Whether it’s a piece of property or a tractor, once you’ve decided to make an investment in your business, the question then turns to the source of capital to finance that investment. Do you invest your cash? If so, how much?
Just as important is what impact this could have on your working capital position. Preserving cash to manage market volatility in the current agriculture economic conditions may be the wisest choice.
But if you’ve chosen to finance your investment, the next decision is whether to buy or lease. There was a time when this decision was fairly clear, based on what you were acquiring, but that’s changed. The speed of technological advancement, along with economic realities, have made the decision of whether to buy or lease less clear.
Should this land be your land?
The conventional wisdom says to always buy real estate. After all, if you want to amass wealth in agriculture, you buy land and hold it for a long time. However, in some cases, a long-term lease may be as effective as owning the property.
In the world of agriculture, where earns and turns are both important, real estate is a slow-turning asset – it’s usually a 20- to 30-year mortgage. And in certain areas, land values are still above the cash flow it generates to support it.
So if you’re cash-poor and the land is overvalued compared to cash flow, a purchase may not make sense because you’ll be tying up capital for a long period on a slow-turning asset.
Machinery and equipment
The buy-versus-lease argument is just as complex for equipment. One thing to point out is the distinction between a capital lease and an operating lease. A capital lease is a long-term lease – essentially treated as a loan – with a very small buyout at the end of the term.
A capital-leased item is reflected on your balance sheet as an asset, while the lease itself should be shown as a liability, just like a loan.
An operating lease, in which the residual value is closer to market value, serves a different purpose – it’s typically used for assets you want to turn fairly quickly. Operating leases are reflected on your balance sheet as a payment requirement and on your income statement as a rental expense.
Capital and operating leases also have different tax implications you should discuss with your accountant prior to entering into an agreement.
Many dairy operators opt for loans or capital leases for equipment that’s used every day and isn’t likely to become technologically obsolete in a few years, like a TMR mixer. But leasing can also be a matter of managing residual value risk. With real estate, the risk is fairly low because the value tends to rise over time. But a TMR mixer’s value often drops rapidly and may have a residual value near zero after five years.
And because this piece of equipment tends to need costly repairs after three years, you may be better off with a three-year operating lease, enabling you to come out ahead by avoiding repair bills – essentially trading lease payments for reliability and lower repair bills.
Also, the pace of technological change alters the calculations for whether to purchase or lease. Take robotic milking systems. Based on initial assumptions about the residual risk and return on investment, a seven-year lease with a 20 percent residual value made sense.
That timeframe, however, turned out to be too aggressive. Now, after the industry has gained more insight about the return on investment and residual values, a typical robot loan term is 10 years – which still may be too steep for many farms based on their cash flow.
Beyond conventional wisdom
In the end, all capital deployment decisions should take both short- and long-term impacts into account. You can consult a basic buy-versus-lease calculator to help guide your decision, but keep in mind there are other variables specific to your business that could make conventional wisdom irrelevant. When you run through all the considerations, you may be surprised which path is the best way to go based on your particular situation.
I recently discussed this topic with Haley Fehlhaber, agriculture portfolio manager at BMO Harris Bank. She was quick to point out, from a cash flow perspective, debt is debt, whether it’s in the form of a lease or a loan. That’s why capital deployment comes down to two basic questions:
- What will it do to my cost of production?
- What will it do to my balance sheet and working capital position?
If you don’t take these factors into consideration, you potentially risk losing flexibility in terms of access to capital. And as Barry Doerfer, BMO Harris Bank assistant vice president, agriculture banking, wrote in these pages last year, knowing your cost of production is crucial for making any strategic decision.
Bottom line: You may not always want to follow conventional wisdom. The key is to be flexible based on the needs of your operation.
Brad Guse is BMO Harris Bank’s senior vice president for agricultural banking. Member FDIC. For more agriculture industry insights, email BMO Harris Bank.
- Senior Vice President of Agricultural Banking
- BMO Harris Bank
- Email Brad Guse