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Investing Fundamentals

July 21, 2018

The 5 Big Dangers of Online Real Estate Crowdfunding

We have watched with excitement and awe as the online commercial and residential real estate crowdfunding market has grown from practically nothing 5 years ago to a multibillion dollar industry today. As a whole, we view the real estate crowdfunding market as an exciting alternative asset for accredited investors, and we note that most platforms and offerings look great at first glance. However, buyer beware; those 13% IRR figures don't come without significant risks. Below we note several risks that may or may not be obvious when it comes to online real estate crowdfunding.

Leverage

As we note in our post "Leverage: A Dangerous Amplifier," debt is a great tool of modern finance that is not without risk. Most real estate crowdfunding sites offer properties with Loan-To-Value (LTV) rates of 75% to 80%, though some of them are even more levered. In an investment with an LTV of 80%, the owners' equity portion is only 20% of deal value, while the debt accounts for the remaining 80%.

While this leverage can amplify your returns, it also amplifies the downside. An economic recession, poor site selection, poor management, increases in local competition, government regulations, or even just a negative cycle in commercial real estate can drive down the value of the property by 20% or more pretty easily. If the value is down just 20%, this means that the investors' portion of the deal is worth ZERO.

Deal Terms

While often overlooked, the articles of organization and subscription documents can hold important information. Sometimes, the grizzliest of these limitations are buried in legalese that is hard to decipher. While most real estate industry terms are standard, look out for predatory terms or unfavorable treatment in the case of default.

Unknown Sponsors

Many of the well-known crowdfunding sites work with established multi-deal sponsors on their sites. However, that isn't always the case, as we have witnessed well-funded deals that relied upon sponsors that had little or no experience. Even in the case of well-experienced deal sponsors, local real estate knowledge is important, and we have seen examples of seemingly well-intentioned sponsors putting together dangerous looking deals in unfamiliar territory.

Due Diligence Limitations

For an example of the above, we recently came across a hotel recap and remodel offering from one of the industry-leading crowdfunding sites in a southern state. The sponsor had experience in neighboring Texas, but none in the target state where they were (successfully) raising millions of dollars to do a heavily-levered hotel deal. Unfortunately for the investors, and likely even the locally-inexperienced sponsors, there is a mostly-unannounced $100 million development being planned across the street that includes two hotels. At the time of capital raise, it is possible that only local developers knew the massive development was going to break ground soon. While the investors' pitch on fixing up an old hotel looked great on paper, a flood of hotel room supply across the street may end up destroying a lot of value... all because the developer was speculating in a new market.

Heavy Cyclicality

As multi-billion dollar commercial real estate lender Bank of the Ozarks said during its July 2018 conference call, competitors that are getting more aggressive with credit structures and pricing may "set of concerns across the banking industry." It is no secret that commercial real estate is a very cyclical industry. In fact, it is not uncommon to see the real estate industry go through 10%, 20%, or greater corrections (see chart below). For this reason, as well as the reasons listed above, we remain cautious about real estate crowdfunding online. Screen Shot 2018-07-21 at 3.34.09 PM.png

Note: The information above is not intended as investment advice. Data referenced herein and in the chart above is through year end 2017 and is sourced from Bloomberg 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.

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The AcreTrader Relative Risk Score (ARRS) is a score we designed internally to judge the relative (not absolute!) risk of various offerings reviewed for listing on our site. While we share this score with our users regarding specific offerings, please note the ARRS is not to be relied upon as a single determinant of risk. Additionally, note the information below is not intended as investment advice. Please see disclosure of additional risks here.

What is Relative Risk?

Put simply, standard investment risk and return usually share a somewhat inverse correlation; the lower the risk of a given investment, the lower the expected return, and vice versa. Government bonds for example, are often seen as low risk, but they offer low returns. Inversely, speculating on currencies in developing countries or typical equity crowdfunding may offer high potential returns, but often come alongside high risks.

Agricultural farmland has historically shown what we view as impressive returns alongside relatively low risk (check out our white paper for more info). However, not all farm investing or general crowdfunding opportunities are created equal. Thus, we created 3 basic questions to help us determine our AcreTrader Relative Risk Score (ARRS):

  • Is there existing or planned debt on the subject investment property?
  • Are there necessary or planned improvements for the property?
  • Are there additional business risks (non-core to farming)?

Examples of the AcreTrader Relative Risk Score

Based on the simple yes or no answer to the above questions, we then describe the project's relative risk as one of four categories:

  • A Low ARRS means a "no" answer to all of the above questions. While these properties will typically have a lower IRR, this comes with a low risk relative to other properties we have reviewed.
    • An example might be an existing corn farm with no debt, no external businesses and no planned improvements.
  • A Moderate ARRS means a "yes" answer to one of the above questions. This type of farm may offer a slightly higher IRR.
    • An example of a moderate relative risk farm would be an existing farm where there is a planned investment in improving the grade of the land, but the project is funded with cash raised up front.
  • A High ARRS means a "yes" answer to two of the three questions.
    • An example might be the same farm above with planned investments, but the project is funded with debt in order to increase returns. While the IRR may be increased via debt (as opposed to using up-front cash from investors), the risk profile is potentially higher as well.
  • A Speculative ARRS means a "yes" answer to all three of the questions. These properties will typically offer the highest IRR but come with the highest risk relative to other properties.
    • An example might be a farm with an attached dairy operation, where debt is issued to improve the property and the dairy business output. Most of the real estate crowdfunding deals we see on the major crowdfunding sites would fall into this "Speculative" category given often high levels of leverage, complex organization, "value-add" necessity, and/or other potential business risks.

Conclusion

To summarize, there is no "one-size-fits-all" in investing, and this holds true with farmland as well. While many farms are lower relative risk, this comes with a lower potential IRR. We don't view agriculture and farmland as a get-rich-quick scheme, but rather as a conservative way to earn attractive risk-adjusted returns.


Note: The information above is not intended as investment advice. 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.

A Brief Explanation of the AcreTrader Relative Risk Score (ARRS)

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Methods for Decreasing Farmland Investment Risk

Net cash farm incomes (take-home money for farm operators) have fallen over the last 5 years, but the price of farmland has remained relatively stable despite the downturn. Despite the stability, investors must think about protection during weak farm economies. Thankfully, many of the risks that can come with owning farmland during turbulent times can be resolved for investors with the right structures. Net_farm_income_and_net_farm_cash_income.png

Method #1: Cash Rent

Rental contracts for farmland vary widely between different regions. However, there are generally two categories of rent contracts: revenue share and cash rent.

Revenue share pays the landowner a percentage of the crop produced on his or her farm at the end of the year. While crop share arrangements can add a some additional upside to the returns, it also adds risk to the investment by giving the landowner 1) exposure to the farmer’s operational successes and failures (including weather risk), and 2) more direct exposure to commodity markets, since the land owner’s crop will have to be sold.

Cash rent is a lease paid to the landowner annually. Importantly, the rent is a fixed dollar amount per acre agreed upon in each lease (leases are typically 1-5 years).

Cash rent is the number most often discussed in farming circles and researched by the USDA; there is good data about state and county average rents, which allows investors to understand an individual farm compared to others around it.

For AcreTrader farmland investors, cash rent provides stability without an immediate link to commodities markets or weather risk. This allows investors to have regular, stable rental returns while allowing the land itself to appreciate over time.

Method #2: Diversification

Another source of stability is diversification of farm property. The more varied properties an investor can own the more likely the income stream will be stable. In any given year a property may be in an area where there is a drought or other weather related problems affecting production. As discussed above, this will generally not affect any given year’s rental income since the rent is negotiated at the beginning of the season. However, a series of problems in an area could reduce the frequency in which it is appropriate to raise rent alongside a farm’s typical productivity increases and economic inflation. In other cases, rent could even decrease.

Any property owner needs to work with farmers to make sure rent is fair to all parties. However, owning multiple properties reduces the risk that the entire portfolio could have these problems at the same time. AcreTrader provides a flow of different investment options to allow investors to build their own portfolios of land and decrease their own concentration risk.

Method #3: No Debt

farm_sector_solvency_ratios.png

Leverage creates a different problem for farmland owners. The fixed cost of a farmland payment can cause issues with the variable revenues farms often generate. For instance, if a farmland investor purchases land and cannot make his debt payments, then he risks losing his investment to the bank. For this reason debt ratios have been low since the 1980’s when many landowners held too much debt on their land.

The most stable investors and funds do not typically use debt to invest in farmland. Land can be purchased outright and should generate income from the investment in the first year with no risk of debt default.

For this reason, AcreTrader typically fully funds all of its deals at closing and places no debt on the subject property. Also, AcreTrader provides an alternative to debt for farmers: a farmer can bring a property to the platform that she would like to farm, but cannot purchase on their own. The farmer can then purchase a portion of the land (depending on what they can afford), sell the rest to investors, and lease the land to farm. This way, they can increase the size of operations, but without taking on the huge expense of land, while still gaining value from land appreciation.

Method #4: Long holding periods

arable_land_use_per_person.png One of the prime advantages of farmland is its ability to store value and appreciate over time. Unlike stocks which depend upon the underlying business’s ability to perform, farmland’s value depends upon the demand for food and the amount of land available to grow that food. As the world’s population increases and the amount of arable land decreases, land assets should grow in value. While there may be fluctuations in the price of farmland during small periods of time, over long periods of time the value has increased greatly. AcreTrader purposefully offers assets with longer holding periods to take advantage of this feature of farmland.

Method #5: Liquidity

That said, AcreTrader does understand that investors need the ability to get money out of an investment. This can be complicated in the case of volatile farmland prices. If the greater farmland market is doing well, but in one area there are no buyers, a landowner could have to wait a long time to find liquidity. Further, selling a farm can be tedious and complicated when owning farmland outright. AcreTrader can provide two solutions to this problem. First, we can provide investors for those wanting to sell land without buyers. Second, for investors needing liquidity, AcreTrader intends to provide the ability to sell shares in farms to other investors on the AcreTrader platform. This allows for liquidity in an efficient and cost effective manner for all involved.

Conclusion

Many factors can contribute to risk during a farm recession; however if investments are made with the factors above in mind, investors can help protect themselves during hard times. While prices can fluctuate in the near term, the AcreTrader platform provides structures and incentives that can help investors attain even more stability in an already highly-attractive asset class.

To see our current offerings, please click here.

Note: The information above is not intended as investment advice. Data referenced herein USDA and World Bank, 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.

Mitigating Risk in Farmland Investments

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There are no guarantees in life, especially when it comes to investing. Recent surges in market volatility for stocks and bonds serves as a fresh reminder that asset prices don’t always go up. Can farmland save us?

In short: there are no guarantees in investing, and past performance is not a guarantee of future results. With that being said...

Farmland prices historically have no relationship with stock market returns and have offered a highly attractive way for investors to diversify their portfolios.

Farmland Prices and Stock Prices Move Independently

Look at the chart below showing the relative movement between United States farmland (the green line) and the S&P 500, a primary equities index (red line). What do you notice about the correlation between the two? pasted image.png

To be statistically precise, the correlation between these two asset classes is -0.03. Said differently, there is zero statistical evidence that stock market prices influence farmland prices and vice versa.

The lack of correlation alone suggests that farmland is a great portfolio diversification tool. In a world where most other asset classes increasingly move together, farmland helps mitigate the risk of financial loss in all assets at once. Additionally, the relative movement in the chart above demonstrates two other very important points.

  1. Stocks are volatile. Yes, this is known, but it is fascinating to see the annual gyrations between positive and negative annual returns from the stock market. Swinging between 30% returns and 40% losses isn’t for the faint of heart.
  2. Farmland is a much more stable asset class. Note that the volatility in the green line is just how much is made each year in farmland. Said differently, the returns of a farmland investment over time have oscillated between making small returns and large ones, not between huge profits and massive losses like the stock market saw in the early 2000’s or the great financial crisis. To learn more about the historical investment performance of farmland, please see the for investors section of our website. To learn more about our current offerings, please click here.

Note: The information above is not intended as investment advice. Data in the charts above is sourced from Bloomberg and NCREIF. 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.

Can Farmland Protect You From Stock Market Volatility?