Is Farmland A Good Investment?

Sep 26, 2023 | Uncategorized

The talk of the ag world often revolves around land.

  • land prices
  • land valuations
  • who’s buying it
  • how can I buy some
  • is it a good investment
  • how does this investment stack up to other investments
  • how the heck do you calculate a return on this investment

From an investment perspective, there’s 3 good metrics to use when evaluating a land purchase:

  1. Cash on Cash ROI (ROI stands for Return on Investment)-This is a measure of how much cashflow (profit) is being generated each year compared to the initial investment amount.-It’s a good measure of profitability & seeing how long it will take to recoup the dollars invested, but it has its limitations…-It doesn’t calculate the increase in the value of the land each year. Land is typically a long-term play, with much of the benefit of the investment coming from the appreciation of the land.-It doesn’t consider time value of money. A dollar 5 years from now is worth less than a dollar today, so the cash returns at year 5 may be misleading.
  2. Internal Rate of Return (IRR)-This metric combines the future cash flows (discounted) with the appreciation of the land value over time giving it more of an accurate measurement for real estate.-One limitation of IRR is the projected “sale event” (what the fair market value of the land will be at a target date) is anybody’s guess. And, that impacts the IRR quite significantly.
  3. Equity Multiple-This calculates how many times your initial investment “turns over” during the life of the investment period.-Again, it doesn’t consider time value of money, but does give a good indicator of profits and can easily be used to compare one deal to the next.

Okay, now that we know what we’re trying to calculate, how do we go about it?

We use a proforma to evaluate the deal.

This is essentially a forward looking projection that takes into consideration all the costs to acquire the land, and what the ongoing revenues and expenses will be.

I recently did a proforma for a Braintrust Ag member, so here’s a real life example:

First, our assumptions…

  • 120 acres
  • $9,000 per acre (asking price)
  • No loan needed (100% cash buyer)
  • Current cash rent of $250 per acre

This is what the ten year investment period returned based on those assumptions:

Now, the costs associated with the purchase & how they’ll be paid.

This is called the Uses & Sources

There’s three components to this first step:

  • Soft Costs: the service fees to get the deal done
  • Hard Costs: the actual purchase price of the land
  • Sources: how we’re paying for it (cash, bank loan, subordinated debt, seller financed, etc…)

This was very straightforward deal, since we were looking at it from a 100% cash buyer perspective.

*Note: Uses and Sources must always match.

Also, had we been using a loan on this deal, we’d enter the following info to help calculate the debt service amounts…

Alright, now that we have the deal outlined and our Uses and Sources match, we need to look at the Cash Flow Summary.

-This is where the future revenues and expenses are input, tracked, and calculated to view how much cashflow we can expect per year.

Here, our income is cash rent. (Next week I’m going to evaluate this same deal from a owner/operator perspective & a share crop perspective)

The typical cash rent agreement term is for 3 years, so there’s a built in rate increase at the end of Year 3.

You can see, we’re starting at revenue of $30,000 (120 acres x $250/acre)

*the full Cash Flow Summary carries out revenues & expenses for 10 years, but for the purposes of this post I cut the pictures off after Year 4

Next we enter the operating expenses.

These are the annual costs associated with the ownership of the land. (They increase each year by 3% in this model)

The operating expenses get subtracted from the revenue to give us one of the most important metrics in real estate: Net Operating Income (NOI)

Here, we end up with $25,640 NOI in year 1

Then, below NOI comes our other expenses.

This would be our capital expenditures (fences, drain tile, approaches, shelter belts, other improvements) and our debt service.

These are subtracted from NOI to give us our Cash Flow.

In this example, we don’t have any capital expenditures or debt service (mortgage payments), but most deals will have one or both.

OK, we now know what the purchase looks like and we’ve estimated what the cash flow looks like in the future.

So what are our returns? Is this farmland a good investment?

*I made an assumption of 5% appreciation in value per year of the property based on similar sales, current interest rate environment, and market trends.

This portion of the proforma does the calculations:

And spits out these returns for a 10 year hold period:

Finally, to answer the initial question: Is that farmland a good investment?

The answer: it depends

Farmland is a stable investment that doesn’t print cash, isn’t a get rich quick investment, and is used as a way to balance out portfolios or hedge against inflation.

But, recent years have shown 15+% increase in valuations year over year on some deals. So, if my conservative estimates are much too low (entirely possible) this could turn out to be a very good long-term investment.

If there had been debt (mortgage) on this deal, it would have shown a negative cash flow & not been feasible from a banking standpoint.

That’s why proformas are crucial to put together for potential lenders and investors.

I’m convinced the returns will improve when we evaluate from a share crop perspective and an owner/operator perspective.

If you want to run your own proforma and evaluate potential deals, a copy of this proforma spreadsheet is uploaded to the Resource Library.

Hopefully you found this useful.

If you aren’t already a paid member, consider doing so. Tools & breakdowns like this are coming out each week in our newsletter highlighting:

  • Business Planning
  • Finance
  • Legal
  • Grain/Livestock Marketing
  • Insurance
  • Risk Management
  • and more

You May Also Like