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Agricultural Land Investing 101

Investing in raw land can be a lucrative venture, but it requires more than a little bit of expertise to ensure that the payoff is worth the risk. This is especially true with agricultural property, or in simpler terms, farmland – an investment which may not only be financially based, but driven also by a yearning for a lifestyle with a country flair. While some are born into the family farming business, others are city folk seeking the solitude and simplicity rural life has to offer. Regardless of one’s motivation, agricultural property investments are sprinkled with risk, not the least of which is unpredictable weather and volatility of the commodities markets. Proper planning and execution of your purchase can mitigate these risks, but as with any investment, don’t underestimate the potential power and weight of the unknown.

Setting Your Expectations

Property investors accustomed to short-term profits from flipping houses or refurbishing dated office buildings may find themselves in uncharted water in the agricultural business. This is an investment for the patient, hands-on investor. Don’t expect to be earning six-figure incomes from buying up every cornfield in Iowa. Rather, this is an investment for the long haul and at times, an investment of opportunity. There are thousands of examples across the country in which those with the endurance and foresight to look ahead have made a hefty return once urban sprawl inched closer to their land -- tempting speculators and developers, and subsequently drove up the price of open land. These are clearly not investments for the impatient, and setting reasonable expectations can make for a much more rewarding investment.

What Type of Investor Will You Be?

This is a decision that is probably already made for most. Are you seeking to become a hands-on investor, essentially a farmer, or are you looking for a more passive investment in which you either have someone else manage the business or lease the land out? The differences are fairly dramatic. Learning the ropes in the farming business presents a whole new set of challenges for the average investor, while the passive investor can essentially shift a majority of their risk (and headaches) to the lessee. Many lease arrangements include profit sharing and can be a great way for a would-be farmer to get their feet wet in the farming industry. There are advantages and disadvantages to both paths, so if you are still unsure of which direction you’d like to go, it will behoove you to do some research on the pros and cons of each. For example, a passive investor who plans to lease their land may forfeit their capital gains tax exemption status.

Risk, Contracts and Due Diligence

All investments have some element of risk. As a real estate investor, one of your primary strategies should be to diminish that risk. Unlike many other investments, you do have some control over the final outcome, so performing your due diligence and implementing sound legal protections are probably the two most important steps an investor can take.

Contracts
Anyone who has ever bought a home knows how many contracts there are throughout the lifecycle of the transaction, and land deals are no different. While all of these contracts serve a purpose, perhaps the most important to the buyer are contracts that address the initial expectations of the transaction and disclosure of the condition of the property. The Land Purchase Contract or Land Purchase Agreement are the most commonly used forms for making an official offer to purchase a piece of land, but can also be used to outline some protections for the buyer, especially as it relates to recovery of earnest money or deposits and termination of the transaction.

Disclosure laws vary from state to state, with some states requiring full disclosure by the seller, while others live by the old adage “let the buyer beware,” thereby placing the burden on the buyer to perform thorough inspections and inquiries. Either way, it is important to protect yourself with a contract outlining the terms under which the deal can be immediately terminated, hence potentially saving you thousands in deposit money. These terms should include ample time to discover any problems with the land, either through tests or your own research, which will affect the property suitability for your intended purpose.

Due Diligence
While contracts can serve as your first line of defense should a problem arise during or even after the purchase process, performing thorough due diligence is critically important when considering a rural land investment. The old adage that an ounce of prevention is worth a pound of cure certainly applies here. Some questions you’ll want to ensure you have answers to include:

Has the land been neglected?
This includes land that has been overgrazed, water deprived, or simply not maintained for some length of time.

Were there any incidents of livestock disease?
If the land was previously used for livestock, you should find out if there were any issues regarding livestock disease, even if the livestock have been removed. It is not unheard of for the disease to linger for a length of time afterward.

Were chemicals or pesticides used on the land?
While this is common practice and is not a threat by itself, the property should be tested for concentrated areas of contamination near storage and disposal sites. Abandoned machinery and equipment can cause similar problems.

Did the land experience any problems with plant disease, pests or insects?
This is quite common with fruit trees especially, but no tree, plant or crop is entirely exempt from this problem.

What’s up with weeds?
There are weeds that can actually kill other plants. They are often very resilient and hard to contain. Worse yet, there are some states that will hold you liable if they spread beyond your property.

What are my irrigation rights?
Especially in drier climates, it will behoove you to do some research on irrigation rights and whether there are any new legislative measures in the pipeline that may affect this property. You may want to hire a Water Rights Attorney to do the research if this will be a critical part of your operation.

What about soil quality?
There are 4 primary soil types: sandy, silt, clay and loam. Loam is the best soil type for agriculture and is made up equally of the first 3 soil types. Its texture is optimal for proper aeration and water retention. It is important that there is adequate topsoil on the land you are purchasing and you should have the soil tested for humus and nitrogen levels to determine its fertility. 8. Are there any other environmental issues, flood zone information, etc.?

These are just a few of the questions you should consider during the due diligence process. It is advisable to make your own list and get the answers from as many sources as possible, from government agencies to other citizens in the community.

Perhaps your best source of information will be a County Extension Office. The United States Department of Agriculture has partnered with what is known as the Cooperative Extension System, a nationwide, county level set of offices staffed with experts in agriculture, often with specific expertise on local needs and concerns. These offices are specifically set up to provide assistance and advice for those in the agricultural industry. You’ll likely find them just as helpful even after you’ve purchased a property, especially if you are new to the farming business.

Finally, don’t underestimate the power of asking the seller to answer your questions in writing. Even unscrupulous sellers will be less likely to lie once they are asked to put something in writing.

Valuation and Financing

Once you are comfortable with the overall condition of the property, your next step is to determine what price you are willing to pay. As with any other commercial real estate purchase, valuation is very closely tied to the income or potential income it will produce. Just as office buildings are tied to rents, so is agricultural land, although in this case, rent is defined by the return you can expect to receive on the land. Specifically, it is defined as cash rent and measured in dollars per acre. The formulas in their simplest form looks like this:

Rent = Income (before cost of land)

Cash Rent = Rent/Total Acreage

So essentially, a 1,000 acre farm that produces $30,000 dollars of income will have a cash rent of $30 per acre.

To determine valuation, you’ll need one more piece of information known as the rent-to-value ratio or RTV which can be found through the U.S. Department of Agriculture.

This agency has been collecting data relative to agricultural property and incomes since the late 1800’s. You can go to their Web site and find a wealth of information, and for this particular exercise, you’ll want to go directly to their tables of Rent to Value Ratios. This data is very thorough and they have compiled many decades of information to give some surprisingly accurate averages. They’ve also broken the data down by state and region into 3 categories of land: irrigated, non-irrigated, and pasture. On average, 5 to –6 percent is a reasonable RTV ratio, but visiting the site is recommended, as you may find yourself in an area with 8 to –9 percent RTVs. And the higher the ratio, the less you should be paying relative to cash rent.

To get the total value use this formula:

Value per Acre = Cash Rent/ RTV ratio

Using the example above:

Total Value = $30/.06 = $500 per acre
Or
$500,000 for the whole property.

Financing

Financing agricultural land is a relatively straightforward procedure -- essentially, it requires finding a lender with acceptable terms that will enable you to meet your cash flow needs. If traditional financing methods aren’t working, consider looking into owners willing to utilize carry-back loans. These are quite popular in agricultural investment and worth considering, as it will eliminate some hassle and a good percentage of closing costs.

A Word on Farm Subsidies

Originally designed to protect the small family farmer from the potentially devastating effects of the weather and crop prices, farm subsidies have become increasingly more beneficial to the large-scale corporate farms. The rules for qualifying for subsidies have become more complex in recent years and for better or worse, have begun to favor farms that are both large and profitable. Even more disconcerting for some is that the subsidies are based on what you are growing as well. Corn, wheat, cotton, soybeans and rice farmers receive more than 90 percent of all farm subsidies. Grow anything else and you may be left out in the cold. Regardless, it’s worth doing some research to see if your farm will qualify and thereby help mitigate some of your risk.

The Big Picture

While all of this information is valuable in determining the viability of any agricultural property investment, there is one statistic that should give the investor some solace. The Department of Agriculture has determined that over the past 100 plus years, agricultural land has averaged a 3 to –5 percent annual increase in value. Combined with income returns in the 5 to 6 percent range -- you’ve got yourself an investment with an average total return of 10 percent. Using this formula:

Investment Return = Rent + Capital Gains – Property Tax Rate
(Beware of areas where this number is extraordinarily high!)

This is considered to be a reasonable return for an investment of this type, and certainly worth considering if you are in a high-growth area that will eventually drive land prices up further as development creeps closer.