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For investors looking to diversify outside the stock market, real estate is often one of the first places they think to go.
This is for good reason. Real estate is an asset class that has stood the test of time and delivered consistent returns and cashflow.
Within classes of real estate, commercial real estate is where the everyday investor typically thinks to start out. Due to the rise of crowdfunding real estate platforms, it’s understandable why this asset class is receiving more attention as of late.
However, another time-tested investment that is less likely to come to mind is farmland. Farmland has been an asset class ever since our ancestors began growing their own food. As the world population continues to grow, it’s likely that the need for farmland will only continue to grow.
In fact, Warren Buffet has been an advocate for investing in farmland. In 1986, Buffet bought a 400-acre piece of farmland, and in the 28 years following, only visited the site twice.
But if you’re interested in pursuing either of these investments, it’s wise to know the advantages and disadvantages. As investors, it’s crucial that we become educated before deploying our capital.
It is also important to keep in mind that farmland vs commercial real estate is not an either/or decision. With the development of new technologies, it’s possible to invest in both asset classes without much capital or headache.
Historical Returns: Farmland vs. Real Estate
When evaluating any investment vehicle, it’s important to look back at historical performance. While this does not necessarily present a prediction of future returns, it’s useful to know how investments have fared in the past.
Going back to 1990, commercial real estate has returned an average of 8.3% per year. During the same time period, farmland returned 11.5% annually to investors on average.
While this only scratches the surface of comparing the two asset classes, this is often the first question on investors’ minds.
Investors should keep in mind that during this period, the economy experienced the Great Recession. While this made a big impact on commercial real estate, farmland was much less affected. This is for a number of reasons.
First, the need for individuals to eat does not depend on market conditions. Whether the economy is booming or in a recession, families still need to put food on the table.
Next, it’s much harder for tenants to pick up and leave. Farmers are one of the best tenants to have because it’s extremely difficult for them to relocate. You’re pretty much locked into one plot of land for good.
In general, it stands to reason that the returns generated from farmland would be more consistent than those of commercial real estate. From year-to-year, commercial real estate has experienced 8.2% volatility on average, where farmland has only seen 6.7%.
This is a result of a number of factors including the differing risk profiles for these asset classes and how returns are generated.
How Returns Are Generated
Farmland returns can come from one of three sources: capital appreciation, rental income, and crop profits.
Capital appreciation occurs when a piece of farmland is sold for more than it was purchased for. Over time farmland tends to appreciate, and so when it is held for a period of years it can typically be sold for more than it was bought for. The typical timeline on most farmland investments is 5+ years.
Rental income is received from the farmer who is renting the land. In general, this tends to amount to a 3% – 9% cash yield per year. Farmers typically pay rent once per year.
Crop profits are occasionally structured as part of the payment to farmland owners. In some cases, the landowner will own the farm as well and participate in all of the profits. In other cases, the farmer may pay a lower rent and also pay a portion of crop profits to the landowner.
Commercial real estate returns are typically generated in one of two ways: capital appreciation or rental income.
Capital appreciation occurs when a property is sold for more than was paid for it. A difference between farmland is that with commercial real estate, there is more potential for short-term deals. This includes fix & flip deals where investors purchase and improve a property before immediately selling it.
Rental income is typically received on a monthly basis in commercial real estate. However, some leases may be structured on a quarterly or annual basis.
Risks: Farmland vs. Real Estate
Commercial real estate and farmland investors share many of the same risks. This is because both investments involve the purchase of real estate. The key differences come in the types of tenants each has and how outside factors play into the equation.
When it comes to commercial real estate, the types of tenants run far and wide. From high-growth startups, to Fortune 100 companies, to mom-and-pop shops, there is some serious variety here. Farmland on the other hand has one tenant: farmers.
The primary risk posed by commercial real estate tenants is that they will be unable to pay rent. Depending on the tenant and various economic factors, there are a number of reasons this could happen. During recessions, there tends to be a surge in evictions and tenants unable to pay rent.
With farmland, recessions are much less likely to prevent rent from getting paid. However, there are still a number of factors that can make farmers difficult tenants.
A farmer’s income is going to depend almost entirely on the yearly harvest. If something happens to disrupt the harvest, this could significantly impact their ability to pay rent. Three of the most common threats to the harvest are weather, disease, and insects.
In order to mitigate against these risks, farmland owners often charge cash rent prior to planting season. This ensures that rent will be paid regardless of the year’s harvest.
Both farmland and commercial real estate owners face interest rate risk. This is the risk that increasing interest rates will lower the value of future cash flows. When this happens, both types of investors can see the value of their properties fall.
Another shared risk for both types of investors is environmental risk. This is typically a more significant factor for farmland investors, who could see their investment returns dry up with low-quality soil or overuse of pesticides.
Commercial real estate investors experience environmental risk differently. For them, it has more to do with land-use regulations and environmental legislation. When investors purchase older buildings, they run the risk of new laws deeming their properties in violation. When this happens, the cost to update the building can be significant.
Tax Advantages: Farmland vs. Real Estate
One of the reasons many investors are drawn to real estate is the significant tax benefits real estate investors receive. There also exist a number of tax benefits specific to farmland investors.
Tax Benefits Of Commercial Real Estate
1031 Exchange – Allows investors to sell an investment property and immediately buy another without recognizing their gain. This allows investors to continue to delay paying taxes on their gains indefinitely.
Opportunity Zone – Areas deemed as opportunity zones typically fall in low-income areas of cities. If investors hold property in these areas for 5+ years, they can reduce and potentially eliminate their capital gains.
Depreciation – The most widely known tax benefit of real estate investing. Allows investors to write off a portion of their investment each year.
Tax Benefits Of Farmland
Depreciation of Crops – Certain crops like grapes and nuts are allowed to be depreciated as well as farm equipment and improvements to the land.
Land Conservation Trust – By declaring the land a land conservation trust, an investor can achieve favorable property tax rates in every state.
How To Purchase: Farmland vs. Real Estate
In the past, it was very difficult for the everyday investor to purchase either of these asset classes. With innovations in fin tech, the barrier to entry for both farmland and commercial real estate has fallen dramatically.
How To Purchase Farmland
When it comes to purchasing farmland, investors have two main options. Either they can choose to buy farmland directly or go through a crowdfunding site.
To purchase farmland directly, the process will be somewhat similar to buying a home. You’ll likely want to work with a real estate agent to facilitate the deal, and a bank to provide financing. After purchasing a plot of land, it will be your responsibility to find a tenant to rent the land. This is typically not an easy task.
The route that most everyday investors instead choose to pursue is going through a crowdfunding platform. These platforms source deals and perform due diligence so investors don’t have to.
As an investor, you’re able to log on to the platform and browse pre-vetted deals. When you find one you like, you can invest as little as a few thousand dollars into it. That’s because the deal is funded by many investors all investing a small portion of the value.
Through this route, you’re able to diversify across many parcels of land without significant capital. You’re also able to avoid all of the responsibilities that come with managing property.
How To Purchase Commercial Real Estate
Investing in commercial real estate typically takes one of three forms: direct, crowdfunded, or REIT.
Direct investing in CRE is very similar to direct investing in farmland. You’ll likely work with a real estate agent specializing in commercial and find a bank willing to lend on commercial. Then it will be your responsibility to fill your building with tenants.
The crowdfunding route for commercial real estate is also very similar to that of farmland. The main difference here is that your options for platforms to choose from are much greater. That’s because crowdfunded commercial real estate has been around for much longer.
Investing in commercial real estate through a REIT is an option that will be attractive to many lower net worth investors. That’s because the barrier to entry is even lower than crowdfunding.
Typically with crowdfunding, you’ll need at least a few thousand dollars to invest in each deal. Some REITs allow investors to get started with as little as $20.
Investing in a REIT or “real estate investment trust” is very similar to investing in a stock in a number of respects. With a REIT, you’re purchasing a share of a company that exclusively owns real estate. Similar to stocks, these shares trade on major exchanges throughout the day and fluctuate in price.
As a REIT owner, you’ll be entitled to dividends from the REIT. Legally, REITs are required to pay out at least 90% of their profits to shareholders as dividends.
Most REITs will specialize in a certain type of real estate like shopping malls or apartment complexes. This allows investors to make some decisions about their investment, but for the most part, you’re not going to exercise much control over a REIT investment.
Final Verdict: Farmland vs. Real Estate
When considering an investment in commercial real estate vs. farmland, there are a number of important factors. It goes without saying, but the goals and situation of the individual will dictate which investment comes out ahead.
The first consideration is the overall returns of the asset class. Farmland comes out ahead here. By delivering returns that are 3% higher than commercial real estate while experiencing less volatility, this is the clear winner.
There is no clear winner when comparing risk profiles as the risks are not directly comparable between asset classes. Some investors will prefer to take on the risks of farmland, while others will prefer the risks of commercial real estate.
Historically, both commercial real estate and farmland have delivered consistent returns over time. However, with the increasing trend towards work-from-home, the future of commercial real estate is uncertain. As more Fortune 500 companies pull the plug on office buildings, the landscape remains uncertain.
In the end, the decision comes down to the individual. When creating a diversified portfolio, it is likely a good idea to include both farmland and commercial real estate. The negative correlation between farmland and REITs suggests that holding both asset classes may reduce overall portfolio volatility.