capital that the grazier has ‘saved’, that he may then draw from; rather than always having to ‘go to the bank’.
2. Each parcel of rural grazing land should be assigned an Adult Equivalent (AE) or Dry Sheep Equivalent (DSE) stock number, as a guide when being marketed for sale.
3. A calculation may be made by DPI (or similar), using the Adult Equivalent (AE) for beef cattle, or Dry Sheep Equivalent (DSE), stocking rates for a certain property, applied against ‘normalised’ production prices available, as discussed above, to then derive a sustainable operating profit.
4. For example: the Pine forestry country of around the Southern Queensland towns of Chinchilla, Miles, Yuleba and back along some areas of the Condamine River, where many blocks are obviously too small, should be re-assessed as to what is a ‘living-area’ in that region, and then possibly resumed, amalgamated with other surrounding parcels as an ‘additional area’, and/or re-allocated on some sustainable basis.
5. This does not mean they should become part of the National Park Estate, possibly becoming mismanaged, and be a haven for vermin and noxious weeds!
6. ‘Wrong size, causes wrong behaviour’; though applying the ‘less is more’ approach may mean you carry less stock and look after the country ,and make a better income regardless. However, I am assuming ‘best practice’ for my theoretical ideal ‘living area’.
7. Is it time for the ‘Strategic Planning’ process to be handed over to a ‘Board of Trustees’, drawn from the Land being administered, and answerable directly to the Minister of Lands and Natural Resources?
This should be chaired by an appropriately experienced individual, drawn from the very Lands to be administered.
8. People investing in a farming/grazing enterprise require diversity of land and soil types, economy of scale, long-term land tenure and long-term sustainability with a ‘margin-of-safety’, to be considered viable by a bank; or any investor for that matter.
9. Future farmers/ graziers need to ‘start how they mean to finish’, with proper planning processes in place when you commence the business, and each year thereafter; and if you understand the ‘Rule of 72’ which helps to explain the erosive powers of inflation, and then to use this to advantage, then each enterprise should be planning to double their Enterprise Value in ‘real’ terms every six to ten years; depending upon inflation and the cost of capital. This is also considered a ‘sustainability’ action.
11. Like any normal business, the past three (preferably seven) years of trading data should be available to a prospective purchaser of grazing land or a farm from the vendor; once a Confidentiality Agreement is signed, of course. The prospective purchaser should not have to use contrived data which is guess-work and probability.
12. The prices being received for units of production, have not even kept pace with inflation in the last twenty-four years; so ‘real’ return is going backwards at an ever-increasing rate; and this is why there is a divergence between income and capital on the rural farm; because there is an expectation that the land value will continue to increase at an ever increasing rate (read exponential); which, of course, is impossible. Why would anyone invest in farming/grazing until this is sorted-out?
13. On inflation: if the cost of a counter-lunch in 1976 was $2.90 to $3.50, and the purchasing power of money has been reduced by around eleven times since, then the ‘normal’ price to pay for a counter-meal today will logically be $31.90 to $38.50. It is ‘normal’ to be paying those prices for a piece of meat (300grams).
14. If beef, for example, is $18 per kilogram (average) for retail, this values a 380kg cold carcase at around $22,800. Surely the producer should get more than $1,077.96 per head (4.73%) average; allowing for close substitutes, of course?
15. It is time for the farmer/grazier to receive an appropriate return on investment; he should ensure he will assist himself, by not paying too much for the land in the first instance, and by ensuring the rules in Item 16 below, are followed closely.
16. Old rules, stemming from harsher times, to manage capital risk in the bush, were:
a. to never borrow more than 50pc of the value of the breeding herd,
b. combined with, never borrow more than 20pc of the improved land, and
c. never pay too much, or more than a fair price; because you make your money when you buy, not when you sell.
d. Strengthen your balance sheet against adversity, by ensuring to take profits off-farm each year, and investing in low-risk assets, with a minimum of leverage.
They are still relevant today!
17. The ‘living area’ is that area required to sustainably support a grazing/pastoral operation, with 2261 breeding cows, growing weaners out, to turn-off at 18-months of age.
I believe this is a debate that must be had, and the farmers and graziers of today, and tomorrow for that matter, should engage with their local Member of Parliament to flash their sustainability credentials, because they are the best stewards of the land.
I welcome debate, and am happy to be proved wrong!
Michael Vail, SA Fin FCPA, is a director of business advisory and consultancy firm Tre Ponte Corporate in Brisbane