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Due diligence on land purchases critical for long-term returns

by Ian McLean and Phil Holmes*, 20 April 2018
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HISTORICALLY, more wealth has been created in the beef industry through increases in the value of land than through beef production. There has also been considerable wealth destroyed when price driven optimism has not eventuated.

We believe that for long term business returns to be dependent on future capital gains, and the eventual sale of the asset, is a risky proposition. It also has the potential to result in significant cash shortfalls in the meantime.

It is possible to have businesses that generate reasonable returns during ownership, rather than only upon sale. Performing comprehensive due diligence on any land purchases is a key factor in achieving this for growing businesses.

A critical component of due diligence is determining what the ‘value’ of the potential acquisition is to you. A premise to this approach is that a piece of land does not have the same value to all potential purchasers but has an intrinsic value unique to each potential purchaser, dependent on what profits they can generate from it. We follow the thinking of Warren Buffett here (arguably one of the best allocators of capital the world has ever seen, and property purchases are all about allocation of capital), who says ‘price is what you pay, value is what you get’.

The management system and existing business of every potential purchaser will determine what the incremental profits from the acquisition are. Estimating these incremental profits will allow you to determine what the intrinsic value of the asset is to you.

A key consideration in these calculations is how to incorporate future capital gains into the purchase price? If historical capital gains are 2-4% p.a. in real terms, do we assume that this will continue and factor it into our incremental returns?

We do not believe you should, primarily because doing so is subscribing to what economists refer to as the ‘bigger fool theory’, which is where more is paid for an asset than its intrinsic value in the belief that a ‘bigger fool’ will come along and pay more in the future. Historically significant wealth has been created (and some lost as well) this way, but there are some serious implications. Firstly, if the returns are all from capital then the business runs the risk of serious cash shortfalls, particularly if debt is involved.

Secondly, there is no guarantee that capital returns will continue, whilst land values have increased on average in the long term, there have been periods where they have been quite stagnant, and also negative. What they will do going forward is unknown (‘prediction is very difficult, especially if it’s about the future’, Nils Bohr), but it would be reasonable to assume that as interest rates and cattle prices trend away from their current lows and highs respectively, there is potential for downward pressure on land prices.

We can draw on the wisdom of Warren Buffet again here; when he purchases shares in a company, he does so under the assumption that the share market could close the next day, and he would not care, because he is happy with the intrinsic value of the asset. He also says ‘Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results’. We believe these apply to rational capital allocation in agriculture, as well as in the share market.

Any future capital gains should be treated as icing on the cake, rather than necessary for the investment to work. A beef business that can generate returns that meet or exceed its cost of capital through business operations alone, rather than through future capital gains will be a sustainable business that can provide a reasonable return to its owners without being sold.

 

* Phil Holmes and Ian McLean are authors of the independently prepared Australian Beef Report. The Australian Beef Report provides the most comprehensive analysis ever undertaken of the production and financial performance of family owned beef businesses in Australia.

The Australian Beef Report has a section on performing due diligence for a property purchase and includes a tool that users can use to value a property purchase or lease for themselves.

  • More information on The Australian Beef Report is available here.
  • A recording of a webinar hosted earlier by Beef Central on the Australian Beef report can be accessed here. 
  • Messrs Holmes and McLean will deliver a summary of key findings from the Australian Beef Report at a breakfast forum during Beef 2018 in Rockhampton on May 9. Click here for details

 



Reader's Comments


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  • Michael J. Vail April 21, 2018

    Thank you to Messers Holmes and McLean, as I have been saying the above insights about property price and value disparity, for years.

    If any reader is interested, you may read my many papers on the issues and the topic of how to value a going concern pastoral property on a Walk-In, Walk-Out basis, with ‘all things necessary’, as published on the Beef Central website; including my Masters Thesis …

    I am currently completing my PhD on the topic of price, value, and premium for the Queensland pastoral property market as we speak; and expect to complete said research and conclusions within the year.

    Investors can of course pay whatever premium above value which they choose; if it is their capital at risk: or to the extent to which a Funder will bankroll the buyers appetite for risk … but the proof is in what earnings the individual property can make looking through the prism of a 10-year cycle as to what is sustainable once all risk-factors are evidenced in the outcomes … cash-flow has to be available to support debt levels, and it is the EBIAT (or Operating Profit After-Tax) that is the amount available to pay Debt and/or Dividends. All else is a fantasy … a Speculation … and therefore not an Investment. Thank you.

    Cheers Michael. Let’s have a look at your PhD thesis once complete. Maybe there’s a story in it. Editor

  • Michael J. Vail April 21, 2018

    Furthermore, for pastoral livestock grazing, all you really need to ask for are the past 10-years Livestock Schedules; as lodged in the Vendor’s tax returns for the operating entity. The ‘truth’ is all there …

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