What and Why?
First, do you want to own a ranch or do you just want to be in the cattle business? Did you know that you can enter the cattle business without owning either land or cattle?
You are already thinking, “This guy has lost his mind!” But seriously, you can. You can lease land and take in pasture cattle–i.e. you can pasture someone else’s cattle on leased land for a monthly per head fee. Once you get a reputation for paying your bills and taking good care of other peoples land, ranch lease opportunities will come to you. You won’t have to look for them.
This is an excellent way for young prospective ranchers to get into the business without having to have a lot of capital. Greg Judy explains the details in his No Risk Ranching: Custom Grazing on Leased Land which is available from our e-Store. Just follow the link.
But let’s say you answered that you want to buy a ranch. Why?
Well, it might be for one (or any combination) of the so many very good reasons for owning such a property. In addition to the benefit of income from the livestock operation, these include:
• Tax Shelter (Income and Estate) – especially if you have substantial income from other sources.
• Inflation hedge – historically, agricultural land has been an excellent hedge against inflation. Considering the current fiscal state of the economy, there is every reason to believe that inflation will increase dramatically over the next few years and no reason to believe it won’t.
• Capital gains potential – an increase in value due to increased productivity and/or inflation may be taxed at a lower capital gains rate (subject to the whelm of the Congress Critters, of course).
• Recreation and Wildlife - many of today’s ranchers are tapping into these two sources of revenue to supplement the livestock operation.
• Life style and maintenance of the rural, western heritage – these are becoming more and more important as we see them both dwindle.
• Conservation and environmental concerns – no government bureaucrat can, or will, husband the land as well as its owner
• Aesthetics and scenic beauty – the things that make life worth living
• Prestige in the community – prominent ranchers are often looked to as community leaders
• As many others as there are individual and potential owners
No matter your reason, just be sure you are ready and able to make the necessary commitment over the long haul or you will fail.
Making Money Ranching
I once introduced a speech at a cattle growers convention with, “You can make money ranching.” I heard several whisper, “Get a rope!” But fortunately, I was quick enough with an explanation for such a seemingly outlandish statement.
Market Value vs. Productive Value: It is virtually impossible to buy a ranch on the Continental United States, ranch it, and amortize the debt. Why?
Because the market value (as represented by the price at which they are actually bought and sold) usually exceeds (by double) the value determined by discounting the potential income stream (or value for production purposes).
There are several reasons for this. One is that ranches are good tax shelters. Wealthy (high income tax bracket) buyers can pay more than the productive value of the ranch and still enjoy a decent return on investment after tax savings are considered. Hence the tendency is for ranch prices to be artificially bid up.
So can you make money ranching? Yes, there are two ways: One is by accounting magic and the other is to buy the land right.
Enterprise Accounting: Anyone who buys a ranch at a current market value that is over and above its productive value, needs to be aware and consider himself engaged in two different enterprises. One is ranching and the other is land speculation.
So, charge the cattle for an appropriate (the going) pasture fee and write the rest off to land speculation. This method of accounting will tell you what kind of rancher you are and also what kind of land speculator you are. It is this continuous increase in land value that makes the whole deal feasible. But always remember, if you buy a ranch strictly for real estate speculation, it will require you to find a bigger fool than yourself when it comes time to sell it. With all of that said…
What to Look For: First, you must be aware that a ranch in the arid Southwest has to be very large to be economically viable. It is called economy of scale. A thousand head (AUs) is probably a good rule of thumb minimum for good economy of scale in the arid Southwest. It can be done with less and by those interested in values other than return on investment. But just be aware that it is much harder to earn a competitive return on investment with less.
Now remember, we are buying this ranch “right” which means for ranching. Therefore, it must not be within commuting distance of a major city nor should it have any kind of tourist attraction like spectacular scenery. If you are a land speculator, you may be willing to pay extra for those “amenities.” But in either case, the ranch most not be on any environmentalist group’s hit list.
The ranch must have adequate and reliable stock water. Do not forget to allow for the increase (doubling initially and maybe even tripling or quadrupling) you will get from our method of intensive management.
It is also very desirable for the ranch to have some sort of unusual advantage–for example, unlimited irrigation water on a desert ranch.
Buy abused ranches. These would be ranches that the government boys at the NRCS would classify as being in “poor” range condition class. The sows ears have more potential for improvement over time than do the silk purses. Improvement in productivity means improvement in value.
Buying it “right:” Never buy a ranch by the acre. Buy it by the head (AUs) converted to cash flow. Never buy a ranch for more than 10 times cash flow (what is left after all expenses are paid except land payments). Caveat: Ranch cash flow is highly volatile. You must have the financial resources to ride out a bad year.
These kinds of ranches are very hard to find because most ranches sell for 20 times cash flow. But, very hard does not mean impossible. Finding a ranch that can be bought this cheaply requires two things: 1) a motivated seller and 2) a lack of motivated buyers.
So the logical first step would be to find out why there are no motivated buyers. You can generally do this by asking knowledgeable local people why they have not bought the ranch.
Generally, the best buys come from three places: 1) bank foreclosures; 2) rich people who leaped before they looked; and 3) people with legal and/or family problems–divorces, estate settlements, etc. Sometimes they will almost pay you to take the albatross from around their neck.
Subsequent management: Profit is the result of management. A critical lack of trained ranch managers is the “Achilles heel” of every absentee ranch owner.
As I mentioned above, ranches should be divided into a land company and a cattle company (and/or farming, hunting, or whatever other appropriately named company(s). These other divisions rent their land from the land company at market rates. (Remember? “Charge the cattle with an appropriate pasture fee and write the rest off to land speculation”).
Managers are responsible for making their land rent payment and a profit. Profit sharing and bonuses are based on “after rent” profit.
Financing: An Example:
Buy the Ranch: Most western ranches are owner financed because the seller believes you will go broke and he will be able to foreclose and sell the ranch again.
If you are going to insist on operating on leverage:
Don’t put more than 20% of your own capital into the ranch. Here is what it would look like (the figures are not meant to be “real” but they are meant to be “round” for simplicity and understanding of the principle. Plug in your own figures and see how it comes out):
Total Cash flow $100,000.
Ten times that = $1,000,000
Equity at 20% = $200,000
Amount of Loan at 80% = $800,000
Interest on the loan at 7% = $56,000 which leaves a
Free Cash flow of $44,000 (100,000 – 56,000) which provides a
Return on Equity of 22% (44,000 ÷ 200,000)
Your goal should be to increase cash flow by at least 50% over five years. (Note: This is a very conservative estimate. It will probably be more. In fact, 300% is not unheard
of.) The primary focus should be on increasing the stocking rate by subdividing pastures and applying better grazing management to increase the carrying capacity of the land. (This can be done by knowledgeable herders but they must be well schooled in the principles of intensive grazing.)
Returning to the above example: If total cash flow increases to $150,000 (from $100,000) in 5 years, we now have $94,000 (150,000-56,000) in annual free cash flow. This amounts to a 47% annual return on investment (94,000 ÷ 200,000).
Sell the Ranch:
Now let’s sell the ranch to the typical sucker…err buyer that is willing to pay 20 times cash flow:
|Gross Sales Price ($150,000 X 20)||
|Less: Balance on the Note||
|Capital Gains Tax||
|Initial Equity Investment||
This represents a total 625% return on investment (1,250,000 ÷ 200,000) or an average annual yield over the 5 year period of 125% per year.
Refinance the Ranch: This is an option for those who buy a ranch that they wish to own for 100 years.
Having the ranch appraised and refinanced on the basis of improved cash flow allows one to recapture his equity investment without selling the ranch.
There is no problem in getting banks to appraise and finance a ranch at 10 times free cash flow when the norm is 20 times. Here is how it would work:
Free Cash Flow $150,000
New appraisal at 10 times – $1,500,000
Borrow 80% ($1,200,000)
Repay the original Note of $800,000
Take $400,000 cash out ($1,200,000 – $800,000)
Interest @ 7% on $1,200,000 = $84,000
Free Cash Flow $66,000 ($150,000 – $84,000)
Return on equity is “infinite” because your investment is negative $400,000
Other Management Considerations:
- Never borrow money against cows—both feed and cattle prices are just too volatile.
- It is permissible to borrow money against stocker cattle because you can lock in a selling price by hedging with futures or advanced contracting.
- The best option is to run other people’s cattle. This is best because it gives you total flexibility in matching stocking rates with available forage and total risk insurance against falling prices. In fact, generally speaking when cattle prices tank, grass prices increase due to cattle owners being reluctant to sell on a depressed market. My personal philosophy has always been, the only owned cow that should be near the place is the one the old lady milks in the morning.
- Over capitalization has a way of creeping onto a ranch one pick-up at a time. The first option with any machinery is to hire it done. The next (and much less desirable) option is to buy used equipment. As my old mentor, Stan Parsons used to say, the largest piece of machinery on the ranch should be a wheel barrow and then only if you are an extreme machine nut. All you need is a Toyota pick-up truck and three hammers. That way, if times get hard, you can sell a hammer.
- A high level of labor productivity is critical in order to maximize returns. The rule of thumb is one employee per 1000 cows. Subdividing pastures is the most efficient way to improve labor productivity. With enough subdivisions one man can easily handle more than 1,000 cattle. All he has to do is open the gate to a fresh subdivision (paddock), sound a signal that the cattle have been conditioned to, and get on the fence because they will trample him while moving themselves. With today’s technology in (portable) electric fencing , you can attain an adequate number of pasture subdivisions for a surprisingly low cost. Generally, and especially at first, fencing is the best investment anyone can make on any ranch.
Summary of what it takes to buy a ranch and make it profitable:
- A committed and competent management team
- A purchase price of no more than 10 times net cash flow (before land costs)
- A ranch that has a large potential for improvement in carrying capacity
- A ranch that can be a least-cost producer of its primary commodity (usually cattle)
- The willingness to own the ranch forever
Obviously, getting all these ducks lined up is not an easy task. But, by the same token, it is not impossible–especially for you young cowboys and cowgirls with bountiful energy. Set your strategic goal as we outlined here, duck your head and go for it. Good luck and God bless.