What is farmland like as an asset class?
Farmland is a natural inflation hedge that is non-correlated to other markets, making it a unique asset class. Its steady returns and low volatility are attractive to investors with a long-term outlook. Investors in farmland see returns from yearly rental payments, but the biggest return comes from the appreciation of the land realized in a sale. Farmland also acts as an inflation hedge because as the cost of goods rises, the more valuable the crops that farmers grow become. Of course, as the cost of food rises, the amount farmers can get for food crops rises, but this also holds true for raw material crops as well -- for example, corn for ethanol and biofuel purposes, or cotton for clothing and manufacturing. While investors can get exposure to agriculture via commodities markets, those demand a high level of knowledge and come with a higher degree of risk.
Because much of the return in this asset class comes from the eventual sale of the property, the purchase price of the farm is of utmost importance. Much like with commercial property, the most accurate way to price a farm is from the financial projections based on potential rent and expenses. Historical land appreciation in the area is also important to consider, though it may not be relevant to individual farms.
However, unlike with commercial property, it is very tough to value farms based on comparables, as the specific characteristics of individual farms as discussed above are the drivers of value. There is also a lack of good data with sales records hard to find and generally unreliable, and crop and yield records even more difficult to track down. Very few farms keep accurate records or provide audited financial statements.
What should you look for with farmland?
When analyzing a potential farmland investment, there are three categories to consider - Land, Crop, and Farmer.
Let’s start with land - the most important aspect of the three, because without good quality land, the other two factors won’t matter. You can replace the crop or replace the farmer, but you can’t replace the land.
As you might expect, access to water is extremely important and has received a lot of coverage due to California’s ongoing drought. Water can come from an onsite well, from an onsite or offsite surface water source and can come from rainfall. The question is whether the sources available are high quality. Does the well provide enough water? What are the local laws for access to surface water sources? Who controls access? In the driest circumstances with peak demand, will there still water? How much rainfall is there in the area? What is the timing of the rainfall - if it is not spread out throughout a growing season, that presents an issue. What is the variability of the rainfall? Are there some years with a lot, followed by years of drought? Also of importance is whether the land is irrigated, which makes water use much more efficient.
While drought gets the attention, there is also the problem of too much water in some areas, and in those areas drainage is crucial. Some farms have installed drainage tiles beneath the soil to help with water runoff. The topography of the land and uniformity of the fields are also factors in drainage, as well as factors in the consistency of crop yields.
Next is the soil present in the land - how healthy it is and what type it is. There are eight categories of soil, and there is a publicly available database that keeps track of soil characteristics in the U.S. The important factors are the tilth of the soil (the size of the particles), the chemical nature of the soil, and the distribution of certain types within the land. The type of soil will determine what type of crops can be grown and will thrive on a certain farm.
The geographic location of the land is important, not just for the weather and microclimate and length of growing seasons, but also for the surrounding infrastructure and community. Is this a farming community, with access to tangible resources but also institutional and local knowledge? How easy is it to transport crops? What is the local labor supply? Are you in a market where you can sell direct to consumer via a CSA or farm to table restaurants?
If the investment is international, what are the macroeconomic conditions in that country? What are the laws relating to title and water rights? Is there liquidity in that country’s land market?
There are also a number of ways to force appreciation through value-adds. Can you drill a well or add irrigation or add drainage? Can you improve soil health? Can you level the land or make other structural changes to improve crop yields? Are there other sources of income, for example renting unused land for hunting and fishing, or wind and solar power? Are there opportunities for mining or drilling? It’s not just the crops and rent that can provide income on farmland.
There are two categories of crops - row crops, such as corn, which are planted and harvested every year, and permanent crops, such as fruit and nuts, which may take years before harvest, but then produce every year without the need for replanting. Row crops make up the vast majority of U.S. farmland, with 85% consisting of the big 3 of corn, soybeans and wheat. Crop insurance, which is subsidized by the federal government, is particularly crucial for row crops because of the annual reliance on a productive harvest. It can mitigate risk factors such as adverse weather events or crop disease.
Because permanent crops generally take years before becoming productive, the capital required for start-up costs is a lot higher than with row crops. The economic risk is higher, but the long-term returns are also generally higher, as they can be lucrative once the tree or plant is producing. Often, permanent crops take a lot more water than row crops, so knowing the water situation is of even greater importance. Traditionally crop insurance for permanent crops protected the yield rather than the tree or plant itself, but that has begun to change.
Ultimately, the crop is going to drive much of the value. Ideally, the crop is one with high demand and low supply that can command a premium price. Usually those are permanent crops and can take a long time to show results. With row crops, the market for those commodities is important both in the present and future. For corn, is ethanol going to continue to be important with the rise of electric vehicles? Will there be a different type of biofuel or diesel that emerges? Will corn and soybeans continue to be needed for feed in a world where meat consumption decreases?
Is the farm able to pivot to a different kind of crop if necessary? What other kinds of crops can be grown there? This will be a huge factor in whether there will be demand for the land even if the current crop loses value.
When looking at the farmer who is going to operate the land, the best measure is historical performance. This gives an idea of their skill set and ability to control costs, which in many ways is just as important as pure yield.
The lease structure is important to make sure the farmer’s incentives are aligned with the owner. Is the lease long-term, to ensure the farmer has the ability to plan for the future and is incentivized to rotate crops to maintain soil health? A farmer with a long-term mindset is going to treat the land better. Is the lease a straight cash lease, or a flex lease, where part of the rent is dependent on yield and crop prices? The latter gives the owner upside if the farm performs above expectations.
From the other perspective, why would a farmer partner with these platforms? Why would a farmer sell their land to investors and stay on to continue farming it? Specifically with these platforms, the structure allows farmers to have skin in the game - they can retain equity in the land and raise capital to expand their operations by buying more land or equipment. Or perhaps they want to raise capital for their day-to-day life or a future retirement. Farming is a capital intensive enterprise and it is a good opportunity to be able to raise funds while retaining equity, particularly with permanent crops that have many non-productive years at the front end. A farmer with skin in the game is also going to treat the land better and certainly will have their incentives aligned with investors.
Finally, an important factor to consider independent of the farm itself is the fee structure of the platform and operator/sponsor. That can often be buried in the offering documents but it will determine exactly how an investor gets paid.