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Investing Fundamentals

December 20, 2018

Mitigating Risk in Farmland Investments

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.

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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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This post is our second of a four-part series where we discuss the process of selling a farm. If you haven't yet read the introductory post, you should do so first.

This article also provides good information for those who might be interested in purchasing a farm, either by understanding how AcreTrader’s process works or by doing their own research. However, this is not by any means the only resource one should use. It is a thorough introduction meant to help guide one’s own research and understanding.

A Seller’s Guide to Farmland: Price

As we mentioned in our first post on selling farmland, price is the first component that most consider when selling an investment. Many factors will play a role in determining price. The next posts in this series will dig deeper into the conditions that might raise or lower a price. However, for this piece, we will look at how investors and farmers tend to find the starting value of a property.

Land investors value land two primary ways - comparable sales and capitalization rate. While these two valuation methods can be done independently, they often affect one another.

Comparable Sales

Comparable sales, also known as "comps," are core to understanding the value of a property. Unlike the stock market, land does not sell on a daily basis much less a second-by-second basis. Further, every piece of farmland is unique and not exactly like any other. Therefore, it can be more difficult to determine what the price of any particular property should be.

The best way to compare a farm is to look at nearby sales and adjust their prices by the value of the different qualities each might have. For instance, consider a non-irrigated property which might have sold for $3,500 per acre nearby an example irrigated, top-tier property of similar quality.

If the value of irrigation were estimated at $500 per acre, then an investor would take the value of the non-irrigated comp and add $500 to the per acre price ($3,500+$500=$4,000). This would give the seller an idea of what might be a good price to list the property.

A seller should look at many different comps to understand the prices in a given area. Any single property might have been sold at a higher or lower price due to issues which might not affect the seller’s land. For example, a farm in foreclosure might sell at a lower price because a bank would rather sell the property quickly than hold out for the best price. Or, a large family farm may meaningfully overpay for a long sought-after neighboring parcel. Usually, five to ten comparable properties can give the seller a good idea of what local market value for a property may be. As with any research, the more data points one has the better one’s understanding of the situation.

A high-quality land valuation will consider many different farm qualities by which to adjust comparable sales. These might be irrigation, drainage, soil type, road access, number of tenants in an area, availability of places to deliver the crop after harvest, and many others. Ideally, though, comparable sales will be close in quality to the land that is being sold.

In other words, a potential buyer should be able to understand the property well enough to throw out the comparable properties that are not close enough in quality, while also identifying enough comps of a similar quality to value it against.

Unfortunately, these comparable sales can be difficult to find. This is one advantage of working with an experienced seller or broker like AcreTrader. People who see many sales a year in a given area will be able to quickly estimate what a seller’s property may be worth.

The best investors and brokers will follow up on this intuitive understanding with in-depth research and financial modeling on a farm. They will analyze many sales in the local area and region and derive a fair market comparable value for the property. This will be a starting point for any further discussion of terms a seller might desire (which we will discuss in later posts).

Comps and county average land prices can be found through courthouses, brokers, bankers, land managers, government websites, other farmers, and even some new technology companies like FarmlandFinder or AcreValue. However, throughout the research process, many times a seller may find dated or incorrect information that can be misleading. Keeping a constant eye on the market and having experience with many different sales is an advantage to any seller. There can be limitations to this practice as well. Since comparable sales are backward looking, they only tell you what people have recently paid. Further, this data is often delayed by months or longer.

Comps also do not tell what kind of annual cash return can be expected on a property. There may be a localized buyer who is driving prices up. Paying too much for any property can hurt the long term return, as can buying a “cheap” property with poor rental prices.

Avoiding value traps like this is imperative to making a good purchase. Knowing not only the local market but also the regional and national markets for land provide a material advantage.

Capitalization Rate

Capitalization Rate, also known as “cap rate,” is the expected rent as a percentage of the purchase price of the land (for example, $5 rent on land worth $100 equals a 5% capitalization rate). Most land investors will have a percentage range they hope to hit and will need to adjust either the rent or the purchase price accordingly. Like any equation, a cap rate can be misleading. For example, buying a farm for $1,000,000 per acre and receiving a $50,000 per acre rent will give a 5% cap rate, similar to buying a farm for $10,000 per acre and receiving $500 in rent. However, at $1,000,000 an acre, the buyer would be grossly overpaying based on inflated rents. A seller must have a thorough understanding of what is typical for both sides of the equation to value a farm. Average rent and farm prices can be found in many of the places that comps can be found. The helpful thing about cap rates is that many more sources may be used. Usually land of varying qualities sells for similar cap rates.

Of the two components of cap rates (rent paid and value of the land), true market rent is the more difficult to find. Government surveys will report an average rent paid, but they are dependent on those responding to the survey. There is little data to show the quality of responses and quality of farmer who responds.

For example, while unlikely, what if fifty percent of those who responded to the survey in a given county went out of business in the following year? In that scenario it would be likely that a large number of the respondents were paying too much in rent. Those who rent land themselves, those who rent their land to good farmers, those who sell land frequently, and those who lend to farmers will know the typical rent in a given area. They will likely know the typical farm price and be able to tell you a typical cap rate as well.

The limitations of cap rates can be linked to expectations as well. Many farm investors would love to have rent equal to twenty percent of the purchase price of their land, but this is virtually unheard of under normal circumstances. On the other side of the equation, many sellers would like it if their buyer expected one percent rent on their investment. Understanding a buyer’s motive and expectation for their return can help a buyer price their land.

Most often a seller aims for a buyer’s cap rate range rather than any particular number. The final price will then come down to negotiation and the buyer’s ability to set a rental rate that makes sense for both the buyer and the farmer.

Combining both methods

These two methods are often combined to find the price at which the property is listed. Comps help the seller find typical prices, and a buyer’s return expectations and rents in the area help back into what price could be paid. Most often these numbers are similar. When they are not, a seller must do more research to understand which number is incorrect and adjust one or both to align a price with what the market will pay.

Ultimately this process requires not only market knowledge of rents and prices but also of farmers and farm budgets. This way a seller can understand what a buyer will be able to expect of a tenant in the future. The only way for a property to continue to return rent and gain value in the long term is to have good farmers who are able to make money and take care of the farm. They are the ones who work the land and keep it productive.

To find out more about selling a farm or investing in land, feel free to contact us here. AcreTrader knows farmers, sellers, buyers, and farmland markets. It’s what we do.

How to Sell a Farm Part 2

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All things considered, time is our most valuable resource. We are all given a finite amount, and, unlike most resources, it cannot be recovered. To maximize the potential of this precious resource, we must be wise about how we invest both our time and hard earned money. Building passive income streams can be one of the best investments of both - eventually leading to financial freedom and greater control over your time.

Make money while you sleep

One of the greatest benefits of a passive income stream is that it requires very little effort to maintain and it generates automatic income. In contrast, active income streams often involve the direct exchange of your time for money. Most of us have to work to make a living. However, if we can only produce income while actively working, we leave ourselves exposed to the threat of being unable to earn in the event of an incapacitating injury or illness. If your goal is to achieve financial freedom and have greater control over your time, the more effort you put into expanding passive income streams the better. Not to say that this process will be easy nor require a short amount time to get started. No matter which passive income strategy you choose, you will likely have to invest significant amounts of time, earning little income in the beginning. But, keep in mind that after initial setup each income stream will continue producing income with little or no involvement, and in some cases, the underlying asset will continue to appreciate as well.

If you don't find a way to make money while you sleep, you will work until you die.

Warren Buffett

Diversify your portfolio

There are many ways to build passive income streams. Whether you are using your skills to make money online, investing for rental income, or in dividend stocks, you will be hedging your portfolio against more risky investments. However, the riskier investments typically have the potential for higher returns, so you likely wouldn’t leave them completely out of your portfolio either. The key is finding a balance to protect and maximize your portfolio value and sources of passive income are great at helping you achieve this. Diversifying your portfolio is a staple of good investment practices. You wouldn’t want to put all of your money in stocks because values can fall over 30% in a few months. By contrast, you wouldn’t want to place all of your money in bonds, even though they are less volatile. Your returns will be significantly lower than they could be if combined with investments in stocks. Experience shows that is best to have a mix of both, along with other asset classes like real estate. By also investing in non-correlated assets like farmland, which has historically increased in value when stock market values drop, you can provide balance to your portfolio and protect your overall earnings. In the end, the more you diversify your portfolio the less you expose yourself to risk. The right passive income streams are great tools for this because they typically offer low volatility, higher total returns than your standard “safe” investment, and generate income without active involvement.

Compound your earnings

The beginning of any passive income strategy is building a savings plan and sticking to it. Once you have a realistic idea of how much you need to make to cover your expenses, you can begin to look at additional income as fuel for the machine. This also gives you an idea of how much passive income will be needed to achieve your financial goals. As you continue to receive income from your day to day job and passive income streams, you can reinvest what you don’t need for your expenses to continue compounding its value. This takes discipline and dedication towards your goal, but over time is one of the greatest values of this strategy. The goal is to reach financial freedom, or the point at which you make enough passive income to cover all of your expenses. Not to say that passive income vehicles are the only way to get here. In fact, your investments should be diversified to protect you during different market cycles as mentioned above. However, having steady income outside of your primary job that you can use to make money while you sleep is a distinct advantage.

Conclusion

Passive income streams are crucial to your portfolio because they can generate predictable income with little maintenance, diversify your portfolio, and increase your overall cash flow. Remember, those who are the most successful are those who have the most control over their time. The more work you put into building passive income streams, the more control you will have over your precious time in the long run.

Learn more about the impressive diversification properties of passive farmland investments.

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

Why Are Passive Income Streams Important?