The Impact of Fixed Interest Payments

During consultations, it became evident that a leading financial stressor for farmers was having to make fixed interest payments in years when operating revenues were lower than expected, due to either low production or commodity prices, or a combination of the two.  If adverse weather has a material negative impact to crop production, farmers typically have insurance, but fixed payments still need to be made. One of the larger fixed payments is the interest due under the mortgage agreement on their farm land. 

Skyline provides mortgage debt of up to 100% of the underlying land value that a young farmer wishes to purchase. Skyline then offers these farmers the ability to hedge or “swap” their fixed interest rate due under the mortgage with a variable rate tied to revenue generation.  This service was developed after consultation with local farmers and is an effective method to protect farmers in difficult years, either due to depressed production or commodity prices, or both. This is not a mandatory service, but an effective risk mitigation tool that farmers can utilize if it suits their needs.

Skyline’s Solution

Skyline offers its farming clients an interest rate hedge that ties the interest portion of debt servicing payments to be made by the farmer in a given year to revenues (“gross revenue stream” or “GRS”) rather than the fixed amount typically paid as interest under a mortgage. A GRS is beneficial for the farmer as it matches interest payments due under a mortgage loan with the operational success of the farm in each given year.  This helps to protect farmers in difficult years when revenues are less than expected in that the GRS payment would be less compared to a fixed interest payment under a conventional mortgage. Conversely, in good years when operating revenues exceed expectations, a farmer would pay a higher amount under the GRS compared to the fixed interest payments on a conventional mortgage loan, but in these years they can afford to do so. In essence, a GRS eliminates the financial stress of fixed interest rate payments in difficult years, and greatly reduces the likelihood of a farmer being unable to meet their debt servicing obligations. 

Let’s make the following assumptions:

In this example, if a farmer had a $5 million mortgage loan with a 4% interest rate, they would know exactly how much interest would be owed in a given year.  However, rather than paying fixed interest payments, suppose a farmer preferred to reduce their financing risk by more closely aligning interest payments owed under the mortgage loan with the overall health of the farming operation. In this instance, they could enter into an interest rate hedge (“swap”) or GRS with Skyline.  

Under a GRS contract, when a farmer makes a fixed interest payment under their mortgage, Skyline will agree to reimburse this amount in exchange for a fixed percentage of the farm operation's annual revenues, or a GRS.   A GRS contract typically has a term of 10 years, meaning Skyline would be entitled to a fixed percentage of the farmer’s gross revenues in each of the 10 years.

The fixed GRS percentage is negotiated at the outset of the contract and is typically set such that when applying normal production and commodity price assumptions, the estimated GRS payments made by the farmer would be roughly equal to the total value of the fixed payments the farmer would have made under the mortgage loan, over the same period. The GRS percentage is calculated in this way so that it does not risk putting undue financial stress on the farming operations over the longer term, aligning the interests of Skyline and the farmer. 

Following on our example, if the farm's average annual fixed interest costs are forecast to be approximately $200,000, and when applying normal production and commodity price assumptions this equates to 14.5% of the farm’s average annual revenues, this is the fixed GRS percentage that would be used for the GRS contract.

In this case, if the farm’s operating forecasts are met in each year, the GRS payments would essentially be equal to the fixed interest payments that would have been paid under the mortgage, and the farmer is no better or worse off. 

Evaluating a Lower Revenue Year

As previously mentioned, the major benefit to the farmer of entering into a GRS contract is that when revenues and profits fluctuate, so do their payments owed under the mortgage loan.  For example, if revenues were 50% lower than forecast in a given year, the GRS payments in that year would look as follows:

In this situation, the fixed interest cost that the farmer would owe under the mortgage loan is $200,000; however, under the GRS contract, Skyline reimburses this payment to the farmer.  In return, Skyline is entitled to the GRS payment of $100,000, and the farmer has just saved $100,000 in interest payments, a material difference.  A fixed 4% interest rate would have equated to 29.1% of the farming operations revenues in this year, whereas a GRS payment was just 14.5% of revenues which represents an effective interest rate under the mortgage loan of 2% in this year.  As this example illustrates, the farmer is protected in years when revenues are less than expected.  

Evaluating a Higher Revenue Year

The cost to the farmer of a GRS contract, and receiving the benefit of reduced financing risk in difficult years, is that in years where production is higher than expected or commodity prices are higher than forecast, or both, the farmer would pay more under the GRS contract compared to a fixed interest rate under a mortgage loan.  Following further on our example, if farm operating revenues are 50% higher than expected, the GRS payment would be as follows:

In this scenario, the total GRS payment owed by the farmer to Skyline would be $300,000, which is still 14.5% of revenues; however, it represents an effective interest rate under the mortgage loan of 6% in this year.  Of course, this GRS payment is larger compared to a 4% mortgage interest cost; however, the farmer should have significantly higher annual net income given the large increase in revenues. So, the GRS payment is well aligned with the farmer’s ability to pay, in both good years and bad. This is in no way a mandatory contract for farmers who borrow from Skyline, but rather a service offered to help ensure financing costs are aligned with cash flows in a given year.