Determining the value of a real estate investment can be a challenge, especially when it comes to farmland. Comparable sales, opportunity costs and price per acre are all good benchmarks to factor into a land purchase. Another important consideration includes evaluating the land’s potential rate of return.
One strategy for measuring the return on a farmland investment includes calculating cap rate. In this article, we explain the basics of using cap rate, how to calculate it and why it’s an important metric.
What is cap rate?
Cap rate, short for capitalization rate, is used to estimate the profitability or potential return of an investment property. In other words, cap rate represents the expected annual earnings or income stream generated over the course of land ownership.
Unlike stock return rates, cap rates for farmland tend to increase in value over time in addition to earning capital gains. Therefore, this metric is more comparable to the dividend rate received on a stock.
When comparing multiple tracts of land, cap rate can be a useful tool for evaluating earning potential at a glance. It can also help give you an idea of how long it will take to recapture your initial investment.
How is cap rate calculated?
To calculate the capitalization rate of a land investment simply divide the property’s net operating income by its current market value.
Capitalization Rate = Net Operating Income / Current Market Value
The net operating income is the expected annual income generated minus expenses incurred for managing the land. For investors who intend to have the land farmed by a tenant, use a market-based cash rent and subtract property taxes and other pertinent ownership costs such as insurance, maintenance or professional land management fees.
The USDA National Agricultural Statistics Service (NASS) compiles county-level statistics for per-acre cash rental rates. You can also check with the local extension office for cash-rental rate information.
The current market value is the present-day value of the property according to prevailing market rates. Keep in mind that while you can use the purchase price to make a quick cap rate calculation, land values will fluctuate over time.
The resulting ratio is typically expressed as a percentage. For example, let’s say you are interested in purchasing 100 acres at a price of $10,000/acre with a cash rent of $240/acre. Divide $240 by $10,000 and you get a cap rate of 2.4%.
Farm real estate cap rates typically range between 2-6% and are subject to variance depending on the location, overall market value of the property and other factors affecting it’s valuation. As you weigh your risk tolerance with your return expectations, it’s worth noting that as an investment, farmland is generally low in cash flow but high in appreciation.
Try our cap rate calculator.
Why is cap rate important?
Overall, cap rate can be a useful land evaluation tool for several reasons. First, cap rate is a quick and easy method you can use to determine if a property is immediately profitable by comparing the income you will be generating against the purchase price.
Second, cap rate allows you to compare investment properties at their current state. This can be helpful if you are looking at purchasing different tracts of farmland in the same area or around the same price.
Third, using cap rate, you can start to estimate the payback period of your investment or the time it will take to recover your capital outflow.
Finally, because cap rate reflects a snapshot in time of an asset’s return, you can focus on the value of the property alone without the distraction of other factors impacting your investment. Of course, if you plan to finance the land purchase, you’ll want to consider your repayment options.
Estimating the value of farmland doesn’t have to be a guessing game. Make the most of your next land investment by using cap rate as a reference point to justify the purchase price and calculate your rate of return.