Farmland Cap Rates
Introduction
Commercial real estate is often valued based on how much income a property generates. Anyone who has invested in multifamily, office buildings, retail or other traditional CRE assets will be familiar with “cap rates” and how they help influence a property’s sales price.
Farmland is a notable outlier. Unlike other property types, farmland does not sell based on its cap rates. In fact, how much revenue a farm produces plays very little role in the value of that land. Instead, long-time owners sell on a per-acre basis based on their perceived value of the property.
While this may come as a shock to those less familiar with farmland, they should not be scared away from the asset. Indeed, the fact that cap rates are rarely used represents an opportunity for farmland investors. Those who buy property today on a per-acre valuation stand to benefit from a dramatic uptick in that value as more institutional investors enter the fray, and in doing so, begin to use cap rates on a more widespread basis. As we’ll show, the move from per-acre sales to cap rate sales has the potential to send farmland values skyrocketing in the years to come.
Read on to learn more about farmland cap rates.
What are Farmland Cap Rates?
Unlike other commercial real estate product types, like multifamily or industrial real estate, farmland is not valued using cap rates. This may come as a surprise to long-time real estate investors. After all, nearly all other income-producing property is appraised using cap rates.
Instead, farmland is valued on a per-acre basis. Indeed, banking regulations mandate that only sales comparisons and not income serve as the basis for underwriting farmland credit.
For example, someone might sell a ranch for $8,000 per acre. That valuation is not based on a cap rate, but rather on what the farmer knows other farms have sold for on a cost per acre.
One of the challenges with valuing farmland is that each owner has different expectations about what that farm is worth. The farming industry is still highly fragmented. Much farmland has been owned by the same family for generations and many farms are small holdings of under 100 acres. In some areas, the average farmer is 70+ years old. As these long-time farmers age, they (or their children) are looking to cash out and, having become accustomed to valuing their land on the basis of cost per acre, simply do not think of valuing it on in terms of yield or cap rate. And their lenders reinforce this perspective through being bound by regulations to do so.
For some longtime owners, a valuation of $5,000 per acre might be perfectly reasonable. They do not equate that value with the amount of money they can earn from the land because, in part, they have never been tasked with doing so by their bank. Their lenders, mandated to follow federal regulations that prohibit the use of cap rate (yield) in underwriting risk, have only ever looked at price per acre so farmers have not been driven as, say, a multifamily investor might, to maximize revenue which enables them to maximize borrowing which in turn maximizes their return on investment.
These smaller, multigenerational farmers have not been incentivized by the financial system to maximize revenues. If an acre is only worth what a comparable property sold for and is not valued based on the number of income producing trees on the property (or crops or whatever) then there has never been incentive for farmers to think that way. If a farm produces enough income for the farmer to live their lives, send their kids to school, eat out once in a while and not have to worry about money, in many cases that is enough for the farmer and they feel no compunction to upgrade their farms to be more efficient or profitable.
As incomprehensible as this may sound, it is no different as the inefficiencies in the multifamily real estate market that professional investors exploit to add value. A professional sponsor will look for a 30 year vintage apartment building that has had one owner for most of its history. That owner may have maintained the property nicely, kept it fully occupied at below market rents, and never upgraded anything – no kitchen, flooring, exterior shell, landscaping upgrades, for example. That owner, like the farmer, is happy with what they have. A stable, income producing asset that fulfills all their needs.
The professional investor sees more because they understand how to build wealth through adding value, implementing the latest technology and efficiency controls, reducing costs, and driving up revenues.
That said, there are a few variables that factor into what farmland is worth on a per-acre basis. For example, a farm that is vertically integrated with its own packing and sales company, with long-term and well-paying customers, will generally trade for more than a similarly-sized farm whose operation is focused solely on growing. Likewise, the value of the crops being grown on the farmland also influences its value. Higher-valued commodities make farmland more valuable than those harvesting lower-priced goods.
Farmland with a reliable source of water is also always going to be considered more valuable.
Needless to say, most generational farmers – many of whom have had the land passed down to them – are more cognizant of these factors than they are of cap rates. Most farmers have no concept of cap rates and instead, only consider how much they can make to fulfill their daily needs and maintain a standard of living that they are accustomed to (no matter what that translates into using cap rates).
How is Farmland Valued Per Acre?
As noted above, farmland has not historically been valued using cap rates. By extension, the “income-based” appraisal technique is not used because it is not required by banking regulations and which makes it a major deviation from how most other commercial property is valued.
Instead, farmland is valued on a per-acre basis using the sales comparison appraisal technique. The sales comparison approach, which is most often used in residential home sales, uses other farmland sales as the basis for establishing a per-acre value for any farm being sold. The appraiser will adjust the value based on several factors, such as the crop being cultivated on that land, access to reliable water sources, and some other similar factors – much in the same way as a single family home will be compared to other homes based on number of bedrooms and bathrooms, proximity to schools and the like.
In some cases, finding comparable sales can be challenging. There may be no recent comparable sales, or at least none in that general vicinity. For example, an appraiser looking to value a farm cultivated for citrus sales in Fresno, CA will want to find sales data for another citrus farm in that area – recent data for which may or may not be available. Therefore, while the sales approach can be helpful in some cases, it is by no means precise.
The lack of available data, and therefore, the limitations of the sales comp approach, have resulted in farmers having a “sense” for what their property is worth per acre, even if that “sense” is not grounded in solid data. Therefore, one farmer may be willing to sell his farmland for $30,000 per acre whereas the farmer next door, selling the same crops, may be looking to sell for upwards of $45,000 per acre or more.
In neither case is the land being sold based on how much revenue the farm generates (or has the potential to generate).
The fragmentation of farmland ownership, and lack of available data, is one of the primary reasons why farmland prices often appear to be arbitrary compared to other commercial real estate product types and it is this dislocation that provides the opportunity Bravante Farm Capital is looking to exploit.
How do you Calculate the Cap Rate of Farmland?
As noted above, farmland is not currently valued on a cap-rate basis. Instead, it trades on a per-acre basis. However, this is changing and herein lies the opportunity.
Over the past decade in particular, more institutional investors have begun investing in farmland. Farmland appeals to institutional investors for several reasons, including its stability, consistent returns, and low correlation with other asset classes. This makes farmland a valuable addition to any investor’s portfolio, especially those seeking to diversify and mitigate risk.
With more institutional capital pouring into farmland, there will be growing pressure to value farmland the same way other commercial real estate assets are valued: i.e., using cap rates.
As more professional investors move into farmland, the use of the cap rate is becoming more prevalent and is done using the same formula used to derive the cap rates for other income producing-property.
Cap Rate = Net Operating Income / Current Market Value
The net operating income (NOI) of farmland represents a farm’s annual income less all operational expenses.
In addition to not being required by banks for lending purposes, another reason cap rates have not historically been used to calculate the value of farmland is because NOI can vary significantly from year to year depending on the type of crop being grown or by the farmer’s inclination regarding what to plant in any given year.
One off-year (in the case of a severe frost for example) could result in significantly lower income that year for farmland that is otherwise highly productive. Therefore, when calculating the cap rates for farmland, many will use a five-year average when determining the NOI.
But this is largely dependent on the type of crop being grown and the individual farmer’s sophistication. A perennial crop – something that roots long term to the land like an orange tree – is going to provide considerably more predictable and stable income than a crop that is rotated annually. A farmer may decide to grow barley one year on his land and corn the next for any number of reasons and so his income will vary with his whim.
Again, this is not unlike an apartment building owner who inherits the asset from the prior generation. Satisfied with the status quo, the idea of improving that income stream through investment in improvements or technology may simply be beyond the owner’s consciousness. A farm may suffer an avoidable drop in revenues one year because it is poorly managed much in the same way any commercial real estate can.
Farmland is no different. Imperfections in knowledge and capabilities provide opportunity to professionals that are otherwise threats to the amateur. As farming has historically been the domain of the small mom and pop farmer, variations in income streams from otherwise similar properties are the norm and so cap rates have not been a useful tool in calculating value.
Consequently current market value is more difficult to ascertain because the market is far more imperfect than, say, the multifamily is and so pricing is based on the per-acre value which is independent of the variability of income streams.
Therefore, the current market value can be a somewhat arbitrary number that has a significant impact on true cap rates when a farm is operated by a professional farmer and, again, herein lies the opportunity we at Bravante Farm Capital are capitalizing on.
How Cap Rates Impact Farmland Values
As cap rates become more widespread in the world of farmland real estate investing as institutional investors become more active in the field, what sort of impact would that have on farmland values? Let us explore in more detail.
Let us say an owner wants to sell their farmland to an institutional investor. That farm currently generates $7,200 in NOI per acre. The owner is looking to sell the property for $30,000 per acre. That’s equivalent to a 24% cap rate – a staggering number from a purely investment standpoint, and far higher than what most institutional investors are seeking in terms of rates of return.
If farmers started to use cap rates to value their property, this would have a dramatic impact on the valuation.
That same acre of land, if sold at a 10% cap rate, would instead be worth more than double at $72,000 per acre ($7,200 / 10% = $72,000). An investor looking to earn a 6% return might, in theory, be willing to pay even more, perhaps upwards of $120,000 per acre ($7,200 / 6% = $120,000) for that same income stream – an inconceivable number for farmers who today value land solely based on sales comparables.
In other words, in this example, when using cap rates to value farmland, a property that a farmer would have once sold for $30,000 per acre may now be worth well north of $72,000 per acre if sold to an investor who looks at the farm as an income generating instrument and is willing to accept ‘just’ a 10% return.
A farm that is professionally managed may be able to double the NOI which will, therefore, result in dramatically higher farmland values if using cap rates alone. That same farm, if it generates $14,400 per acre in NOI, will now be worth multiples of the purchase price per acre if trading to a buyer who is underwriting to a cap rate and not a price per acre.
What is a Good Cap Rate for Farmland?
Given that cap rates are not widely used to value farmland today, it is difficult to ascertain what a “good” cap rate is for farmland. The cap rate will vary based on the location, the overall market value of the property, and certain factors affecting the valuation such as the type of crops being grown, availability of water, and whether that farm is vertically integrated or not.
In commercial real estate, cap rates generally vary according to the cost of funds rate, or the 10-year Treasury rate, and depending on asset class, location etc., can range from 2% to 6% above that. In the early 2020’s before interest rates began climbing from their historic lows, commercial real estate generally traded for anything between 3% and 6% cap rates. Farmland, which might be perceived as a riskier asset among those less familiar with the sector, can be expected to trade at the higher end of that spectrum or even higher, especially among more risk-averse institutional investors.
An institutional investor might look at two different types of farmland cap rates – the “going-in” cap rate and the “exit” cap rate. The going-in cap right might be lower based on how much income the property earns today. An institutional investor might then look at the various ways to increase the farm’s productivity (e.g., pruning fruit trees, using various water management techniques), just as any investor would deploy value-add strategies at other property types. After increasing the NOI, the investor might then recalculate the cap rate using an “exit cap” based on this higher value.
Typically, the going-in cap rate for farmland is several percentage points lower than the exit cap rate, the spread a result of the farm’s increased profitability.
Here at Bravante Farm Capital, we predict that as farmland valuations become more income based, cap rates will settle in between 10 to 12 percent - which is a significant compression compared to the assets we are targeting for acquisition.
What is the Rate of Return on Farmland?
Most people will look to earn anywhere from a 10 to 20 percent internal rate of return on farmland. For investors, this is generally inclusive of the farm’s revenue streams and the land’s appreciation.
The revenue streams will vary based on several factors, including the farm’s size, location, type of crops, and the profitability of that farm. Vertically integrated farms, such as those that do their packing in-house and use professional sales teams, can be expected to generate higher returns than their less sophisticated competitors.
As more institutional investors enter the fray, farm operations will become increasingly sophisticated and in turn, it is expected that returns will be higher.
In terms of land appreciation, most investors can expect farmland to increase in value by anywhere from 2 to 4 percent per year. The actual rate of appreciation can vary based on both macroeconomic factors (such as interest rates and the prices of alternative investments) as well as parcel-specific attributes (such as location, crop type, soil conditions, water conditions, government payments and the like).
Farmland Appreciation Value vs. Farmland Cap Rate
Farmland, like all land, is never guaranteed to appreciate. However, in recent years, farmland values have increased from 2 to 4 percent per year on average. In fact, according to the U.S. Department of Agriculture, farmland values began rising in 1988 and, except for single-year declines in 2009 and 2016, have continued rising ever since.
Farmland investors benefit from these higher values, which are in addition to the returns an investor would expect to earn on a cap rate basis alone.
For example, using cap rates, an investor can reasonably expect to earn 8 to 15 percent per year on a farmland property. The investor will also benefit from increasing property values, ranging from 2 to 5 percent per year. Therefore, a farmland investor can generally expect to earn between 6-8% cash on cash per year, and more in the long run when the farm’s cash distributions and the value of the farmland appreciation are combined.
It is important to note that a farm’s location plays a major role in the degree to which it will appreciate. For example, between 2016 and 2020, farmland values increased the most in the Pacific States ( +11.3 percent) and decreased the most in the Northern Plains ( -10.0 percent). Moreover, nationally, cropland tends to appreciate faster than pastureland, which speaks to the importance of “what’s being grown” on the land in terms of its appreciation potential.
Conclusion
While cap rates have not historically played a role in the value of U.S. farmland, there is reason to believe they will become so in the near future. Today, farmland ownership remains highly fragmented. Many generational owners are on the brink of retirement, and they, or their children, will be looking to sell. Savvy investors are poised to take advantage of these opportunities as they look to scale their farmland portfolios.
With more institutional investors entering the fray, we can expect both farmland operations and valuation techniques to become more sophisticated. Institutional investors, seeking higher yields and greater profits, will evaluate properties using a property’s going-in and exit-cap potential. Just as they would look for ways to boost NOI at more traditional CRE assets, they are looking to do so with farmland as well. This is fundamentally change the value of farmland, often dramatically, as farmland becomes more profitable on a per-acre basis.
Those who invest in farmland today stand to benefit the most as the industry evolves before our eyes.
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