Cropland & Management Structure Diversification Within Farmland Investing
Farmland has demonstrated strong risk-adjusted returns over the past several decades, is negatively correlated with traditional assets, such as stocks and bonds, and has historically been one of the best inflation hedges, consistently providing returns more than double the inflation rate since before 1992.
That being said, any investment carries risks, and farmland investing is no different. Building a portfolio of multiple properties that have complementary characteristics can be a strong approach to diversify your portfolio, mitigate risk, and help ensure returns over the long-term.
With that said, at FarmTogether we understand the value of total due diligence, deep underwriting of potential investments, and other basics that control the risk of the properties offered on our platform. We are committed to offering only investments that meet our stringent criteria. However, not all risk can be mitigated by a stringent due diligence process, and diversifying your investment dollars not only across a range of assets, but also within an asset and across farmland properties, can help mitigate these potential risks.
In this piece we'll dive into farmland management structure and crop type as key components of building a diversified farmland portfolio. We'll follow up with a sister-article that discusses geographic diversification.
...Let's get started.
A Quick Breakdown of Farmland Management Structures
When you invest in professionally managed farmland, you gain exposure to two main sources of returns: appreciation in the value of the land itself and annual income from the operations of the farm. These sources of returns are tied to how the farm is managed, the types of crops grown, and how much exposure you have to changes in each.
To understand the potential exposure an investor might have to changes in each, let’s unpack the types of management structures common to farmland investment opportunities. As an investor, there are two main modalities of farmland asset management to get to know: lease agreements and direct management contracts.
Lease agreements in farmland work very similarly to leases in other types of real estate, but with a few key differences. With leased farms, a tenant operator will perform all duties related to the operation of the farm; they will earn income from the sales of the crop, while paying the landowner a rental fee. Rental fees can have both fixed and variable components, and in cases of variable rent, the variation is often derived as a share of crop income or as a function of the land’s appraised value. When you invest in a share of a leased farmland deal, your annual income during your hold period will be a prorated share of this rental income.
Direct management contracts essentially flip the economics around between landowner and farmer. Rather than collecting a rental fee, the landowner pays a professional farm manager an annual fee for the services of operating the farm. The landowner makes annual income from the sales of the crops grown, net of the management fee paid to the farm operator. When you invest in this type of deal, the annual income you earn during the hold period is directly linked to gross crop income, which exposes you to fluctuations in commodity prices in the markets that your farm’s crops are sold into, but also carries various types of value-added potential.
Both of these management arrangements present farmers and landowners alike with economic advantages. They can both be good options for farmers who want to increase their operation’s footprint without sacrificing liquidity by buying additional land, as well as for land investors who don’t want to manage the farm themselves, but who do want to benefit from farmland assets’ annual income and appreciation.
Leases and direct management contracts are two great options that enable access to farmland as an investment opportunity.
How Does The Management Structure of a Farm Shape Your Investment?
The management structure chosen for any particular farmland investment is what defines the type of annual income the investment will generate. Leases will typically fluctuate less, in that the parameters of the cash income investors receive are set in the terms of the lease itself. With less exposure to commodity price fluctuations, you have a clearer picture at the outset of what to expect your annual income to look like in each year of the hold period.
Direct management contracts, on the other hand, entail more exposure to commodity markets in that investors’ annual income is directly tied to the prices that the crops harvested on the farm ultimately fetch in the open market, and commodity markets can fluctuate. With this type of deal, you are exposed to various factors impacting crop prices - everything from environmental conditions shaping production at a macro level to international market changes - as well as to production risks on the farm in which you are invested.
This exposure, however, is just as significant a source of upside, especially in crops with high varietal differentiation, such as apples or citrus, as well as value-added potential from certifications like USDA Organic. In fact, direct management contracts are ideal for these kinds of crops.
To explain why, let’s take a moment to explore the differences in crop type across farmland deals and tie them together in a few example deal structures.
A Quick Breakdown of Crop Types
The two most common types of cropland investments are row crops and permanent crops. Both are hugely diverse categories of cropland unto themselves and represent wide ranges of investment opportunities. For now, we’ll focus on one key difference between these two types of farmland that plays the biggest role in diversifying your farmland portfolio - the crops’ life cycle and development timeline.
Row crops, generally speaking, are planted, cultivated, and harvested annually. Farmers will select which varieties they plant each year, and will often rotate crops among different fields to balance soil fertility, water demand, pest and disease pressure, and other agronomic considerations. Some regions, depending on their climate, may even have multiple growing seasons within one year, in which a farmer can harvest one crop and plant another immediately afterward, allowing the farm to generate income from multiple crops on the same field.
Permanent crops, on the other hand, have a multi-year life cycle entailing a management style that keeps the same plants growing on the land “permanently”, often for more than a decade. Tree fruit, tree nuts, and vineyards are examples of this crop type. Some crops in this category - think of pecan orchards or “old-vine” vineyards - can have productive lifespans of 50 years or more with proper, consistent management. Although these crops can’t be swapped out every year, a farmer might grow several varieties on one property in order to take advantage of differences in harvest timing among those crops, allowing the farm to earn money multiple times per year depending on when each variety is harvested and ready to bring to market.
How Does The Type of Crop Planted Shape Your Investment?
Row crops typically represent the most stable category of cropland because of the flexibility the farmer has each year in deciding what to plant. If commodity prices suddenly face headwinds, or if pest or disease pressure with one particular variety is constraining production, the farmer can simply decide to pivot and plant a different variety or even a different crop altogether in the next year. These annual planting decisions allow the row crop farmer to navigate the uncertainty in successive growing seasons with more agility, and to rotate varieties in and out of production based on favorable characteristics. This provides support to both the prices the farmer ultimately receives, as well as to the overall amount of crop harvested.
Permanent crops, on the other hand, represent a different type of investment given the multi-year life cycle of a single planting. Removal of an existing orchard or vineyard is expensive, and thus a successful permanent crop investment relies on either planting a new orchard that will mature into a high-yielding, high-priced farm after several years of development, or maintaining the health and productivity of an existing planting.
That being said, this multi-year life cycle is also a key feature of permanent crops’ upside. When you purchase a parcel of farmland that you intend to use for row crops, you are essentially buying the bare land itself and comparatively minimal infrastructure needed for farming. When you buy a parcel that you intend to develop to permanent crops, you are actually making an investment in both the land and the infrastructure you need to grow the crops, which includes a specialized above- and below-ground irrigation and input delivery system, a trellis system for supporting the upward growth of the trees or vines, pruning and other annual maintenance of the plants, and more.
These extra components constitute “improvements” to the farm that are ultimately captured in appreciation on the price of the land. In fact, these improvements can represent up to 50% of the value of the property at exit. Therefore, mature permanent cropland usually sells for much higher per-acre prices than row cropland does.
Examples of Risk and Reward Involved in Farmland Investment Deals
With these factors in mind, let’s take a detailed look at a few archetypal deal structures common to farmland investing and walk through the reasons to diversify with each one.
Row cropland deals are almost always structured as leases. Most growers who produce commodity grain or oilseed crops, such as corn, soybeans, and wheat, are ultimately “price-takers'' in their respective end markets. Though there are exceptions, these crops generally feature fairly little variety- or organic-driven price differentiation. Therefore, a lease agreement that includes a base rent tied either to the land’s value or to a “base-case” assumption of commodity price is a very common deal structure. This gives the farmer the flexibility to operate as they choose to, including to plant varieties that maximize yields and farm profitability. It also allows the investor some upside if commodity prices exceed expectations, but protects their portfolio from price volatility given the nature of lease agreements.
Meanwhile, permanent crop deals can just as commonly be structured as direct management contracts or as leases, and which structure makes the most sense depends on the specific crops in question as well as their development timeline.
A permanent crop deal might be structured as a lease if the farmer has plans to operate the same property over a very long term, but the investor wants to guarantee a certain amount of short-term annual income. For example, pecan orchards have productive lifespans of over 50 years, but might take 5 years to come into production and even more to be producing at full maturity. A farmer might want to lease an orchard for most of that productive lifespan, anticipating that their income from the sale of the crop will grow over time, but the investors who own the land might prefer to have at least a small amount of annual income guaranteed in early years of the orchard’s development, including before the trees are yielding a crop. In these cases, a long-term lease with base rent tied to the land’s value can be an excellent option.
This structure ensures a certain amount of annual income reaches the investor throughout the pre-productive period, allows the farmer to reap the benefits of the crop’s eventual upside, and also allows the investor to exit the property and capture appreciation from development by selling it during the lease term - either to their tenant operator themselves or to another landowner who wants to expand their own portfolio with a mature, “turn-key” orchard.
Still, permanent crop farms are very commonly structured as direct-managed contracts in cases where the crop presents lots of value-added potential. Apple orchards or citrus groves, for example, represent opportunities for the farmer and the investor to jointly decide to plant varieties that they believe will command a premium in the market. Sometimes, specific varieties can even come with exclusive marketing agreements - such as Wonderful’s Seedless Lemons or Stemilt’s SweeTango® Apples - which further reinforce their value to consumers, and therefore reinforce the income that investors can receive from the sale of the crop. Couple a situation like this with an organic certification for an additional price premium, and you have the ideal management structure for investors in permanent crop farms who want to maximize their potential income from a high-differentiation crop, and who are willing to pay a professional manager for best-in-class operations of these very specialized farms.
Diversification is Key To Success in Farmland Investing
Overall, diversification is a key strategy to help ensure long-term returns. FarmTogether has built its management portfolio with this in mind. We aim to bring you a range of diverse opportunities, across deal structures, commodities, and geographies, which we’ll dive into in our next article, to ensure that our investors can build a balanced portfolio of farmland assets, taking advantage of our team’s expertise and leveraging the optimal deal structure in each investment for maximizing long-term returns.
Our most recent deal, Goldenrod Pecan Orchard, is a great example of a permanent crop development that promises stable income from rent during the orchard’s pre-productive period, as well as potential upside from the sale of the crop itself based on a crop share component to the lease agreement. Investors are able to capture appreciation on the property after the orchard’s development is complete, with a planned exit at year 10 ensuring that the property is of interest to commercial pecan growers who want to expand their own production on a turn-key orchard.
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Disclaimer: FarmTogether is not a registered broker-dealer, investment adviser or investment manager. FarmTogether does not provide tax, legal or investment advice. This material has been prepared for informational and educational purposes only. You should consult your own tax, legal and investment advisors before engaging in any transaction.