Cap Rate Compression and What It Means for Farmland
One metric of special interest to investors in real estate is capitalization rate, more commonly known as cap rate. The cap rate helps define the profitability of investment in a particular property.
Certain market conditions can cause a phenomenon known as “cap rate compression.” This happens when increases in property values are accompanied by decreasing cap rates, (provided net income—often rental rates—remain steady).
We see the same phenomenon in farmland markets, and at surface level, it can make the annual returns look less attractive. However, cap rate compression is generally temporary, and it can present opportunities to investors when the calendar flips and rental values are reset. This article explains how.
(Note that there are two primary ways that people make money from investing in farmland. The first is long term appreciation of the land over time, realized when the farm is sold. The second is an annual yield which is typically generated from rent payments made by the farmer. This article will focus solely on the yield component, which is the part that figures into farmland cap rates.)
What is Cap Rate, and How Is It Calculated?
Cap rate is a valuation measurement that calculates income as a percentage of investment. It’s used to make comparisons between properties and evaluate the suitability of a deal. The standard cap rate formula is:
For farmland, cap rate is determined by two factors: purchase price per tillable acre and rent per acre. Here’s how that equation looks for farmland:
As an example, take a farm that was purchased in 2019 for $100/acre. A farmer has agreed to a two-year lease for $4/acre. That makes the cap rate for this farm is 4% (i.e. 4 / 100 = 0.04).
(Note that AcreTrader cap rates don’t include non-tillable acres. A farmer won’t be renting out wooded acres, ditches, etc. from us to plant crops, so we don’t consider them in our calculations for how much revenue a farm will be receiving on a per-acre basis.)
Cap Rate Compression
Cap rate compression has historically occurred over most leased assets. It typically happens during inflationary periods. The price of assets goes up, which, with all other factors remaining equal, brings the effective cap rate down.
Let’s continue with our example from above. Say farmland values have gone up, and the farm is sold in 2020 for $120/acre. The 2-year rental agreement is still active, so it remains at $4/acre. Because the value of the land has increased, the cap rate has been “compressed” to 3.33% (i.e. 4 / 120 = 0.033).
In many forms of real estate, long term leases are common—10 years, 20 years, or even longer. Locked into this kind of rental structure, cap rate compression can significantly hurt long term returns.
The Relationship Between Farmland Cap Rates and Commodity Prices
One major advantage of farmland investments as compared to other forms of real estate is that most farm leases have shorter term rent structures, often 1-3 years, so rent values are reset more frequently. What’s more, rent values tend to track with changes in commodity prices.
For context, corn, with its myriad uses, is the most widely produced commodity in the United States. Prices for corn fluctuated between $3.43 and $4.50 per bushel in 2019. In 2021 it remained above $5.00 and, while briefly, was as high as $7.73.
With upward cycles in commodity prices, we tend to see more meaningful and immediate improvements in cap rate. That’s because when the price of a commodity grown on a property rises, it becomes more profitable to farm that land, and farmers are willing to pay a higher rent value.
So, looking at our example farm, let’s say that one year after buying the farm, the two year lease agreement reached in 2019 is up, and it’s time to renegotiate the rent.
In this example, both commodity prices and average rent values in the region have increased dramatically in the two year span. A new rent agreement is settled at $5.50/acre. The purchase price of the farm last year remains unchanged ($120/acre). Following the calendar flip and the updated rental agreement, the new effective cap rate is 4.58% (i.e. 5.5 / 120 = 0.0458).
Gross Cap Rate Vs. Net Cash Yield
As in any business, there can be differences between top line revenue and profit that is distributed to owners.
Gross cash yield is an alternative term for cap rate and the most commonly used metric in the farmland industry.
Comparing gross cash yield for similar farms is a way of asking, “How good a deal am I getting given current market conditions?”
We know investors also care about net cash yields, or what return is actually anticipated to be paid out to investors each year. In addition to gross cash yield, net cash yield is also visible on the Financials tab of each AcreTrader offering. This value is arrived at by subtracting any expenses to determine what will be remaining to distribute to investors.
Sample financial summary from a previous AcreTrader offering. Note that gross and net cash yields are estimated at the time of offering; changes in farm rents and land prices may alter estimated returns.
Let’s say that in 2021, our example farm brings in $5.50/acre in rent. We pay out $1.25 in total expenses for farm management services, property taxes, and insurance coverage (common deductions in our farm offerings), leaving $4.25 to be distributed to investors. The Net Cash Yield in this case would be 3.54% (i.e. 4.25 / 120 = 0.0354).
Generally speaking, you will tend to see cap rate compression in inflationary markets like 2021 across many forms of real estate in the U.S.
When it comes to cap rates, farmland is arguably one of the best real estate investments because of rental rates’ responsiveness to commodities markets. Shorter leases and a close connection with commodities prices mean that cap rates tend to track land values pretty closely.
Visit our offerings page to see current farmland investment opportunities.
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