Asset allocation question: How to include farm rental income in my model?

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Chartreuse
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Asset allocation question: How to include farm rental income in my model?

Post by Chartreuse »

I'm puzzling over how to construct an asset allocation model that includes farm land. I own a farm that nets approximately $20,000 annually in rental income. I've owned it for years, and it's a pretty steady performer, but the rent does drift up and down over time according to crop prices. The financial assets I own are a 60/40 mix of indexed equity (Vanguard VTI) and indexed fixed income (Vanguard BND). I rebalance to 60/40 annually. At today's yield, it would take a position of approximately $625,000 in BND to produce $20,000 in annual income. I feel that the farm income I generate could be counted as a fixed income surrogate, and that I should reduce my BND holding by $625,000 and increase my VTI (equity) holding by $625,000. I've listened to a lot of financial advice, and I've done a lot of googling to find articles on this subject, but there is very little that I can find.

I'd appreciate hearing from anyone who has an opinion on whether farm rental income can or should be included in an asset allocation model, and if so, can it properly be considered a fixed income substitute? If anyone can point me to published material on this topic, I would be grateful as well.
RadAudit
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Re: Asset allocation question: How to include farm rental income in my model?

Post by RadAudit »

Welcome to the forum.

Opinions will differ on this one.

Some will argue that with a steady income (rental, SS, pension, high salary, etc.) one can afford to take a more aggressive asset allocation.

Others will argue that the asset allocation has more to do with portfolio management to meet future goals and should be based on your need, ability and willingness to accept the risks involved with investing for that goal.

You get to choose which argument makes sense to you.

I tend to lean toward thinking that I have a certain annual income need. I add up the assured income streams (SS, etc,) and subtract that total from total need. Then, I essentially set up the asset allocation on the portfolio to generate the additional income I need to meet total need. Of course, it's a little more complicated than that; but, the asset allocation is heavily influenced by my view of risk. And, I don't want to feel uncomfortable about the portfolio when stocks drop.

PS: I'm retired so you might want to consider that when you evaluate the response.
Last edited by RadAudit on Wed Oct 03, 2018 8:22 pm, edited 1 time in total.
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bloom2708
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Re: Asset allocation question: How to include farm rental income in my model?

Post by bloom2708 »

The land and the income themselves are not part of your mix of stocks/bonds/cash.

When you receive this year's $20k check, that cash can now be part of your asset allocation.

The land is a fixed asset. The income is just like your paycheck. Future income is realized when you have the cash in hand.

You could likely sell the land and get $250k (just a number) and then add $250k to your mix of stocks/bonds/cash.

The income does reduce your reliance on portfolio withdrawals. I would continue to pick a mix of stocks and bonds based on your need and ability to take risk. Age-10 in bonds or Age-15 in bonds. 20-40% international as a percentage of stocks.

Welcome again!
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vineviz
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Re: Asset allocation question: How to include farm rental income in my model?

Post by vineviz »

Chartreuse wrote: Wed Oct 03, 2018 4:47 pm At today's yield, it would take a position of approximately $625,000 in BND to produce $20,000 in annual income. I feel that the farm income I generate could be counted as a fixed income surrogate, and that I should reduce my BND holding by $625,000 and increase my VTI (equity) holding by $625,000.
If you are going to count the farmland as an asset in your investment portfolio (and its a big if), I'd argue that the best way to do it would be to account for it at its appraised value minus some discount for its lack of liquidity.

Lacking an independent appraisal, you could value the property using a perpetual value calculation (e.g. annual net profit ÷ interest rate). Just be sure the profit is truly net of ALL your expenses and the interest rate matches the riskiness of your investment. The yield on junk bonds right now is about 6%, so I'd use something in that ballpark.

$20,0000 ÷ .06 = $333,333 so that might be a ballpark estimate for how much value to put on this property in your portfolio. There are all SORTS of challenges with such a simplistic calculation, but it might be close enough for you.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
not4me
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Re: Asset allocation question: How to include farm rental income in my model?

Post by not4me »

My comments would largely follow those of RadAudit with some expansion. You'll find a lack on consensus on approach and, within an approach, the detail implementation. To me, the key to answering the question comes down to how YOU will use the answer. It sounds as if you've been using 60/40 & not factored farm in. If the farm is factored in, perhaps one approach is to alter the 60/40...some of that might be based on the relative size of your stocks/bonds to the land value.

Biggest concern I'd have with your approach is twofold: (1) annual rebalance -- which means a snapshot of the rate used; (2) using BND to determine the rate to use. The concern on using BND is that it has a much lower duration than the farm. An alternative might be to use a fund/etf with a long duration. Oddly enough, today the yield for EDV (Extended Duration Treasury from Vanguard) has a lower yield than BND (not sure if you are using SEC yield, yield to maturity...comments apply to either). Do quick calculation to see how much a slight rate change affects the result.

An alternative might be to use cap rate. I'll send you a PM for some reading as I'm not clear on what is appropriate to be cited in the open forum.

Either way you go there will be imprecision & opposing views. Good luck!
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Chartreuse
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Re: Asset allocation question: How to include farm rental income in my model?

Post by Chartreuse »

Thank you all for the very thought-provoking replies. There is a lot to digest here.
Topic Author
Chartreuse
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Re: Asset allocation question: How to include farm rental income in my model?

Post by Chartreuse »

not4me wrote: Thu Oct 04, 2018 11:11 am The concern on using BND is that it has a much lower duration than the farm.
I'm not sure I understand this point. I understand duration as a concept and know that duration is available for bond funds, including BND, but where would I obtain duration for farmland? I've always considered the farm to have a low correlation with returns on both stocks and (to a lesser degree) fixed income, and that strikes me as a good thing. Are there published studies on farmland duration?

Thanks!
AtlBoglehead
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Re: Asset allocation question: How to include farm rental income in my model?

Post by AtlBoglehead »

Simplify the complex. Don't consider the farmland as a part of your AA, but rather as a separate investment in real estate, which often has a somewhat low correlation to stocks and bonds. If you don't need the 20K for cashflow or debt reduction, put it into a separate emergency fund acct. As additional rental income goes into that acct, about once a yr take all of that accruing acct bal over 20K and transfer it into your investment portfolio per your selected AA model. No need to fret about whether it is really cash and a part of your AA. Just keep that amt (or whatever amt you choose) for emergencies and put the excess into your "investment" AA (or spend it on a trip, new car, grandkids, charity, or something on your own your "wish list," depending on your age and where you are in your accumulation/distribution timeline.
not4me
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Re: Asset allocation question: How to include farm rental income in my model?

Post by not4me »

Chartreuse wrote: Sat Nov 10, 2018 3:28 pm I've always considered the farm to have a low correlation with returns on both stocks and (to a lesser degree) fixed income, and that strikes me as a good thing.
So as to be clear upfront, I would recommend advice Radaudit gave upthread. But to clarify why I say that…I see problems with focusing too much on annual income (vs total return, overall volatility, etc) & using dissimilar investments to affect the re-allocation.

I agree that correlations between farmland & other investments is important & “a good thing”. It is difficult to find specific data – for example, what is included as farmland (row crop only? Pasture? Timber….), etc. The correlations will vary by time period as well. So, you must understand what you are looking at to appreciate how relevant that is for your specific. To illustrate, I’ll use some readily available data – portfolio visualizer. It uses ETFs as surrogates & the time period as I look today is April 6, 2009 – Nov 9, 2018. Of course, it uses VNQ for REITs, which isn’t a very good substitute for farmland, but serves to show my point. Correlation for REIT (VNQ) to Total Stock (VTI) is +.73. to iShares 1-3 year treasury (SHY) is -.14, Vanguard Total Bond (BND) is -.09, and iShares 20+ Year Treasury (TLT) -.22.

Note stocks had the only positive correlation & it is strong. All the bonds had a negative correlation & it varied between bond etfs (think different duration, credit quality, etc). Think also about how inflation & interest rates were in this time period (& whether you expect that to continue going forward).

So now turn to your possible revised allocation method & I’ll throw out what is admittedly likely to be an extreme example. Say today your farm land is worth $625k (per your earlier example) & just happens to be generating about the same “yield” as the bonds. That is, your bond holdings are worth $625k & generate a little over $20k, maybe $25k. Since that is 40% of your stock/bond total, your stocks are worth about $940k. After you re-allocate for 2019, you’d have $1565k in stock, $0 in bonds, and $625k in the farm.

Thinking past the cash available for the year, is it reasonable to expect the portfolio to behave the same as without the revised re-allocation? While you could re-invest the bond distributions, that isn’t practical for the farmland. The following year, the farm will (hopefully) still generate $20k -- yet to get to 60/40, would you shift back from stocks to bonds? If inflation picks up &/or interest rates rise ‘significantly’, what will be the affect on your holdings? Would you expect the correlation benefits you enjoy today to carry over? What about the overall net worth?

So, change the example to use your numbers & the degree of impact changes, but same areas still impacted & the cumulative affect would still be there. I may be way off in my understanding, so feel free to tell me if I misunderstood
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happymob
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Re: Asset allocation question: How to include farm rental income in my model?

Post by happymob »

Half of our net worth (and about 30% of our income) comes from inherited farmland and grassland. That's set to increase once my parents pass, even though we continue to add aggressively to our equities every year.

We don't include it in our asset allocation at all. But it does create a couple effects in our thinking:

1) Anytime I think I need to protect myself against severe inflation, I remind myself that we have a lot of assets that are already mostly inflation protected. Commodity prices (and associated rents and land values) should increase with inflation.

2) Because we have this big chunk of added, mostly stable income (and will likely inherit more) we tend to be a bit more aggressive on the equity side of equity vs. bonds. This position was explained by RadAudit in the first response.

Not trying to get political, but just letting you know our thought process, we do find ourselves far more exposed to global warming risk than I'd like to be. In 30 years, the land values (and rents) could be lower due to lower rainfall and increased temperatures. It's been very good grassland and fair upland farm ground, but that could change. But currently we have no great way to hedge that risk (except continue to develop the brokerage side of our assets).
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