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Investing Fundamentals

July 03, 2018

Leverage and Debt: A Dangerous Amplifier For Real Estate Investing

The farm crisis of 1985-1987 was amplified by large amounts of debt in the system, as farm price appreciation of the early 1980s drove heavy amounts of investment from speculating farmers that placed large amounts of leverage on their farms. When prices began to go down, this set into motion a spiral of defaults, forced resales, and lower prices. Debt-to-equity leverage ratios peaked in 1985 at nearly 29%. Compare that with today, where the USDA estimates leverage at a near-record low of 14%. Debt to Equity.png

This small amount of leverage, or total debt, involved in farmland makes the return profile even more impressive when compared to other assets like commercial real estate. While debt can often help amplify returns for real estate investors, it also greatly increases the risk. For example, if you buy a retail center with a 20% down payment, the other 80% is covered by debt from the bank. If the value of the property goes down by 20%, the value of your investment becomes zero. Not only that, but don’t forget you still owe the bank the other 80%. AT Debt.png

Unlike most real estate investments, typical plots of U.S. farmland have little or no debt on them. Typical properties on AcreTrader have no debt on them either, meaning investors own 100% of the subject property without the involvement of banks or significant debt.

Note: The information above is not intended as investment advice. Data in the charts 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 & Disclosures here.

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While the value AcreTrader provides to investors is clear, we are often asked “what do you do for the farmers?” The answer is: a lot! Our management team has historically been involved with farming before founding and working at AcreTrader, and we understand many of the challenges today’s farmers face. While we don’t have a magic wand to solve every farm problem, we do help farmers in a variety of ways.

Ability to Expand Operations

Perhaps most obvious is AcreTrader’s ability to offer farmers access to capital. For example, there are times when a farmer wants to expand his farming operations onto a neighboring parcel of farmland but doesn’t have the funds to purchase it. This farmer can present the land to AcreTrader’s investors. The investors would then purchase the land and rent it back to the farmer, providing him something he might not otherwise have gotten - economies of scale. He can now use his existing farm equipment and labor on the newly-leased neighboring farm, helping him to grow his business and his bottom line. Another avenue for expansion would be for a farmer to sell a portion of their ownership in some land in order to purchase additional land. Where traditionally farmers would go to a bank and get debt (backed by their owned-land), they could instead just sell some portion of that parcel on AcreTrader and use the funds for expansion. AcreTrader can provide another tool for farmers who hope to grow their businesses.It’s one of the qualities of our business about which we are most excited. With more financing options, farmers can choose a solution that helps them reach both their financial and personal goals.

Quick Access To Capital For Improvements

Almost 40% of U.S. farmland is owned by absentee owners that rent the land to farmers. In many of these relationships, the farmer pays a cash rent that is typically up-front before planting season. While some owners will reserve cash for potential capital improvements, others do not or are unable to. This can result in serious problems. For example, the farmer may have the water pump on an electric well break in the middle of the hot summer. If the owner is unavailable, or does not have cash on hand, this can put the farmer in a very difficult situation. The farmer will either have to pay for the well himself (if he has the cash at hand) or risk his crop dying in the field from lack of water. When working with AcreTrader and its management partners, our farmers have support when improvements are needed. Making enhancements and maintaining a farm’s drainage, ditches, and roads not only helps the farmer, it improves the resale value of the farm. In addition to having capital available for on-farm improvements, we move fast. We are always here to answer the call and take action in partnership with our farmers.

Independent Valuation and Information

We work with farms of all sizes and many types of complex situations. From small conservation-focused farms to mega farms, wholly owned parcels to complex family dynamics and ownership structures, we have seen it all. Importantly, we help farm owners and farmers understand their land value and the options available to them as sellers. While we don’t always engage in a commercial relationship with these farmers and owners, we are happy to share our thoughts regarding the value a farm and work through the potential opportunities and options. Understanding the value of a farm and the process of selling can be complicated and stressful; having someone walk you through it can be an invaluable source of both relief and information.

Respectful Farming and Technology Expertise

Farmers know their own business and their land, and we don’t pretend to know better than they do. However, having operational experience over tens-of-thousands of acres has provided us the opportunity to see a lot of problems and solutions. For example, all the new technology offerings from planters and seed solutions to financial software and satellite mapping can, at times, be overwhelming. We have evaluated a myriad of products, and we have seen a lot that are a waste of time and money - the proverbial “solution in search of a problem.” However, we have also seen some true technological advances and products that can immediately help farmers with their business. Here’s an example recent conversation:

Farmer: “Have you guys seen XYZ’s new software for planting season?”
AcreTrader Farming Operations Team: “Yes, but we noticed they were unable to complete their fundraising round, and they have recently gone through layoffs. It’s likely their product functionality and support will suffer. Have you considered solution ABC instead?”

A farmer's localized history and knowledge of the land is irreplaceable. We help our farm partners through our nation-wide knowledge of the agtech industry as well as the nuances of the legal, land improvement, and farm valuation pieces of the business. In short, we let farmers do what they do best and support them wherever we can.

National Presence and Brokerage

As mentioned above, we work with farms of all types and sizes. Farmers usually know their local market dynamics better than anyone around, but our national footprint and years of cumulative regulatory, valuation, and brokerage work help us present additional thoughts and assistance that might otherwise not be available. In addition, we maintain an incredibly unique and large set of relationships with individual and institutional farmland investors alongside a nationwide footprint of partners.

Conclusion

The above are just a few of the ways we work with farmers to make their lives easier and their businesses more profitable. However, every farm is unique, and so are the solutions for its situational improvements. If you are a farmer or farm owner, or someone interested in learning more about investing in farmland, please don’t hesitate to contact us anytime.

Five Ways AcreTrader Helps Farmers

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IRR Defined

The Internal Rate of Return (IRR) is a commonly used method of calculating an investors' overall 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 NARIEF index. Importantly, this has been with relatively little volatility and consistently positive returns: Screen Shot 2018-08-30 at 8.20.28 PM.png

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.

Annual Yield

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%. Screen Shot 2018-08-30 at 8.34.13 PM.png

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 vs. 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.

What's the IRR of Farmland?

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By 2050, we will need to grow global crop production by 70% to feed a larger population with increasing food demands. At this rate, farmers will need to produce more food than they have in the last 250 years combined to keep up with global demand.

In order to think about the problem, let’s first review the different pieces of demand and then think about how much arable land the world has available to grow the necessary crops. cerealcropandmeatproductionincreases2050.png

Increasing meat production equals higher grain production

Cereal crops, aka grain crops, make up more than 50% of the global daily caloric intake, and therefore, they make up one of the largest commodity markets in the world. Cereal plants are things like corn, rice, wheat, and soybeans, all of which produce an edible grain for both humans and livestock.

As you can imagine, a rather large portion of the projected crop production increase will be for direct consumption. However, the majority will be used for feed as the global demand for more protein and higher quality food sources is expected to rise by over 130%. feedrequiredperpoundofmeat.png

Rising income levels lead to higher demand for protein

Historically, we have seen that as a country grows their GDP and income levels rise, so does the demand for proteins such as chicken, pork and beef. While this market is mostly saturated in developed countries, the majority of future income growth per capita and population increase is expected to come from developing countries. As you can see, it takes a considerable amount of grain to produce one pound of meat. A 6 to 1 ratio in the case of beef!

The impact of increased demand for cereal crops has already been felt via long-term rising commodity prices, but global demand for these commodities and the land on which they are produced will become increasingly important. arable_land_use_per_person-1.png

The amount of arable land has been decreasing

In the US, like most other countries, the amount of arable land has actually decreased. Basic economics would suggest that, as the supply of land decreases and the demand for food increases, the value of the land will increase in price. After all, they’re not making any more land!

Beyond the obviously favorable supply/demand characteristics for investors, we must also be highly conscious of how we are using the land we have. For these reasons, progressive farmers and agtech companies are constantly innovating with new technologies that help them maintain soil quality, improve planting efficiency and increase their overall yields in a sustainable manner.

The world will need all of this and more to produce all the food that we need by 2050.At the center of all new investments in agriculture is one central question:

Will we continue to be able to feed our growing population with limited natural resources?

Two of the most important keys to success will be protecting arable land against some unnecessary types of sprawling real estate development and innovating in order to increase crop yields on the ground we have remaining.

Today farmland owners have opportunities to partner with progressive farmers and profit from helping to solve a global-scale problem. Individuals can preserve farmland by investing in it and keeping it in production. Further, farmers and agriculture companies are finding new and innovative ways to meet future demand every day. The opportunity for partnership in innovation should be both life-changing and lucrative for those making a difference in the right places.

We believe the future of agriculture looks bright.

Note: The information above is not intended as investment advice. Data in the charts above is sourced from the FAO and NCBI. 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 & Disclosures here.

Limited Farmland Supply and the 2050 Problem