The majority of rural land is owned free and clear, and property taxes are generally low due to ag exemptions. As a result, most landowners don’t feel the financial pressure from monthly PITI payments to sell during a period of weak demand.
Landowners aren’t usually forced to move and sell when a major life event takes place during a down market, as is often seen with single-family housing.
Land values don’t tend to inflate and then deflate due to the addition and subsequent removal of easy financing as we saw with housing leading up to and during the Great Recession.
If land values do go down, our profits could get squeezed to some extent, but the fund and its investors should not. In a typical scenario, we’ll buy a property for $1M, put $250K in improvements into it and sell for $2.5M in total. That’s a $1.25M gross profit. If land values were to fall by an unprecedented 20% over 6-12 months, those numbers might be as follows: $1M purchase, $250K in improvements, and a $2M sales price. The result would be a $750K gross profit, which is still well in the black.
We tend to own each parcel of land for just a few months, so there typically isn’t much time for us to benefit from rising values or be hurt by falling values.
Land values for the Texas Gulf Coast region fell by 13.5% following the Great Recession (source), so they can and do fall on rare occasions. But when they do drop, that drop has historically been much smaller than what you see in the housing market. Some of the reasons for that are as follows:
A change in access to financing or financing terms (think interest rates) doesn’t affect land as much because many more transactions are done with cash or large down payments.
When demand for rural land softens and prices would otherwise fall, many or most landowners have a high enough net worth to simply wait it out. This is unlike what is generally seen in the housing market.
Positive: Over time, inflation leads to higher wages and higher profits in nominal dollars. Hawthorne Interests (HI) collects monthly payments from those who bought ranchettes on owner financing. (More on that in this video.) These payment amounts don’t change, thus making them more affordable in comparison with our borrowers’ higher wages and/or profits over time. This helps HI keep its default rate down, which provides HI with a more reliable steam of income. That stream of income is used to make monthly payments to the fund and its investors by extension.
Neutral: Returns on some other types of investments tend to rise with inflation. That could make them more appealing to some of our current or prospective investors, therefore making it more difficult for us to attract or retain investor capital. This has not happened thus far. One reason could be that many of those types of investments are seen as overvalued, high-risk, volatile, or unappealing for other reasons.
Positive: On occasion, HI must foreclose on a borrower, take possession of the underlying land and resell it. A desirable outcome is reselling the land for more than it was first sold for and generating an even larger note with a larger monthly payment coming in. This is much more likely when land values have gone up. Inflation has helped that to happen.
Not a day goes by that we’re not reminded of inflation, whether it be in the headlines or as we move about in our lives and businesses.
It’s impacting individuals, companies and governments in various ways, often negative, but sometimes positive… especially for Uncle Sam. Below are some of the ways it’s impacting the business and/or fund that you invest in:
Negative: Inflation has increased our costs. We’re spending more on people and equipment. We’re also spending more on land improvements. Before the pandemic, most wells ran about $6K each, and now they’re typically $10-$11K each. Fencing was about $6K per ranchette, and now it’s about $9.5K.
Positive: Real estate values tend to rise with inflation. That includes rural land. This means that we now must pay more for land when we buy. It also means that we sell for more. Every deal is very different, but we used to buy a typical property for about $4K per acre and sell it for about $12K per acre. On a more recent deal, we paid about $10K per acre and sold it for about $25K per acre. We have gone back and forth on whether this change has been good or bad. We currently believe it has been a net positive because we can squeeze more profits out of each deal for the same amount of time and effort.
Negative: In the short run, inflation tends to squeeze the disposable income of our prospective buyers and current borrowers. This can reduce the demand for rural land or make it more difficult for a borrower to make his or her mortgage payment. The cost of fuel is one particular pain point. The notes we collect on continue to perform well, so that’s reassuring. In addition, sales remain very strong. Still, we are prepared to overcome weakened demand if needed by ramping up our marketing efforts.
A recession could empty the pockets of some prospective buyers and simply give other buyers cold feet. Due to the fund’s structure, our ability to provide investor returns is largely independent of how quickly we’re selling land or whether we’re selling for top dollar. Regardless, it’s worth noting that sales are still strong.
In a slowing economy, there is reduced demand across all or most sectors, including real estate. This is extremely good news for us on the buy side. Getting our purchase offers accepted has been a major challenge ever since demand for rural land skyrocketed during the pandemic. We would love for some of the wealthy “buy and hold” investors we compete with to curtail their buying activity so that we can take on more projects.
Lastly, recessions provide us with an opportunity to generate an even stronger track record and thus attract more investor capital going forward.
The bottom line:
A recession would bring a few pros and cons for us, but we have confidence in both our model and your collateral and don’t see it impacting your investment.
Even higher rates and your investment:
Some fear that rates could rise much further. What might that look like?
It’s important to keep in mind that the Federal Reserve is not incentivized to increase rates to levels that would have a crippling impact on the government or the economy.
The U.S. federal government carries substantial debt, and sky-high rates would result in it paying out substantially higher amounts via regular interest payments. According to this WSJ article, “if the average interest rate were to rise from 1.5% to 5% … the federal government’s interest bill would balloon from $400 billion to more than $1 trillion.”
Sky-high rates would also be devastating for the countless people who carry consumer debt. That is not a pain that the Federal Reserve is eager to inflict upon Americans.
Should bond rates follow climbing interest rates, you may come to believe that your capital would be better placed in bonds or elsewhere. In that case, you may request a return of capital. That process will be carried out according to the information in the “return of capital” FAQ in the first section of this FAQ page. We are typically able to return your funds within 1-3 business days.
In the unlikely case that bond rates were to rise above 10%, we would consider a temporary increase in the fund’s loan rates and preferred returns to match those of bonds.
Review this Forbes article for more information on the direction of interest rates. Just scroll down and find this section: “Mortgage Interest Rates Forecast for August 2022.” Although economic predictions can be tricky, leading experts expect rates to be in the range of 5-7% by the end of the year. That is compared to the current 5-6%.
We are very pleased with how well the notes that HI owns are performing. Should we experience a prolonged recession with large job losses, some of the borrowers on those notes will be affected. That would likely increase the default rate. Although HI is to make monthly payments to the fund each month, regardless of the income it collects, a steady stream of income into HI does help in making those payments.
It would be difficult but not impossible for HI’s income to drop below what it pays to the fund. If that happened, we suspect it would only be temporary until HI was able to foreclose on its non-performing loans and originate new ones. During that temporary period, HI could cover the difference with proceeds it regularly receives from borrowing against new notes. Additional capital could also be funneled into HI from our sizable cash reserves.
Although we are prepared for substantially higher default rates, they seem unlikely because: 1) they didn’t occur during the COVID-19 recession, 2) borrowers are incentivized to keep a property that they are proud to own and that they have put a substantial amount of money into via a down payment, mortgage payments and improvements, and 3) we feel that we have properly screened and selected our buyers with the help of Texas Pride Lending, a licensed loan originator.
More to think about:
This is not needed or even desired to get the fund or our business through a recession, but we have seen a strong willingness by the U.S. government to prop up consumers during challenging economic times. This can mitigate foreclosures in all areas of real estate, including rural land.
A little background:
We entered into what’s known as the COVID-19 recession in early 2020. It was one of the deepest recessions in U.S. history, with 14.7% peak unemployment and a 19.2% drop in GDP. By comparison, the Great Recession resulted in only 10% and 5.1% respectively. (Further reading)
For about two months, buying activity slowed down and some borrowers didn’t make their mortgage payments, largely due to some misinformation that had spread in the media. These issues were quickly resolved, and we went on to sell over $10M worth of ranchettes in 2020. This bodes well for this business’s ability to thrive during a downturn.
In addition, selling on owner financing and collecting on those payments is traditionally seen as a recession strategy. Doug and his colleagues saw this work extremely well during and after the Great Recession when selling real estate conventionally often proved difficult.
Our borrowers and the economy:
As a reminder, Hawthorne Interests (HI) is an entity that Doug owns. It derives income by collecting on real estate notes from the land that we have sold on owner financing. It borrows against those notes from the fund and subsequently makes monthly principal/interest payments to the fund.
While broad demand for rural land has ebbed and flowed over the years, our target “blue collar plus” buyers have displayed a relatively constant interest in purchasing our ranchettes.
We have seen high demand in the following markets: 1) before the COVID-19 recession, 2) during that recession, 3) during the subsequent boom, and 4) in the current economic climate. It’s reassuring that demand for our product has far exceeded our ability to supply it across very different market cycles.
Sales are strong right now. But if we were to see them slowing down, we are well-positioned to ramp up our currently modest marketing efforts to attract more interest.
If we were to witness an alarming drop in demand for our ranchettes, we could certainly curtail buying activity. In the unlikely scenario where we needed to stop buying, we would finish out current projects and provide investors with preferred returns and a return of their capital over time.
Rising interest rates have been top of mind of late, so it’s worth addressing their impact on the land business.
A little background:
We do not borrow from banks for these land deals, so they are not in a position to increase rates on loans we do not have and do not plan to take out.
Instead, we borrow from the fund (that’s you) at a fixed 10%. That rate is already well above going mortgage rates of 5-6%, but it is acceptable to us because the terms are favorable and allow this business model to work.
Pros and cons of higher rates:
Pro: We sell ranchettes on owner financing, typically at rates exceeding 10%. Rising rates (chart) amongst other lenders have had the positive effect of making our rates much more palatable to prospective ranchette buyers, thus helping with sales.
Con: Higher rates are causing consumers to pay more for other purchases that they finance. This could squeeze the disposable income of some of our prospective buyers and therefore hurt sales a bit.
Con: It’s probable that rising rates are beginning to soften the real estate market, which includes rural land. We welcome this shift. A hot market attracted a lot of “buy and hold” land investors with deep pockets who have been competing with us as we attempt to buy. In a softer (or simply normalized) market, we can buy with greater ease and sell with what historically has also been relative ease.
The bottom line
Rising rates may be a net positive for our business, and we don’t see it impacting our investors.