Property

Property value lies in the eye of the beholder

Michael J Vail, Tre Ponte Corporate, 24/01/2014

 

Is a beast area an accurate way to establish the value of a rural property? No argues Brisbane based rural financial consultant Michael Vail.

Is a beast area an accurate way to establish the value of a rural property? No argues Brisbane based rural financial consultant Michael Vail.

I was having a long conversation with an old friend on the future direction of rural land prices, whilst in Western Queensland a couple of weeks ago.

He posed me this question: “You talk so confidently about how to approach an investment valuation of rural grazing land, but why is it so hard for me to understand that there is a big difference between this derived value, and the actual prices being paid for the same parcel of land?”

This fellow is a smart and pragmatic person, whom I have known for over 30 years, and it really opened-up for me the struggle some have conceptually, when approaching the value of their own parcel of land, let alone a new one which they do not know.

What is a grazing property worth? A simple question, is it not?

The usual recourse towards an answer is the rule-of-thumb, industry method called the Beast Area Valuation, as touted by most stock and station agents and bankers; but this is not an accurate method, in my opinion, and by a long shot; and especially how it relates to comparable sales.

The purpose of this article is a written attempt to answer this question (as I am sure there are others who might be thinking the same), and explain how rural land value is defined and calculated.

Price on the day, of course, seals the deal, but what is important, if a premium is to be paid, is that the decision to pay it is an informed one, and knowing the risks; rather than an emotional trip.

Value & Price

Value, as a concept, is both a fragile and a nebulous thing; hard to define, brittle and hard to hold. Whereas price, once crystalised at a point in time, is forever.

Value and price are not the same, albeit they may briefly agree, as the pendulum of economics and the current financial environment continue their eternal dance around each other; as price is what you pay, and value is what you get.

The basic investment idea is to buy low (below sustainable long-term value), and then sell high (above long-term sustainable value) taking a profit as you go; with the market as the great leveller.

In the bush, there is also the variable seasons and the tyranny of distance to contend with, in the planning to be sustainable.

Long-term value is like the slope of the 10-year trend-line, looking through the market; with price seemingly oscillating around it, as the markets wax and wane, like the economic tides of opportunity.

Price paid, on the other hand, is a fact; and a factor of the push and pull of supply and demand for a Product. Which is why the old saying goes, “You make your money when you buy, not when you sell!”

It is easy to buy ‘things’/property; you just do. However, if you pay more than Intrinsic Value (which is the ‘Full (or True) Price’), then you may find the number of suitable investors ready to buy from you at your expected price, quite diminished in number.

The intelligent investors have an investment horizon, and exit strategy, planned before they buy; and usually roughly know the price they may expect, and the likely buyer.

Value of land, like beauty, is in the eye of the beholder; it may be dispassionate (and should be), but is usually a raw and passionate emotion.

Owning land, especially farming, grazing, and pastoral land is like that; like the love felt for a woman (or a man). It is a wonderful, and prideful thing; as you breathe the scent into your lungs of a morning, and cast your gaze across your land.

Unfortunately, emotion can get in the way, impeding sensible decision-making; both on the buy-side, and the sell-side of a transaction.

One need look no further than the price volatility observed on the boards of the Australian Stock Exchange (ASX), as the price of the market as a whole, or an individual stock goes up and down each day ofthe week, seemingly blowing with the breeze; or guided by Adam Smith’s ‘invisible hand’.

Liquidity

Liquidity is defined as the volume and speed of transactions in a market, leading to the exchange of goods and services for money.

There is no more liquid a market-place than the ASX, where the shares of our country’s listed companys’ assets are valued by the milli-second, between the hours of 10:00AM and 4:00pm each weekday, and you may have your money, if a seller, in T+3 (Transaction date, plus 3-days).

The individual target company may be the same in all aspects, as it was yesterday, probably selling the same amount of ‘widgets’ as it will today, and probably tomorrow, and to the same clientele. So, what is different? What has changed; to cause this continual re-rating of the company’s value (as represented by the market capitalisation of the issued shares at the bid/ask spread. Usually it is simply the ‘story’ of the day, or other ‘tit-bits’ of information, which cause this behavioural outcome, as buyers and sellers assess their risk and return.

Where there is a highly liquid market, as represented above, there is no need for a professional and/or Registered Valuer to perform a valuation process and report; for the market has spoken in real time.

However, in thinly traded markets like rural property, the market is not liquid, and so correct value, and likely price to pay, are uncertain.

In the large rural property space, some property may not change hands for 50-years or more; though since unsustainable prices started being paid around 20-odd years ago, they are certainly turning-over more often, in recent times. real value, in an economic sense, is a ‘look-through’ the ‘story’ and ‘noise’ and take a long-term (between 10 & 30 years) view of the prospects for the company’s produce, and also the medium-term trends of a normal business cycle; which takes from 7-years to 10-years tomove through the cycle of ‘boom’ to ‘bust’, and back to ‘boom’.

Unmanaged growth, or growth at any price, will cause businesses to run out of cash; and that is why a great many business start-ups do not survive 3-years of trading, and roughly one-third last past 5-years.

The value of any business will grow at different rates of growth momentum, during different stages of its life-cycle. When a ‘child’, the growth is fast, furious, and hard to keep pace with; when an ‘adolescent’, the growth rate comes back from the frantic pace of >20pc pa, to around 8pc to 10pc pa and manageable; then arriving at an ‘adult’ stage after around 8-to-10-years, where growth rate settles back to around the long-term average of Gross Domestic Product (GDP), at around 3pc to 5pc pa.

Then as the business approaches middle-age and maturity (around 10-to-15-years in these technologically advanced times), unless new growth products may be added to the repertoire via innovation, or the old ones evolve , the company will start to die.

Growth may only then come from Merger & Acquisition activity (where growth is found through asset purchases, sometimes whole businesses, and the apparent synergies provided therefrom); and the company itself, rather than the product, evolves.

Rural Property Operations & Value

Of course, the business of agriculture and farming (agri-business) is a very mature industry, with inception going back to the dawn of time.

Rural property investment is not the place for a quick profit (though it sometimes rarely happens), but rather, the home of patient capital, expecting no more than long-term average return on investment (ROI) of around 5pc, on EBIT profitability of around 20pc to 30pc; of course, depending on price paid for the parcel of land, and the current operational and economic environment.

In the absence of a liquid market, the investment value of a rural enterprise is usually derived from a Corporate Finance process called Fundamental Analysis; where the business itself is broken-down, measured, analysed, and the metrics understood (looking back to learn, and forward to grow).

This process then evolves into a Feasibility Study (if a start-up, a new innovation/product/process, or on the buy-side); which may, (once the viability is proven on-paper, with a suitable margin-of-safety) then proceed to a full Business Planning process to ensure the owners (or prospective owners) understand the business model, and the inherent risks in operations, the financial structure adopted, and the business model itself.

The Business Plan (BP), whilst a ‘living’ document which grows with the business, may also be used as an instrument to apply for a loan to fund the debt capital being used; and may in turn reduce the risk premiuminterest rate on the loan, if the financier can see mitigation of their risk to capital being repaid.

Anyone lending into a risky market will price appropriately the risk they understand; however if the Banker does not understand the business model chosen or the risks associated with it, will either refuse the loan, else load it up with an above normal risk premium, if their security is well covered, knowing they will win regardless. There has been too much of this type of lending into rural markets in the past, in my opinion, including a pricing premium for expected capital gain.

This attitude to risk is untenable; especially considering the future implementation of BASEL III regulatory rules around banking equity risk and liquidity.

The BP places the actual or intended business firmly into a place within the industry or sector, the regional economy, the national setting, and finally the international context; using a bottom-up, supply-side, approach, and how that fits into the world demand for that product.

So you may observe, rural business analysis is not simply a matter (as some would have you believe) of sitting down with a blank piece of paper, divining the hypothetical production and sales budgets, cash-flows, pro-forma Profit & Loss Statements, and Balance Sheets of the proposed enterprise; and all by assumption and guess-work.

This, all because the Vendor will not allow you, the intending Purchaser to sign a Confidentiality Agreement (normal business practice elsewhere), so you may receive, analyse and understand the past 10- years of rainfall, production and financial data, as a central component of the due-diligence process; and necessary to reduce your risk going into the investment.

Private business has private knowledge; which must be gleaned through asking the correct questions.

If one is to invest several million dollars, and to receive a suitable return on that investment, one should not have to guess too much.

An appropriate response may be to take the banker’s attitude to such a refusal: “If I do not understand the risks and returns (and maybe the

borrower does not either), I’ll just apply a higher risk weighting to the decision”. Which may translate into a higher applied discount rate (eg.

up from around 20pc, to 40pc already applied), and therefore a lower calculated potential for value-transfer, and price-gain to the Vendor; regardless of what the figures may have revealed.

Transparency gives comfort and confidence, reduces apparent risk, and possibly a higher price, if the value stacks-up.

Risk

Recognising Risk factors, and being able to measure their possible impact upon the business, is a way of introducing some certainty to the potential outcomes for the enterprise into the future.

Risk and uncertainty are not the same thing.

A Risk factor is what might occur, and adversely affect potential outcomes. We then allay where we may, we push it away from us to others who understand the risk (and can adopt and price it appropriately), we insure, or get others to indemnify where possible, and we only take-on the risks we understand, and can price appropriately.

Then to increase certainty of the planned outcome occurring, we apply a proportion (or risk weighting) to the expected outcome, to reduce expectations of a higher return.

Of course, in a rural primary production setting, as has always been the case, no-one has control of the weather, or the market-prices achievable at auction; which is why management strategy is all-important, to manage the available grass and water, and to seek long-term supply contracts for price certainty where possible.

Every business should have a written risk management strategy (RMS) that describes each type of risk faced, place a risk weighting on each, and be able to show/demonstrate what actions are being taken to mitigate each one, and strategy to be followed, if one should occur.

This exercise may singularly be, the most important management exercise completed each year; as the process really makes you think about risk.

Risk is an interesting topic, and having spent over 40-years closely associated with pastoral production, I can say with some certainty/authority that if you ask most rural owners/managers today (and the average age is over 65-years of age, and left-skewed to the high side) if they consider themselves conservative in their attitudes and actions, nearly to a man or woman they would say “Yes!”

However, when the level of operational, business, and financial risk they face is measured and ranked, it lines-up quite neatly with the levels Venture Capitalists face at the extreme end of the investment spectrum; up around 15pc to 45pc pa; and these are risk premiums which should be reflected in the discount rates applied to the decision-making process.

As a comparison, VC’s say, “I like the story. I’ll invest, but I’m in and out in three to five years; and with a 33.33% pa compound return on Capital invested (as a minimum), to compensate me for the risk taken.” That is their yard-stick for investment and risk management. Graziers and pastoralists face the same level of risk every day in what they do for a living; sometimes throwing the dice every year for a 5% pa long-term average Return-on-Investment, at best.

Only around 20pc of farms in Australia are profitable to an acceptable rate of return. Why is this so? What happens to the rest; the other 80pc?

I believe a focus on risk management is the key to success, For example: After nearly 10-years of drought, it rained a year or so ago.

During the drought, how many capped, re-lined or put-down new bores, de-silted tanks, Turkey-nests, and dams, and/or made them deeper to

increase storage, and concurrently reduce the risk of loss through evaporation? This is water risk mitigation.

Conversely, after the rain, how many harvested the abundance of grass to place green inside a silage pit; which when covered properly to keep out the air, can retain protein and roughage for upwards of 40-years.

This is feed risk mitigation.

Water and grass. Simple things, but necessary inputs for survival. If you have plenty of water, you may always place an order for feed. If you have enough feed to carry your breeders through, the factory is up and running with something to sell in 12-months to 18-months time; else, if a forced seller, you sell your Capital (the cows) at greatly reduced prices, and then have to replace them at re-stocker’s rates at the top of the market when the rain eventually falls. ‘An ounce of prevention, is worth more than a pound of cure’, or so the old saying goes.

Many have let over-grown pasture grow old and rank, thereby providing a high risk of bush-fire during the storm season. This may be considered a wasted opportunity; or just a waste. Good rainfall will make a good manager look better, always; but a badmanager will always be a bad manager, despite the quantum of rain in the gauge.

Adapt or die … This is the message. It is not enough to merely survive, whilst eking out a living; it is no way for anyone to live! There is no margin-of-safety if the worst happens, and hope is not a strategy.

Going forward, the accumulation of harsh seasons, the dismal market- prices, a lack of equity in the business, and the Bank’s higher cost-of- capital, may be factors that make the decisions obvious for many on the land today in the drought-stricken areas of Q’ld, NSW and the NT, as many have passed the point of no return, and will need to be sold-up (as disheartening as this prospect is, at any time); for it is a very emotional experience for all concerned. However, it also means new beginnings for the old owners (as they start again somewhere else), and the new, who are just beginning.

Scale of operations is very important, and some blocks are far too small for a viable and sustainable operation; and should probably be amalgamated with other leases (either by M&A, or by Government decree via legislation). If the land lacks scale, yet it is all you can afford; then look again at the numbers; else you may buy a money-pit, where you may never pick-up momentum or get to the critical mass in numbers required to ever reach a reasonable ROI. Your capital is then ‘lost’.

When the rural sector is happily bubbling along, a lot of top-line revenue/money is made, and a lot of this money is spent in the country towns, and this holds them sustainable.

In my opinion, a ‘living area’ for a sustainable return, and one which will allow you to invest off-farm and reduce your risk, is the amount of land required to run # 2,200-breeding beef cows, wherever you may be situated.

Conclusion

There is a lot of talk about the Asian Century and meat-sales growth into the various regions (including China and Viet-Nam), as diets change to higher levels of protein.

However, in my opinion, the minimum farm-gate price must increase to around $2.50 per Kilo (live-weight). This translates to a sale-price of around $1,500 per Head for a 600kg animal, as a farm-gate price; and $4.81/kg (dressed-weight) for the buyer at a yield of 52pc (assuming there is NIL value to the abattoir for the offal, which we know is untrue.

These prices will attract quality stock North to these Asian markets, and reduce the numbers going South for domestic consumption, thereby increasing demand (and price) for a lower supply in Australia; everyone wins.

It is only then that prices being currently asked for quality rural grazing and pastoral stations, will be considered sustainable.

This is because farmers, graziers, and pastoralists make a living ‘off theland’, rather than ‘on the land’; or is that vice versa. The land for a farmer, grazier or pastoralist is likened to a factory whose resources (grass and run-off water) provide the nourishment to value-add to the raw product. There is a symbiotic relationship, where each needs the other.

Land therefore is like equity in a company, and is considered a ‘residual’; whose value is calculated after all other measurable factors of the apportionments are deducted. You should note: This residual ‘value’ may be a negative amount, if the

land is marginal at best.

For example:-

An 82,000 acre property, being sold WIWO, as a Going Concern, with ‘all things necessary’, where the Stocking Rate is 1: 25 acres.

Valuation

  • Sustainable EBIT @ 36% $0.63954-M.
  • Price Earnings Multiple (PER) 8.2-Times
  • Implied Intrinsic Value $5.244-M. (WIWO)
  • Implied Value per Acre $63.95/Acre (WIWO)

Apportionments

  • Stock-on-Hand $2.73-M. (#3,212 @ $850ea. Avg.)
  • Plant & Equipment $0.40-M. (DRC)
  • Improvements $0.28-M. (DRC)
  • Land (a residual) $1.83-M.
  • Total $5.24-M.
  • Land & Improvements $25.78/Acre (Bare basis).
  • What happens in reality though, is that instead of the

Present Value of Stock-on-Hand being used at $850, the Book Value (for Taxation purposes) is applied.

That value may be $450/Head, and the $400/Head difference is applied to the Land apportionment to increase the value of the land.

Land & Improvements now becomes worth an extra $1.2848-M.; and the Bare value becomes $41.45/Acre ($3.3988-M. divided by 82,000-Acres), an increase, as if by magic, of $15.67 per Acre.

This is of course, legitimate for tax planning purposes, as the land may have been owned on or before 19th September 1985, when Capital gains Tax was introduced; and so they are increasing the value to the land portion, as there is NIL tax to pay on that portion.

  • This may give prospective buyers the wrong clue as to how to price the parcel, and affect the decision-making  process accordingly, as this ‘new’ value is unreal.
  • However, we are valuing the target property for investment purposes, before purchase; so why would the Vendor’s tax arrangements be important to us in making the decision to buy? The answer is; it is not important at all.

When buying a business operation, or setting one up from scratch, three questions must be answered:-

1. What is the ‘big idea’; the fully scoped-out, analysis report? Does the idea and business model make sense economically and from an investment stand-point; operationally and financially?

2. As you will start how you mean to finish, for asset protection, succession planning, and estate planning purposes, what is the best legal structure to use, to house this asset?

3. How will I fund the asset purchase? Will it be Equity Capital, or a mixture of Equity and Debt Capital? How much will I need to borrow, and from whom? How will I structure the Debt Capital?

What will Debt Capital cost today, and in 5-years time?

Once these above questions have been satisfactorily answered by your advisors (and then understood by yourself), and the risk and return metrics understood by you implicitly, then you may make a decision to invest; or not.

Value lies in the eye of the beholder; do not pay too much for this value; take a long-term view, buy for the right reasons, and always build-in a margin-of-safety into decision-making. Remembering it is also a decision to do nothing, if the deal does not stack-up for you.

Price is what you pay; and Value is what you get.

Happy to be proved wrong. Also happy to take questions.

 

 

Michael J. Vail, SA Fin, FCPA, CTA is principal of TRE PONTE corporate, Business Advisors & Accountants, Brisbane.Michael J Vail is a director of Tre Ponte Corporate, Level 5, “Toowong Tower”, 9 Sherwood Road, Toowoong,  QLD  4066. He can be contacted at (07) 3376 7111 or by email michael@treponte.com.au

PREVIOUS ARTICLES BY MICHAEL VAIL:

What value is a fair market price to pay for rural land?

What is a living area these days?

Are we valuing rural land correctly?

Rural Land: Rent, buy, or both?

 

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