Rising Interest Rates Squeeze Profits

Experts Say Rising Interest Rates Could Pressure Farmers' Balance Sheets

In 2015, more than 40% of farm loans used to finance non-real estate purchases were originated with an interest rate of less than 4%. At that time, only about 10% of these farm loans carried an interest rate of more than 6%. In the first quarter of 2018, only 21% of non-real estate loans, by volume, were originated with an interest rate less than 4%. About 22% of loans had an interest rate greater than 6%. (Chart courtesy of Kansas City Federal Reserve)

MOUNT JULIET, Tenn. (DTN) -- The Federal Reserve's cheap-money policies coincided with a highly profitable time in U.S. agriculture, and many farmers took advantage of rock-bottom interest rates to invest in land.

The picture is much different today. With farm incomes roughly half of what they were just five years ago, more farmers are turning to operating loans. Since 2015, interest rates on most types of farm loans at commercial banks have increased between 1 and 1.5 percentage points. A report from the Kansas City Federal Reserve finds more than half of non-real estate farm loans issued in the first quarter of this year carry an interest rate above 5%. (To view the full report, visit https://www.kansascityfed.org/….)

And those rates are likely to keep marching higher. Markets expect the Federal Reserve to increase interest rates by 25 basis points, or 0.25%, three times in 2018 -- the increase it made in March, along with two more in June and September.

Matt Monteiro, Farm Credit Mid-America vice president of finance and treasurer, said there's a 34% likelihood the committee could raise rates for a fourth time in December.

"They're monitoring for 2% inflation, and we're right around that level," Monteiro said. "The question is, how quick will the Fed react in order to keep inflation from overshooting that 2%? And that's what that whole debate about the fourth increase, and future increases going out beyond 2018, are about."

CoBank senior economist Tanner Ehmke said each change may seem small, but it adds up. If a farmer has a small $100,000 operating line of credit, for example, a 0.25% increase in interest rates raises the borrowing cost by $250. If the Fed follows through with its plan for six total increases between 2018 and 2019, that adds up to an extra $1,500.

"When you've gotten used to a very cheap money environment, these incremental increases in interest rates can start to tighten people's belts," Ehmke said. "Also keep in mind this is in a rising cost environment. The price of everything that's important to agriculture is rising. So now, this is one more brick on the load that farmers have to carry."

University of Illinois agriculture economist Gary Schnitkey said interest costs won't deal a big blow to cash flow because they're still smaller than some other costs. "The larger question is: Will these rate increases have an impact on land prices?"

Historically, higher interest rates put downward pressure on farmland values, and the Kansas City Federal Reserve says that could have "a more significant effect on farm finances than interest rates directly," Schnitkey said.

Lenders consider land values when determining a borrower's risk, so if land values begin to slip, it lowers the value of most farmers' primary asset.

"That's going to weaken your balance sheet and increase your risk as a borrower. So then your borrowing costs go up even higher," Ehmke said. The Federal Reserve is aware its cheap-money policies could create asset bubbles, and it's taking a measured and transparent path forward with its rate increases to avoid any dramatic market disruptions.

Ehmke said the effects of higher short-term interest rates, from increased borrowing costs to lower land values, bear watching.

"In this environment where a lot of farmers are barely making it, these are real costs that have to be taken seriously. Productivity has kept a lot of farmers in the game over the past two years. And when we start to see yield come back to trend line or lower as your costs are going up, it's just that much of a tighter squeeze and it will, unfortunately, make things a lot more difficult for some people. And for those that are on the margins, you will see more people exit the industry."

Farmers that are more dependent on credit, like smaller farms and younger operators, are the most vulnerable along with those struggling with drought and lower productivity, Ehmke said. Farmers that chased the land market or high cash rents and burned through their cash reserves are also at risk.

There are few things farmers can do to limit their exposure to higher rates.

Monteiro said if farmers have longer-term loans with variable or adjustable rates, they should consider locking in a fixed rate through refinancing or, if your loan is through a farm credit bank, a conversion.

"To the extent that you can increase certainty by locking in interest rates, that at least gives the ability to plan and at least know what your breakeven will be," he said. He also suggests looking at all options offered by your bank. Farm credit banks sometimes offer a higher interest rate on cash-management accounts connected to operating lines of credit. That can help offset a variety of rising costs.

Schnitkey said managing your cash flow and working capital becomes even more important as rates rise. "Because once you're out of working capital, the only option if you have an adverse event is to borrow, and then rising interest rates will cause that borrowing cost to go up."

Katie Dehlinger can be reached at Katie.dehlinger@dtn.com

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