Mitigating Risk in Farmland Investments
Originally published December 20, 2018. This article was edited to meet broker-dealer compliance guidelines in April of 2023.
While farmland has historically shown stability and even appreciation during times of economic difficulty, the very nature of farmland is not risk free in that it is exposed to the elements, to water supplies, and to macroeconomic factors. Farmland as an asset class has its own set of risks that investors need to be aware of.
Thankfully, many of the risks that can come with owning farmland during turbulent times can be resolved with the right financial structures. This article will explore some of the most common concerns associated with farmland investing, then talk through a few historically reliable ways of mitigating those risks to protect your farmland investment.
Contents
- What Are the Risks of Farmland Investing?
- Farmland’s Intrinsic Resiliency
- Methods for Decreasing Farmland Investment Risk
- Final Thoughts
What Are the Risks of Farmland Investing?
Like all investments, farmland investments come with risk. Some that are most relevant to farmland include operational risk, commodity price and land value risk, and limited liquidity.
Operational Risk
This refers to the potential success or failure of a farmer’s operation depending on a variety of factors, including weather events.
Perhaps a California permanent crop farmer’s water allocation is reduced in a tough drought year. Or Midwestern farmers endure a worse-than-usual infestation of corn rootworm. Or a Pacific Northwest timber plantation is threatened by wildfire. Or maybe a few financial setbacks compromise a farm’s business health. These are all examples of potential operational risk.
Commodity Price Risk
This refers to the potential negative impact of falling commodity prices on the market outlook for the crops produced on a farm. If you have a revenue or flex share arrangement on your land, this could hurt your profits, or it could adversely affect the ability of a farmer to pay rent.
Commodity prices are notorious for swinging in different directions and are the result of many different factors, from geopolitical events to climate pressures.
Land Value Risk
This refers to the potential for farmland prices to fall below what you originally paid for a property and could result from extreme economic pressures.
It is important to remember that no matter how historically stable an investment is, there is always a chance for that investment to depreciate in value. Factors like weaker demand for popular commodity crops, productivity gains leading to more crops in the global market, or large export sources disappearing can all lead to income losses for farmers, which would therefore lead to lower land prices and are intertwined with commodity price risk.
Limited Liquidity
This refers to the inability to sell your land when you want or need your original investment back.
Real estate is generally viewed as a long term investment. Farmland in particular operates on a seasonal schedule and is in active use much of the year. Land markets and investments in them are relatively slow to transact, especially in comparison with stock markets, where you can buy or sell shares at the touch of a button.
While some of these risks are intrinsic to investing itself, many can be mitigated with smart financial structures and investment strategies.
Farmland’s Intrinsic Resiliency
Before we dive into risk mitigation practices, it’s relevant to revisit farmland’s inherent strength as a time-tested asset.
Notably, farmland values have only declined a few times during the last 50 years—most markedly during the interest rate and oil crises of the early to mid-1980s.
Source: USDA
In the graph above, you can see the effects of the farm crisis of the 1980s, which was precipitated by a decrease in export sources, extremely high (~20%) interest rates, and an over-leveraged farm economy.
Even during those years, land was still producing commodities—and annual cash rent yields of 5-8%. That left the farmland owner with only around a -3% return, and land values have since rebounded by more than 400%.
Today, there are multiple indicators that the farm economy is somewhat protected from a return to the conditions of the 1980s, including stable debt-to-asset ratios (see the farming sector solvency figure later in the article).
Farmland’s performance in the 1980s highlights one of farmland’s strengths as an investment, namely, that it produces a return in two ways: annual income and appreciation. And both components tend to move in cycles that are not necessarily related to each other.
Methods for Decreasing Farmland Investment Risk
1. Cash Rent
Rental contracts for farmland vary widely between regions. The two most common types of rent contracts: revenue share and cash rent.
Revenue share, also known as crop share, pays the landowner a percentage of the crop produced on their farm at the end of the year. While crop share arrangements can add some additional upside to the returns, they can also add risk to the investment by giving the landowner:
- exposure to the operational successes and failures of the farmer (including weather risk), and
- more direct exposure to commodity markets, since the landowner's crop will have to be sold.
Cash rent is a lease paid to the landowner annually. Importantly, the rent is a fixed dollar amount per acre agreed upon in each lease. Leases are typically 1-5 years long. Furthermore, cash rents may be negotiated to be paid up front, ahead of the planting season and the emergence of any potential risk factors.
Cash rent is the number most often discussed in farming circles and researched by the USDA. Good data is available about state and county average rents, which allows investors to understand an individual farm compared to others around it.
For AcreTrader farmland investors, cash rent provides stability without an immediate link to commodities markets or weather risk. This allows investors to have regular, stable rental returns while allowing the land itself to appreciate over time.
Source: USDA
2. Diversification
Another source of stability is diversification of farm property.
The more varied properties an investor can own, the more likely their income stream will be stable. In any given year a property may be in an area where there is a drought or other weather related problems affecting production.
As discussed above, this will generally not affect any given year’s rental income since the rent is negotiated at the beginning of the season. However, a series of problems in an area could reduce the frequency in which it is appropriate to raise rent alongside a farm’s typical productivity increases and economic inflation. In other cases, rent could even decrease.
Any landowner needs to work with farmers to make sure rent is fair to all parties. However, owning multiple properties reduces the risk that the entire portfolio could experience these challenges at the same time. For farmers themselves, who often have most of their net worth in the region they farm in, AcreTrader can provide a valuable diversification opportunity into other farming regions as well.
AcreTrader provides a flow of different investment options to allow investors to build their own portfolios of land decrease their concentration risk.
3. No/Low Debt
Leverage creates a different problem for farmland owners. The fixed cost of a farmland payment can cause issues with the variable revenues farms often generate.
For instance, if a farmland investor purchases land and cannot make their debt payments, then they risk losing their investment to the bank.
For this reason debt ratios have been low since the 1980’s when many landowners held too much debt on their land.
Source: USDA
The most stable investors and funds are cautious and calculated about using debt to purchase farmland.
Row crop land can be purchased outright and should generate income from the investment in the first year with no risk of debt default. For this reason, AcreTrader typically fully funds all row crop farm offerings at closing and places no debt on the subject property.
Because permanent crops like nut and fruit trees take some time to reach full production, a level of debt is needed to finance the early years of the operation. In these cases it’s critical to have stable LTV (Loan to Value) ratios and strong debt terms to mitigate risk. While it is not uncommon to see commercial real estate loans with LTV ratios over 80%, AcreTrader permanent crop investments generally take on debt equal to only about 25-55% of the value of the underlying property.
AcreTrader’s Debt Alternative for Farmers
In fact, AcreTrader provides an alternative to debt for farmers:
A farmer may identify a property that they would like to operate but aren’t able or prefer not to purchase on their own. The farmer can bring the opportunity to the attention of the AcreTrader team. If it's a good fit, AcreTrader will work with the seller and local brokers to potentially create an offering on the AcreTrader platform for purchase by investors, then lease the land to the farmer.
As mentioned earlier, the farmer can also have the option of investing fractionally themselves in the property they will be farming or others on the platform.
This way, the farmer can increase their acreage under operation but avoid taking on the major expense of land, while still gaining value from land appreciation in proportion to their fractional investment.
Method #4: Long holding periods
One of the prime advantages of farmland is its ability to store value and appreciate over time.
Farmland’s value depends in part upon the demand for food and the amount of land available to grow that food. As the world’s population increases and the amount of arable land decreases, land assets may grow in value.
Source: USDA and World Bank
While there may be fluctuations in the price of farmland during small periods of time, over long periods of time the value has increased greatly. AcreTrader purposely offers investments with longer holding periods to take advantage of this feature of farmland.
5. Liquidity
All this said, sometimes you just need to get your money out of an investment.
And it can be complicated in farmland markets. If the greater market is doing well, but the buyer pool is limited in a given area, a landowner could face a long wait to find liquidity. Further, selling a farm can be a tedious and complex task on your own.
On the front end, AcreTrader investors bring a new buyer option to the table for landowners looking to sell.
On the other side, those who have invested with AcreTrader may be able to personally sell their farmland shares following a mandatory one-year lockup, subject to compliance with state and federal securities regulations.
Final Thoughts
Many factors can contribute to risk in farmland investments. However, if investments are made with these factors in mind, investors can help protect themselves during hard times.
- While prices can fluctuate in the near term, farmland investments have proven to be resilient and high-performing in the long term.
- AcreTrader takes these risks into account with models that strive to reduce some of the risk for both investors and farmers.
- The structures covered here properly implemented with a balanced approach can help investors attain even more stability in an already highly attractive asset class.
Learn more about how investing in farmland works through AcreTrader.
The above content is not intended to be a comparison between products, but is intended for general, educational and informational purposes only. Any performance noted is historical and there is no guarantee any trends will continue. All investing involves risks, including the complete loss of principal. Diversification does not guarantee a profit or protect against loss in a declining market. It is important for each investor to review their investment objectives, risk tolerance, tax liability and liquidity needs before investing. Investment vehicles have differences in fee structure, risk factors and objectives. Investments are considered speculative, involve a high degree of risk and therefore are not suitable for all investors.
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