There’s a simple lesson to be learned from the recent Farmland Partner’s accusations that has nothing to do with ethics. It first needs to be said that these are still, in fact, accusations. I want to make that part clear. The recent article that came out this week on Seeking Alpha was posted anonymously and, while the author provides a strong argument, time (and pending lawsuits) will uncover the truth. However, let’s assume that the accusations are true...Not for the purposes of picking on Farmland Partners but to get a good reminder of a simple business lesson that can lead to ruin if forgotten (as it often is).
A good investment is determined by two factors: The price you pay relative to the value of the investment and the rate of return that the investment produces. That’s it. It’s pretty simple. Yet, smart people continually make bad decisions by forgetting these two rules.
If you live or farm in an area where Farmland Partners has purchased property in recent years, and you have an idea of what fair market value is in your area, then there’s a good chance that one of the major themes of the article was not news to you. The prices they have been paying for farmland in most cases was far higher than fair market value. It’s painfully obvious to type this, but an investment’s rate of return is simply determined by dividing the cash an investment produces by the price paid for the asset. That’s all you need! You can run discounted cash flow calculations, determine cap rates, IRR, etc., but--at the end of the day--it comes down to what you pay for the asset and what rate of return you expect based on the cash flows the asset produces.
Why did they overpay? One reason: they were buying large tracts of farmland nationwide at a clip unprecedented in modern times. They were not sitting on cash and waiting for deals to come their way but rather actively seeking buying opportunities. The old saying is that the person who cares the least wins the negotiation. This could just as easily mean that the person who wants the deal the most will compromise their position the easiest. I’m sure there was pressure for activity from shareholders and management to get deals done. After all, it’s a farmland investment company not a money market fund.
However, the best deals come to those who wait for the deals to come to them.
Hindsight is 20/20 and Farmland Partners may have gotten away with overpaying for those assets had farming not entered a volatile downturn in the last few years. That’s why margin of safety is so important. It’s important to remember that traditional farming is a commodity business. This means we are price takers for both what we buy (inputs) and what we sell (crops). An investor can afford a growth premium if betting on a brand that has the capacity to grow rapidly on lower capital requirements. It would have been fine to overpay for Google at almost any time in the last decade because the cash flow generated was growing so quickly (again, hindsight). Unfortunately, this is not the case for traditional row crop farms. It’s much easier to scale something like software or a branded business than it is a farmland investment because the returns you get as a farmland owner are essentially tied to the returns that the farmland’s producer experiences through cash or crop-share rents.
I think there’s little doubt that Farmland Partners bought much of their portfolio while using financial modeling that reflected peak commodity prices. However, for whatever reason, it seems they lost sight of the fact that volatility is extremely common in farming and they were leveraged to the point where things have to go right in order for them to remain solvent (according to the Seeking Alpha article).
It will be interesting to see how all of this plays out but, if nothing else, I hope the accusations against Farmland Partners encourage farmland investors and farmers to step back and re-examine their own personal farmland investment strategies.
Don’t overpay for assets.
No one is making you invest. Pick your spots and wait patiently for your opportunity.
Know the range of cash flows (both good and bad) you expect the farmland to produce.
Don’t become so over-leveraged that cash flow volatility threatens your solvency or ability to service debt.
If the article is correct, the irony of this whole situation is that many of the farmers who sat on the sidelines and watched Farmland Partners enter their areas could now be in a position to take advantage of distressed sale opportunities. Hopefully, mistakes from the past won’t be repeated.