by Brent Gloy and David Widmar
When you write and speak about farmland values, you inevitably get variations of the question, “Should I buy the farm?” And when farmland values soar, those questions come in even more frequently.
Because each farmland investment decision is unique and one that individuals ultimately have to make for themselves, we aren’t in the farmland acquisition consulting role. However, as we think about this topic a lot, we’ve outlined three questions that are applicable to consider whenever folks are considering a farmland investment.
1) Is farmland a good investment?
From an ROI perspective, two of the most attractive features of owning farmland are the annual dividends (i.e., cash rents or farmland earnings) and the potential for long-term asset value gains (i.e., higher future farmland values). Aside from property taxes, farmland doesn’t generally require future capital upgrades or maintenance (hence you can’t get a depreciation expense for purchased farmland). Another benefit is that farmland is almost always able to be farmed or rented out – someone is always willing to rent another acre of farmland.
From an economist’s perspective, farmland is the residual claimant on profits in agriculture. Throughout an economy, the constrained factor of production is generally where profits accrue. In production agriculture – especially corn, soybean, and wheat production – this is farmland. Why? If profits are strong, producers will want to “bid-up” farmland via cash rents and farmland values to expand their operations. Globally, we know that large profits incentivize producers to increase production through more acres of farmland brought into production. This is all to say that if you are optimistic about the future of agriculture, farmland is an investment that will likely capture those future profits.
Third, farmland can have a sentimental connection for some. Perhaps it is land that’s been in the family for generations or that coveted “neighbor’s place” that has only sold once in 125 years. If you don’t think this is true, just consider how quickly an unfarmable low-spot grown up in trees and bush – generating zero economic value via cash rent – can transform into a rare and seclusive retreat for wildlife thanks to the images of aerial drone footage. This isn’t a problem or criticism, but simply pointing out that some of us – and we are guilty of this to some degree ourselves – find farmland valuable beyond the investment parameters outlined above.
Stepping back a bit, it’s worth noting that the expected rate of return for buying a farm – specifically the capitalization rate – has trended lower since the early 1980s. In 2022, this reached a low of 2.4% in Indiana. In other words, the current relationship between farmland values and the income potential (cash rent) has never been this low. At any point in the last 30-35 years, you could have purchased farmland with better current rates of return. Of course, this isn’t a problem unique to farmland as cap rates are low throughout the economy. Furthermore, this tells us very little about the future as the valuation-income relationship could remain low, or perhaps even fall lower, in the years to come.
Lastly, purchasing a farm isn’t exactly a low-cost transaction, and the asset isn’t as liquid as some financial assets. This is to say that if you decide to buy a farm, you will likely need to hold it for several years to overcome the fees associated with purchasing/selling. Furthermore, it takes weeks, if not months, of planning to exit the investment. For these reasons, farmland might be less ideal if investors know liquidity is a priority. For instance, buying farmland might not be the best investment vehicle when saving for college or retirement. In short, investing in farmland isn’t a fool-proof solution that works for every situation. Farmland generally does well as an investment when investors know they have a long investment horizon and can be patient.
2) Is this specific farm a good investment?
After sorting out the 30,000-foot question about “Is farmland a good investment,” given your goals and needs, the next consideration is the specific farm being considered.
To help you think about this, we’ll borrow Warren Buffet’s 20 Punches idea:
“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”
If you look at every farmland opportunity in a vacuum or without considering alternatives, you’ll likely find all of them favorable and highly attractive. We sometimes consider this the whack-a-mole approach as you’re only focused on the current option. But taking a bigger-picture view can be helpful because, in all likelihood, you will only be able to financially swing so many farmland acquisitions in your career. Is this farm – and the specific returns and projections – worth the punch on your card?
Now, you can take this concept to the extreme and wait for a perfect opportunity that never comes. If you never buy a farm or use the punches, the outcome will also end up less than ideal. The main idea here is that most of us would benefit from thinking about if the opportunity in front of us is worth pursuing given its specific details and characteristics, but also realizing it will tie up our resources and limit our ability to pursue future deals for years to come.
Building off the earlier point about cap rates being historically low, remember that those data report the average across an entire state. Without a doubt, farms were acquired at substantially higher and lower cap rates. While there isn’t good data on this, it doesn’t seem unreasonable that the cap rate might vary by at least +/- 100 basis points. So, while cap rates are, overall, historically low, there could easily be opportunities that are considerably better – or worse – than the average. Throughout your career, there will likely be opportunities to purchase farmland at a cap rate higher than the annual average. Similarly, you might find yourself purchasing land with a considerably lower-than-average cap rate. There are countless valid reasons why one might pass on the opportunity to buy a high-cap-rate farm or purchase a low-cap-rate farm, but the important managerial consideration is – at a minimum – to know and consider how much of a premium or discount is at stake. The data do not have to be a hard-and-fast investment rule but should at least be considered.
3) Are the terms feasible and favorable?
Once it’s been determined that 1) farmland is a good investment and 2) the farm in question is a desirable investment, the third step would be to consider the terms and financial considerations. In other words, can we afford this opportunity?
Low-cap-rates environments – or when a dollar of investment generates fewer dollars of annual income – often require additional income to subsidize the early years of debt service. These additional dollars may come from off-farm income or the profits of other farming activities, but this needs to be carefully considered.
Outside of the annual income, there are also balance sheet considerations. How does the acquisition affect financial metrics such as the debt-to-asset ratio? How much working capital is needed for the down payments, and what are the long-run implications? However frustrating, producers may walk away from good opportunities that create challenges on the balance sheet. This builds off the punch card concept – there are only so many “good deals” one can pursue.
The question of affordability is intentionally the final consideration. While some will start the decision process here, the logic is flawed and can lead to suboptimal decisions. For instance, assume you and your lending partners determine you can afford – from an income and balance sheet perspective – to make a $1,000,000 investment in farmland with a 20% down payment. Whether intentional or not, that “approval” will start a clock for you to find a farm to buy. First, you might bid higher than you initially planned. Then, if you’re unsuccessful, you might rebound and buy an entirely different farm. Again, these outcomes may be reached using sound and justified decision-making processes, but the path is the one often utilized by faulty or insufficient decision-making processes.
Wrapping it Up
When a neighbor outbids us on a piece of farmland – paying more to rent or purchase – a common default is to conclude that the highest bidders are somehow better. A better producer. Better financial manager. Or, perhaps, in a better financial position. However, it’s more likely that the neighbor was simply willing to accept a lower return to manage the asset. And as we like to remind each other: Never underestimate how low of a return a competitor might be willing to accept.
Large investments are never easy to make. In times of great uncertainty, low cap rates, and rapid appreciation in valuations, navigating a potential farmland purchase becomes even more difficult. In our opinion and experience, sticking with simple assumptions and investment considerations – as we’ve attempted to outline in this article – can often provide great insights and comfort.
Lastly, this article has focused on farmland. Farmland is important as it accounts for approximately 80% of total farm assets. However, these principles and frameworks broadly apply to most other asset purchase decisions.
Note: This article was originally published in December 2022 as a “What We Are Thinking About” memo for AEI Premium readers (here). See what other ideas and articles you’ve missed by starting your Premium trial today.