Mike Wilson made some good points about the potential end of the ag boom cycle in a recent column. Here's something to watch along with that: With the overall U.S. economy strengthening, the Fed may now have room to raise interest rates. So what will that mean for farmers?
You'd be affected the most on financing of fixed assets – land, buildings, bins, machinery. Even if you have a fixed rate loan, banks will rarely lock in rates for more than five years.
The bottom line is that the rates you have right now are not necessarily locked in for a long period of time. Let's say you have an interest rate of 3.5% on a $2 million land note. You expect interest rates to stay near that area.
Fast forward five years – what if they've doubled to 7%? Your balance sheet could take a hit – unless you already ran the numbers to check whether your cash flow could handle an increase like that.
Land prices are at historic highs and interest rates are at historic lows. If interest rates increase and land values don't decrease, you could be facing higher land payments than you originally planned for. Couple that with lower revenue if grain prices decline and suddenly you could be looking at very thin to negative profit margins.
You can do a few things now to prepare. The first thing is to know and understand the impact it would have on your operation.
Let's say you have a term loan at 3.5% and you know your rate will reset in five years. Figure out what impact an increase will have – and prepare for it. If it goes up 3%, for example, what kind of revenue does your operation need to make to stay profitable?
Once you see the numbers, decide whether you're still comfortable with that scenario. Is the income you'll need still realistic? No one knows what the price of corn will look like in five years. But if you'll need to sell all of your corn at $8 to make your numbers work, it's not a good situation.
Manage your debt load and your debt coverage levels. That means you know your costs and the revenue you need to cover those. The term debt coverage benchmark for our clients is 1.5 times more in revenue than the cost of the principal portion of your debt payment.
Understand what levels of debt you can and can't afford to take on – and how interest rates will affect that. Protect your operation from any surprises in the future – run the numbers now.