Editor’s Note: This report is part of a series that explores the shifting economic landscape of the specialty crop industry.
Risk is inherent in farming, but risk no longer extends only to farming operations; it also extends to ag credit and lending.
Traditional bank lenders face significant constraints in managing risk, says Jon DeVaney, president of the Washington State Tree Fruit Association. Some of those constraints, he says, stem from bank regulations while others came after the financial crisis in the 2000s.
“If you have an industry like ag that is prone to downturns in farm returns and weather volatility and problems, there’s a lot of risk out there,” DeVaney says. “And if banks are constrained to really minimize risk as much as possible, that makes it hard for them to operate in the ag lending space.”
Bank Regulations and the Rise of Private Equity in Ag Lending
DeVaney says this forces growers to turn to traditional lenders for credit or private equity partners to raise capital without constraints.
“An investor operating in that kind of private equity world may not like a downturn, but they’re sort of taken on board a greater level of volatility just by virtue of approaching it like an investment rather than a bank, and I think that that is pushing the industry in that direction,” DeVaney says.
He adds that while it is easier to access private equity capital for vertically integrated operations, smaller producers face more challenges when lower commodity prices devalue an orchard or farm, as the value is assessed relative to expected return. A grower faces lower returns for fruit and then a lower property valuation.
“As the comparable sales go down because people go out of business or they’re selling, that starts to decrease the land valuations,” he says. “A grower that hasn’t even taken on additional debt can find themselves in a credit crunch and potentially cut off by a lender because suddenly your debt-to-asset ratio is wrong because your assets have been revalued based on lower commodity prices. You can have zero change in the way you’re operating and feel like you’re struggling, but nothing significantly different has happened this year.”
Adding to this, DeVaney says, means a lender could look at the lower land valuations and higher debt-to-asset ratios and decide not to extend the same amount of credit as in previous years.
“If you are trying to continue farming in the same way, you suddenly find yourself having to adjust your operations, maybe to the detriment of your returns because of those credit constraints,” he says. “It’s particularly problematic if you see a credit crunch for those smaller growers.”
Specialty Crop Crisis Caused by Oversupply and Prolonged Downturns
As growers face economic headwinds, lending may be the only option to secure financing to remain in business. A major challenge with securing financing amid these headwinds, says Wesley Davis, partner and chief agricultural economist with Meridian Agribusiness Advisors, is that some specialty crops have been persistently unprofitable.
“The difference between the best performers and the weakest performers continues to diverge,” he says. “When you add on top of that an oversupply, you especially have the tail producers that end up being more out of the money than not.”
Davis says that unlike row crops, which can pivot with market conditions, permanent crops don’t experience quick market corrections. It often takes five to 10 years of sustained unprofitability before enough acreage is pulled to bring supply back in line with demand. Because specialty crop operations historically carried low debt, many growers are now taking on new loans to stay afloat through downturns. This delays market recovery by keeping excess supply in the ground. The lower-for-longer cycle is worsened by lost export and consumer markets, and retail and food demand pressures.
Patrick Smith, a fourth-generation apple and hop grower in Washington, says that as growers take on debt to survive significant economic headwinds, their only option is to keep farming to pay it off.
“Those orchards stay in production because it’s the only way to pay back the debt,” he says. “To hope that there’s cash flow above and beyond the cash cost of production in order to service that debt.”
Smith says apple revenue often doesn’t cover production costs and debt, leading growers to spiral into more debt, seek outside investment or pull money from other business areas to cover orchard losses.
“While that helps you plug the cash hole, it still doesn’t make it a good business overall,” he says. “Even if you’re a vertically integrated operation and you’ve got enough packing and sales margin to cover losses that are happening on the farm, that whole value chain is likely not returning a fair, risk-adjusted return for the amount of capital that’s deployed.”
How Institutional Capital Delays Natural Market Rebalancing
Private capital has also added additional financing options for specialty crops. And this, Davis says, continues to delay any needed market corrections.
“They’re able to take out additional working capital loans and continue to produce,” he says of operations that have private equity backing. “What that means is you have a lower for longer trough in the overall cycle for these crops.”
Davis is quick to point out that it’s easy to paint private equity as the bad guy in a story about the economics of specialty crops, but “there are many more factors here than just private equity driving this dynamic.”
And this “lower for longer” means it prolongs the inevitable rebalance of supply and demand — and that’s driven by land prices. In the past, land value and production value were much more closely aligned. Still, Davis says those have unfortunately become disconnected as growers leverage high-value land to take out additional loans.
“What that does is allow folks to take out more operating loans to fund a lower-for-longer part of the cycle,” he says. “What it also does is it means that the industry continues to produce lower for longer. So, it just takes longer for supply and demand to start to rebalance.”
Smith says some orchards in the Pacific Northwest have used institutional investors, changing the economic calculus of tree fruit growing in the region.
“It can feel like the two sides are playing the same game but by two very different sets of rules,” he says.
Smith says this influx of private equity has unfortunately slowed the apple industry’s recovery and kept less profitable orchards in the game longer.
“Farmers with really good orchards that definitely had a profitable path in any market are not selling those orchards by and large,” he says. “Probably some portion of the orchards that have taken on outside capital in the last few years in an alternate universe where that outside capital didn’t come in, those orchards wouldn’t exist anymore.”
For a traditional family farm carrying big debt, it needs to make debt service payments on time, but those farms are often challenged to do so when margins are slim, Smith says. Compare that to farms owned by institutional investors, which carry a lower debt load as a percentage of total balance-sheet capital.
“Consequently, then the debt service is much less of a of an issue relative to the operating cash flows,” he says.
And, Smith says, institutional owners build asset-value appreciation into the model for when the orchard goes up for sale in a decade or less.
“A family farm that expects to pass the farm down to the next generation, they can’t rely on asset price appreciation to cover up those operating losses,” he says. “And in a weird way, the asset price appreciation can make the problem worse in that it makes the paper wealth of the farm potentially look better. But when you go to transition that to the next generation, it just loads the next generation up with an expensive asset that they have to figure out how to buy from the previous generation.”
Smith says it also sets the farm up for potential issues when the family borrows against the orchard’s value, which then makes it that much harder to pay back. So, the asset price appreciation can really work against a family operator.
“It does feel like playing a football game where I can field eight guys and my opponent fields 11,” he says. “I’m not going to win that game very often without some really lucky breaks. And that’s challenging.”
Smith points out that nothing is intrinsically wrong with how private equity deploys asset price appreciation to mask operating losses; it’s just that it changes the math for family farms in a tough way.
“In this industry, scale economies are so powerful,” he says. “And high debt loads are often fatal. And that combination of factors really works against the independent, family-owned and operated orchard or grower.”
Managing Farm Cash Flow Through Cost Curves and Benchmark Data
Davis cautions that multiyear profitability cycles can be deceptive in specialty crops if owner-operators ignore capital expenditure schedules. Large cash infusions are periodically required for equipment, facility upkeep and crop renewal.
“Understanding what’s the full lifetime of that specific variety to be productive and when you think you’re going to need to replant different blocks is something they really want to know a lot about,” he says.
Operations feel the margin squeeze when unit production costs sit to the right of the market-clearing price on the industry’s cost curve. High-cost producers often feel the burden of escalating line items such as labor and are forced to absorb operating losses or accept sub-break-even pricing to move inventory. But higher yield per acre lowers a grower’s cost per box, which keeps the operation on the left side of the cost curve.
Davis says a key factor in surviving margin compression is how a grower captures price. Does a farm own its packing facility or rely on a third-party packinghouse? Another challenge the industry faces, he says, is that there’s not much good data to help differentiate between good performers and the weakest performers.
“At the end of the day, the biggest and the highest efficiency farms continue to progress, and the smaller to medium size are not always keeping up in the same way,” he says. “And that’s not to say that they’re bad farmers; it’s just that this is the reality of how buying and selling economics works in a market when there’s oversupply.”
Compounding this lack of benchmark data, specialty crop growers are reluctant to share data, even through a third-party intermediary. Standardized data would help growers understand how their operation stacks up against others. And while quantitative information may not be readily available, what qualitative information is available? Growers can track each line item of the business and what they’re spending and how that stacks up relative to other growers or varieties.
“If you don’t know that, then it’s really, again, hard to make that decision of do I continue to produce or not? Or am I going to be in the money or not?” he says.
Scott Mickey, senior extension associate and assistant agribusiness team director for Clemson University, says a simple way to approach cash flow and profitability is the acronym FLOID — Family Living, Operating expenses, Interest and Debt service.
“When we just look at a crop budget, I don’t think we tell the whole story,” Mickey says. “We’re only telling 60% of the story. You really have to know what else you need revenue for, and that’s where we’re seeing a lot of slipping. With operating expenses, ideally, it would be 70% of revenue, and right now they’re pushing more like 80 and 85%. That just leaves a lot less margin for family living and debt service, let alone any asset growth.”
While there’s an inclination for an operation to stick it out long enough to weather the storm and market corrections without making major changes, Davis says, “hope is not a strategy.”
“Ultimately, where you’re positioned will drive if you’re profitable or not in the market because the reality is price is set by a supply that you have no control over, but you do around your cost basis,” he says.
Adam Kantrovich, an Extension economist at Clemson University, says growers often look at the wrong metrics or incomplete data, which paints the wrong picture about a farm’s finances.
“Too many times individuals are solely concerned at looking at profit or no profit, and sometimes that’s not necessarily the right question to ask because of how we manage our accounts,” Kantrovich says. “You can have a profitable farm that cannot make cash flow, while you may have another farm that can make cash flow but is not profitable — but our net worth might still be moving in an okay direction.”
He also says growers make a mistake of reactive tax management that manufactures new debt and capital expenditure pressures.
“At the end of the year — and sometimes unfortunately after the year has concluded, which ties our hands — we get to ‘What do I need to do to get out of paying taxes if I had a potentially profitable year?’” he says.
Growers, instead of managing taxes throughout the year, scramble at the end to avoid paying taxes. This overuse of Section 179 and bonus depreciation creates unnecessary debt to avoid paying taxes.
“We end up creating cash flow issues or disturbances in future years just because I don’t want to have to pay anything to the government,” he says. “I’m willing to go out and take out debt to buy new stuff, whether needed or not, just so I can try to get out of paying.”
The Future of Family Farms Driven by Scale, Niche Markets and Efficiency
Acknowledging that the industry’s path to recovery remains uncertain, Smith says family farms need to get bigger or become hyperspecific to succeed.
“Scale economies are just so important in this industry that if you can’t get to a certain size where you can benefit from your scale, that’s not a very comfortable place to be,” he says. “Or you’ve got to identify a higher value niche in the industry that you can target and then just do that thing really, really well.”
And this, Smith says, will fundamentally change the apple industry’s future.
“The apple industry is undergoing and will continue to undergo change unlike it has ever seen before,” he says. “I don’t know whether that’s good or bad. It depends on the seat that you’re in, but I don’t think we’re going to stop it either.”
DeVaney says growers will often look to automation or technology to help the balance sheet, hoping to get the same or better outcome with fewer operational expenses.
“That desire to get back to a profitable environment needs to either wait until conditions change and hope they just do on their own,” he says. “Or, ‘What can I do to invest to make my corporation more efficient, to get back into profitability?’”
Davis says it’s also harder for businesses to make long-term, multimillion-dollar capex decisions when headwinds such as uncertainty in consumer demand, inflation, rising input costs, changes in trade and farm policy, and more compound at once.
“It just makes it more difficult to confidently go out and make these investments and also rationally knowing when it’s time to right-size an operation or grow it,” Davis says.
Pointing to consistent findings from leading ag research universities, Davis emphasizes that bottom-line success always returns to basic production economics.
“The most profitable farmers are not the ones that market the best,” he says. “They’re not the ones that are most sophisticated with hedging. It all comes down to which ones are the best farmers and the most efficient at producing their products. And they’re the ones that always are the most profitable.”
More Stories from This Series
- Input Squeeze Forcing Produce Growers to Retool Farm Operations
- Why Specialty Crop Economics Has Become an Endurance Game
- Are Fresh Produce Growers Price Takers in a Consolidated Retail Market?
- Is Global Trade Volatility Putting the U.S. Fresh Produce Industry at Risk?
- Rising Labor Costs Are Pushing Specialty Crop Growers Out of Business
- The Hidden Cost of Regulations Squeezing Specialty Crop Farmers
- Why Investing in Specialty Crop Ag-Tech Is the Ultimate Catch-22
