It’s always a challenge to value real estate, especially when it comes to farmland.
After reading Paul Moore's book The Perfect Investment, my perspective on valuing real estate at a professional and investment level changed dramatically.
So many farmers only think about the dollar per acre amount and not what Paul talks about in his book: “cap rate.” Today we’re going to unpack cap rate and how that makes a difference when you’re valuing real estate. You’ll learn how you can put a number on all the real estate values that you operate on your farm.
What is cap rate?
Cap rate is short for “capitalization rate,” which is equal to your net operating income divided by your property asset value. It’s hard to determine your net operating income because the commodities business is volatile. Corn and soybeans go up and down, so your net operating income fluctuates dramatically.
But think about it in terms of five-year averages. Take a piece of land and figure out your five-year net operating income average. (Note: net operating income is revenue minus operating expenses).
Let’s say you’re making $500 net operating income. That’s not taxes and everything, just operating income. If you take $500 and divide it by a good cap rate – let’s say 5% - you’ll get $10,000.
That basically says, if you bought land at $10,000/acre, and you were able to get a net operating income of $500, then your cap rate is 5%. Meaning you’re getting 5% of your money every single year, not to mention the fact that the land’s more than likely appreciating every year, which isn’t even included in the cap rate.
You can apply that to basically any real estate investment. If you wanted to buy a $250,000 house as an investment, in order to get 5% on that, every year you’d have to collect $12,500 in operating income with your rents. That’s your rents minus your operating expenses.
Let’s go back to farmland as an example. Usually, when cap rates are high, the risk is high. But I’d say farmland is often the opposite: when cap rates are low, the risk is high. When cap rates are low, that means you’re not getting a good return on your money.
A couple of years ago in my area, real estate values were $13,000. That land should be able to get you $400/acre. That 400 divided by 13,000 gets you a 3% cap rate—which is not very good.
But nowadays you can buy that same land for $8,000. Divide 400 by 8,000 and you now have a cap rate of 5%.
Let’s bring this straight to your doorstep. If you want to sell a piece of land you’ve been farming for several years, be very transparent about what you’ve made on that land.
Let’s say you’ve made $300/acre operating income, at a 5% cap rate: 300 divided by 0.05 gives you $6,000/acre. So the buying farmer could pay you $6,000/acre for that operation and still be making a 5% return on investment. This is super important when valuing real estate.
Use this equation for all real estate valuation
Cap rate is a nice nugget to put into your tool belt when valuing land. If you ever want to know what a reasonable price is, figure out the net operating income and divide it by a reasonable cap rate, probably 5%-6%. (If you can get 5%, you should take it.)
Also know that a farmer who operates the land himself has a much lower risk because he controls the operating income based on his level of farming knowledge and ability. If you’re an extremely efficient farmer, you’ll be able to afford to pay higher because your operating income will also be higher. That’s how Henry Ford could sell his cars for one-fifth of his competitors—his revolutionary factories were so efficient.
You can refer to the equation in the image above the next time you’re trying to figure out if farmland is worth the investment. I’d also recommend that you not stop there: definitely pick up a copy of Paul Moore’s book and read it through.
Once you do, you’ll begin to realize that valuing real estate isn’t as much of a crapshoot as it seems. On the contrary, you can actually project how good of an investment any land, anywhere, will be.
The opinions of the author are not necessarily those of Farm Futures or Penton Agriculture.
Scott is a South Dakota farmer who formerly worked in investment banking on Wall Street. After the commodity markets crashed, Scott took his financial know-how and built a software program for farmers called Cash Cow Farmer, which empowers farmers to master the business side of farming by knowing real-time field-by-field productivity and profitability. Scott consults with farmers all over the United States on risk and financial management, farm strategy and strategic growth. Contact him at [email protected]