The Internal Rate of Return (IRR) is a commonly used method of calculating an investor's overall annual rate of return. The method is widely used in real estate and project-based investing, as it takes into account the investor's return without the influence of external factors such as inflation or the cost of capital. In the context of savings and loans, the IRR is often referred to as the effective interest rate.
Said differently, the internal rate of return is a general indicator of the profitability or overall annualized yield of an investment. While the actual rate of return that any given project ends up generating will often differ from its estimated IRR, a higher IRR is generally the goal.
That being said, the risk an investor accepts in trade for a higher rate of return is a big deal.
The Historical IRR of Farmland
As discussed in our white paper, the average annual return of farmland for the last 25 years has been roughly 11%-12% according to the NCREIF index. Importantly, this has been with relatively little volatility and consistently positive returns: This annual return is the combination of yield plus appreciation in land value. Though calculation of IRR over long time periods can become slightly complex, a decent rule of thumb we use for IRR regarding farmland is simply using this combination of yield and appreciation in land value.
How We Calculate Expected IRR
Given the combination of annual yield plus annual land value appreciation is a decent proxy for IRR, we use this to illustrate IRR given it is the simplest approximation of what an investor's overall return could be.
Interestingly, annual yield is often the larger variable. This annual yield, or rent the landowner receives from the farmer, can vary based on commodity prices. While we seek longer-term leases with farmers (typically 3-5 years), over time, the underlying yield should represent expansion in commodity prices. Commodity prices like beans and corn often follow overall inflation. Thus, the attractive inflationary hedge of owning farmland.
In today's environment, due to exceptionally good farming weather for several years in a row, looming trade wars, low interest rates, and a myriad of other factors, commodity prices are relatively depressed. Thus, the yield on farmland is pretty low. However, as history has shown us, the upward trend in commodity prices should persist over time, and thus farmland yields may increase as well.
Despite this potential for increasing commodity prices over the long term, we assume the currently-depressed yields persist for purposes of our IRR calculation.
Land Value Appreciation
On top of annual yield is the growth in farmland value. As the table below shows, the Cumulative Average Growth Rate (CAGR) of farmland over the last 50 years has been relatively stable, regardless of the time period chosen. For our IRR calculation, we use the longest time period available from the USDA database, 50 years. Over that time period, the average annual value growth in farmland has been 5.4%.
An Example IRR
For an example of above, if we look at a fairly standard piece of farmland in the Midwest or the South, let's assume an annual yield of 3% and an annual growth in land value of 5.4%. The resulting IRR would be roughly 8.4%.
While this is a simplified view of IRR, and actual outcomes can vary widely versus projections, this gives us an idea of the anticipated IRR.
It is worth noting that this IRR was calculated WITHOUT assuming any debt.
While debt can amplify an investment's anticipated returns, it is also a potentially dangerous mechanism, as noted in our post about leverage and debt.
Additional Note: The information above is not intended as investment advice. Data referenced herein is through year end 2017 and is sourced from Bloomberg, USDA Agricultural Land Values Survey, USDA Nominal Farmland Values, USDA Farm Sector Equity Assessment, and NCREIF, with additional calculations and analysis performed by AcreTrader. Past performance is no guarantee of future results. For additional risk disclosures regarding farmland investing and the risks of investing on AcreTrader, please see individual farm offering pages as well as our terms and disclosures.