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Capitalization rate or cap rate as it is more commonly referred to, is most simply explained as the return on investment (ROI) expected over the life of the investment. Cap rate is the net income generated by a farm (which is the cash rental rate per acre minus expenses such as property taxes) divided by the interest rate. The graph below provides the example of the cash rent of $217 per acre divided by the interest rate or expected ROI of 3% which equates to a land value of $7,233 as shown by the red line. This means that if you can receive $217 of rent per acre from a farm and you want a cash return of 3% annually, that a buyer could pay $7,233 per acre for the farm.
The importance of projections when establishing purchase prices for farmland comes into play when one is trying to establish expected ROI and future interest rates. Again, using the graph for an example, if one expects cash rental rates for this farm to move to $300 per acre and cap rates (interest rates) stay at 3%, then a buyer could pay $10,000 per acre for this farm. But if interest rates move higher with a resulting increase in ROI expectations, then the cap rate will increase. For example, if income stays at the $217 per acre level, but cap rate expectations increase to 4%, the equation moves to the blue line and one could pay $5,425 for the land. If rent was $300 per acre at the 4% rate, then the land value would calculate out to $7,500 per acre.
This demonstrates the importance of understanding current and future economic factors in making pricing decisions when buying farmland. One cannot predict the future but it is good to have thought through income and risk factors over a period of years when making the long-term decision to purchase farmland.
Thank you to David Widmar and Brent Gloy of Agricultural Economic Insights for the graph and calculations.
Senior Vice President - Real Estate Operations
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