This post is our second of a four-part series where we discuss the process of selling a farm. If you haven't yet read the introductory post, you should do so first.
This article also provides good information for those who might be interested in purchasing a farm, either by understanding how AcreTrader’s process works or by doing their own research. However, this is not by any means the only resource one should use. It is a thorough introduction meant to help guide one’s own research and understanding.
A Seller’s Guide to Farmland: Price
As we mentioned in our first post on selling farmland, price is the first component that most consider when selling an investment. Many factors will play a role in determining price. The next posts in this series will dig deeper into the conditions that might raise or lower a price. However, for this piece, we will look at how investors and farmers tend to find the starting value of a property.
Land investors value land two primary ways - comparable sales and capitalization rate. While these two valuation methods can be done independently, they often affect one another.
Comparable Sales
Comparable sales, also known as “comps,” are core to understanding the value of a property. Unlike the stock market, land does not sell on a daily basis much less a second-by-second basis. Further, every piece of farmland is unique and not exactly like any other. Therefore, it can be more difficult to determine what the price of any particular property should be.
The best way to compare a farm is to look at nearby sales and adjust their prices by the value of the different qualities each might have. For instance, consider a non-irrigated property which might have sold for $3,500 per acre nearby an example irrigated, top-tier property of similar quality.
If the value of irrigation were estimated at $500 per acre, then an investor would take the value of the non-irrigated comp and add $500 to the per acre price ($3,500+$500=$4,000). This would give the seller an idea of what might be a good price to list the property.
A seller should look at many different comps to understand the prices in a given area. Any single property might have been sold at a higher or lower price due to issues which might not affect the seller’s land. For example, a farm in foreclosure might sell at a lower price because a bank would rather sell the property quickly than hold out for the best price. Or, a large family farm may meaningfully overpay for a long sought-after neighboring parcel.
Usually, five to ten comparable properties can give the seller a good idea of what local market value for a property may be. As with any research, the more data points one has the better one’s understanding of the situation.
A high-quality land valuation will consider many different farm qualities by which to adjust comparable sales. These might be irrigation, drainage, soil type, road access, number of tenants in an area, availability of places to deliver the crop after harvest, and many others. Ideally, though, comparable sales will be close in quality to the land that is being sold.
In other words, a potential buyer should be able to understand the property well enough to throw out the comparable properties that are not close enough in quality, while also identifying enough comps of a similar quality to value it against.
Unfortunately, these comparable sales can be difficult to find. This is one advantage of working with an experienced seller or broker like AcreTrader. People who see many sales a year in a given area will be able to quickly estimate what a seller’s property may be worth.
The best investors and brokers will follow up on this intuitive understanding with in-depth research and financial modeling on a farm. They will analyze many sales in the local area and region and derive a fair market comparable value for the property. This will be a starting point for any further discussion of terms a seller might desire (which we will discuss in later posts).
Comps and county average land prices can be found through courthouses, brokers, bankers, land managers, government websites, other farmers, and even some new technology companies like FarmlandFinder or AcreValue. However, throughout the research process, many times a seller may find dated or incorrect information that can be misleading. Keeping a constant eye on the market and having experience with many different sales is an advantage to any seller.
There can be limitations to this practice as well. Since comparable sales are backward looking, they only tell you what people have recently paid. Further, this data is often delayed by months or longer.
Comps also do not tell what kind of annual cash return can be expected on a property. There may be a localized buyer who is driving prices up. Paying too much for any property can hurt the long term return, as can buying a “cheap” property with poor rental prices.
Avoiding value traps like this is imperative to making a good purchase. Knowing not only the local market but also the regional and national markets for land provide a material advantage.
Capitalization Rate
Capitalization Rate, also known as “cap rate,” is the expected rent as a percentage of the purchase price of the land (for example, $5 rent on land worth $100 equals a 5% capitalization rate). Most land investors will have a percentage range they hope to hit and will need to adjust either the rent or the purchase price accordingly.
Like any equation, a cap rate can be misleading. For example, buying a farm for $1,000,000 per acre and receiving a $50,000 per acre rent will give a 5% cap rate, similar to buying a farm for $10,000 per acre and receiving $500 in rent. However, at $1,000,000 an acre, the buyer would be grossly overpaying based on inflated rents. A seller must have a thorough understanding of what is typical for both sides of the equation to value a farm.
Average rent and farm prices can be found in many of the places that comps can be found. The helpful thing about cap rates is that many more sources may be used. Usually land of varying qualities sells for similar cap rates.
Of the two components of cap rates (rent paid and value of the land), true market rent is the more difficult to find. Government surveys will report an average rent paid, but they are dependent on those responding to the survey. There is little data to show the quality of responses and quality of farmer who responds.
For example, while unlikely, what if fifty percent of those who responded to the survey in a given county went out of business in the following year? In that scenario it would be likely that a large number of the respondents were paying too much in rent.
Those who rent land themselves, those who rent their land to good farmers, those who sell land frequently, and those who lend to farmers will know the typical rent in a given area. They will likely know the typical farm price and be able to tell you a typical cap rate as well.
The limitations of cap rates can be linked to expectations as well. Many farm investors would love to have rent equal to twenty percent of the purchase price of their land, but this is virtually unheard of under normal circumstances. On the other side of the equation, many sellers would like it if their buyer expected one percent rent on their investment. Understanding a buyer’s motive and expectation for their return can help a buyer price their land.
Most often a seller aims for a buyer’s cap rate range rather than any particular number. The final price will then come down to negotiation and the buyer’s ability to set a rental rate that makes sense for both the buyer and the farmer.
Combining both methods
These two methods are often combined to find the price at which the property is listed. Comps help the seller find typical prices, and a buyer’s return expectations and rents in the area help back into what price could be paid. Most often these numbers are similar. When they are not, a seller must do more research to understand which number is incorrect and adjust one or both to align a price with what the market will pay.
Ultimately this process requires not only market knowledge of rents and prices but also of farmers and farm budgets. This way a seller can understand what a buyer will be able to expect of a tenant in the future. The only way for a property to continue to return rent and gain value in the long term is to have good farmers who are able to make money and take care of the farm. They are the ones who work the land and keep it productive.
To find out more about selling a farm or investing in land, contact us here.
AcreTrader knows farmers, sellers, buyers, and farmland markets. It’s what we do.