[P1-DROP] MIP6 Risk Assessment: Alternative Equity Advisors DROP: US Agricultural Real Estate

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Executive summary

Debt Ceiling: 20 million

Stability Fees: 2%
Min SPV CR: 142%
Min Vault CR: 100%
Min Vault Underlying CR: 142%
Liquidation Process: MIP21/MIP22 (Centrifuge Model)

Highlights

The MIP6 Proposal is to have a special purpose vehicle (“SPV”) established by Alternative Equity Advisors or owners or affiliates thereof (the “Issuer”) to acquire U.S. farm properties (stated primarily in the United States Midwest). Upon acquisition of a farm property, the SPV will be the legal owner of the farm property and hold fee simple title to each farm real estate property. Rented farm properties are quite a safe asset compared to other MakerDAO RWA collateral at this time. The price for crops is quite supportive of farmer profitability at this time.

The two main risks are a degradation in farm profitability (reduction of cash rents) and a sharp reduction in farm real estate property values. These two items often happen in tandem, with reduction in farm profitability reducing the amount of cash rent that farmers are able and willing to pay, and therefore reducing the value of farm real estate that can be sustained via the cash rents. It is still expected that the rent would be able to cover the MakerDAO stability fee.

Interest rates and economic conditions often play a role in both the profitability to the farmer (the “tenant), and the expected return to the investor. Interest rates are unlikely to dramatically increase in the short term and economic conditions, while speculative to predict, are unlikely to impair the senior position of Maker if the investment is made with proper risk management.

Major risks

  • Geographical concentration: It is expected that most/all farms will be located in Iowa and surrounding states and Oregon and Washington which could add some diversification.
  • There is possibly a conflict of interest as the SPV and Alternative Equity Advisors (AEA) or owners or affiliates (the Issuer) are managed by the same people. An independent director will be added to mitigate this issue (similar with all Centrifuge collaterals)
  • The MakerDAO related LTV on farmland acquisition is 70%, down from 90% in the MIP6. A mezzanine tranche was added on top of MakerDAO senior position for 20%. AEA will be invested in both the equity of the SPV and in the junior tranche.
  • The liquidation is quite unusual as we grant a 5 year delay, subject to maintaining parameters, after which we get a MakerDAO Put Option. The counterpoint is that the properties are rent yielding.
  • The liquidation process also relies upon the Issuer to sell owned farm properties (encumbered by leases which are typically year to year) into the market to reduce the debt exposure. AEA and its affiliate, Peoples Company, have extensive experience in selling farm properties and the typical time to sell a high quality farm is less than 6 months but to sell a portfolio of farms could take longer (6-18 months).
  • This collateral is based on a 5-year commitment which may limit MakerDAO to change its balance sheet allocation in a timely manner. A 20M DC represents 0.5% of the MakerDAO balance sheet at the time of writing.

Outline

  1. Background
  2. Industry analysis
  3. Asset originator analysis
  4. Token issuer analysis
  5. Implementation details
  6. Proposed covenants

Industry analysis

Industry Lending Standards

For agricultural mortgages, the Farm Credit System underpins and guides much of the existing lending parameters. Including interest rates, loan to value ratios, covenants, etc. The chart below demonstrates the funding index for Farm Credit Bonds that many consider to be implicitly government backed bonds (similar to Fannie Mae or Freddie Mac are for housing). This chart uses data for the funding index from the initial data series 6/29/2001 through 4/30/2021.

The trend is clearly one of a reducing interest rate environment, with large decreases in the interest rate during the 2009-2009 great recession, and then again after a period of increasing interest rates the unprecedented support due to the Covid 19.

Typical Lending Terms

It is the author’s experience as someone who has been involved in agricultural lending for the past 15 years to various lending sources that there are generally accepted lending parameters for most loans to secure agricultural secured debt financing.

A typical loan to an owner/operator requires proof of sufficient debt coverages, acceptable collateral due diligence, acceptable borrower balance sheet strength, and limits on advance rates “loan-to-value”.

Since it appears the proposed MKRDAO lending facility is non-recourse, five year term and backed by farm assets, it would appear that the most comparable would be fast-track, and other more asset based lending facilities.

Every lender is different and has different standards, but as a generalization, we typically see LTV’s (“loans to value”) in the 50-75% of appraised asset value. Debt coverage requirements to service the debt 1.25x historical, current ratios of 1.25x, and strong credit scores above 700+.

The lending rates typical for 1 year fixed rates are generally in the range of 220-240bps over the funding source, Treasuries or in cases of Farm Credit, the farm credit funding bonds. We are currently seeing interest rates to farm borrowers in the range of 30-day LIBOR “variable” rates at 2.4% to 5 year adjustable rates at 3.10% (rate resets every five years). As loans are fixed for longer time frames, the interest rates are typically higher (unless the yield curve is inverted). So for a 30 Year fixed agricultural mortgage the rate is currently around 4.5 - 4.7%. The longer term fixed rates have moved considerably at this end of the yield curve in 2021 along with 30 year treasuries and farm credit bonds. Every credit is different, of course and interest rates will vary based on specific risks, to borrower, industry, etc. So these indicative rates are only provided as an illustrative example.

Peers analysis

This peer analysis section presents a comparison with other companies in the industry. As the proposed lending facility is non-recourse the peers are of limited value in the analysis.

Farm Real Estate Management Case Study

Farmland Partners is a publicly traded NYSE under the ticker FPI. Farmland Partners owns approximately 155,0000 acres in 16 states, including Alabama, Arkansas, California, Colorado, Florida, Georgia, Illinois, Kansas, Louisiana, Michigan, Mississippi, Nebraska, North Carolina, South Carolina, South Dakota, and Virginia. Their latest 10Q and 10K would also provide indicated industry interest rate lending facilities for structures that are in many ways comparable to the proposed term facility. The 3-month spread over LIBOR is 1.56%-2.94% with longer term debt in the 3.68%-4.27% range (but some numbers coming before the rate cuts due to covid).

It is worth noting in the 10Q that Farmland Reserve financials also indicate that Farmer Mac facility has financial covenant with a LTV of not more than 60%, fixed charge coverage ratios of 1.5 to 1 and similar parameters with the MetLife facility.

While not a perfect comparison, this example allows us to understand the overall market. It contains mainly a company managed portfolio of farm properties that are leased out to the 3rd party tenants.

The stock price (equity valuation) was hit by the lower prices for Corn/Soybeans and Covid fear but the current price level is above five year highs despite earnings lower in 2020 than 2019. The increase in the stock price might be due to the significant increase in crop price as we will see later.

Also pursuant to the Farmland Reserve 10Q it should be noted that they are experiencing relatively stable lease rates, and for high quality farmland a modest strengthening in lease rates.

In conclusion, this example shows that the industry is well rated by investors even in the middle of the Covid crisis.

Expected Tenants analysis

As discussed earlier, the quality of the farm ground and the health and strength of the tenant will drive the stability of the cash flows that will flow to the Issuer. In other words, strong economics will drive cash rents, farm values and the sustainability of the SPV’s ability to service its debts to the MakerDAO vault.

The tenant, in this case can be fairly interest rate sensitive, especially over the intermediate to longer term. The farmer tenant has operating lines to a bank and needs to budget the cash rental rates and obviously have enough money left over to service the debt (and lease).

Often interest rates seem to follow certain bounds, staying within a trading range, never breaching the ceiling or the floor. That is, they follow their bounds until something or someone comes along that upsets the apple cart. By way of example, in 2016 the shock to the system was the election of Donald Trump as president. Overall, the election appeared to have ushered in a new paradigm, changing expectations of overall GDP growth and interest rate expectations.

Illustrative Example of Interest rate shocks to tenant farmers.

After the election in 2008, we saw 30 year US Treasuries increase 60 basis points, or 0.6% interest in a little over 30 days. That is obviously a huge move and has substantial impacts to the borrowing costs of farmers and ranchers.

What impact on the bottom line?

  1. One method is to look at how borrowing costs increase over the life of a loan. Assuming a 60 basis point increase on a hypothetical $1,000,000 loan the interest paid over the life of a 20-year loan increases $79,447.43 over the lower interest loan.

  2. Interest over the life of a loan is an important consideration, but often the more important question is what are the increased borrowing costs per acre?

Obviously, most farmers and ranchers need to generate enough income per acre to service their debt and provide a living. Once again stepping into hypothetical land. Let’s assume farmground is worth/costs $8,000 per acre and that the debt load is 65% loan-to-value. That is debt of $5,200 per acre. The 60 basis point increase in interest rates leads to an increase in per acre interest of $31.2 per acre.

  1. The squeeze of the bottom line is particularly acute in situations where many farm commodities are bouncing along their 10 year lows. It is also felt in situations where there are decreasing rental rates for landlord held farms.

The increasing interest rate environment will need to be either offset by cost cutting or increasing productivity or higher commodity prices. If interest rates are rising, it is often related to or accompanied by higher inflation. Commodity prices tend to be a leading indicator of inflation. So higher commodity prices are reasonable to expect when interest rates increase.

  1. Budget Cost Cutting - The ability of farmers to get more out of the same inputs and increase yields at lower costs has a long-term track record. We have been in a decreasing interest rate environment for so long, it is difficult to fathom what impact a rising interest rate environment has on the bottom line, but it is calculable with a little time and effort. These are the considerations necessary for the tenant/farmers whether making the purchase/lease decision or whether to expand.

  2. Typical Lease Structure

Typical cash rent farm leases can range from year-to-year, to longer term (5-year leases). These leases can also have a base rent, with a component that increases or decreases, based on outside factors, such as corn price. That way, the landlord and tenant share in the upside and downside risks associated with farmland prices.

Simulation of a Farm Real Estate Fluctuations

To get a feeling of what can happen with a portfolio of agricultural properties, it is important to analyze the historic fluctuations in farm real estate values. As this is likely the canary in the coal mine, and in the case of a degradation in the cash rents of the farmer tenant pool, the source of repayment as the farm properties are auctioned off (disposed) to repay the MKRDAO facility.

Farmland Values - The Data

Iowa State University

This data is from surveys and economists from Iowa State University for the state of Iowa. This is assumed to be the asset class, or at least comparable to the farms that are anticipated to be purchased by the SPV.

This data demonstrates the strong upward trend of agricultural farmland values over time, with two major dips. The upward trend has followed a trend of increasing world wide food demand met by increasing farm productivity. The first major dip in farm values was during the high inflation era of the late 1970’s and early 1980’s and again with the great recession of 2007-2009. The crisis of the 1980’s was high interest rate driven, whereas the 2008 Great Recession was more a credit shock and collapse in demand. The Great Recession hit agricultural values much later than was felt in the housing market and came off historic profitability. So the drop was more low commodity price driven 2013-2018 in Iowa.

The data indicates that the highest annual drop in farmland prices was 1985 with a (30.13% drop), which was a sustained drop from 1981 of $1,931 per acre to 1986 low of $699 per acre or total decrease of 63.8%.

The drop in real estate values spawned by the Great Recession was much more subdued. The farmland value’s highest yearly decrease was (8.87%) drop in 2014 and overall a decrease, from peak to trough, of (16.68%) drop.

The Iowa State University modified data set is here. Basically added the column to compute year over year changes in the index.

Federal Reserve of Chicago

The Federal Reserve of Chicago is in charge of monitoring the banks covering Iowa, Illinois, Indiana, Michigan and Wisconsin. In their issue of the AgLetter November 2020, they indicate a strengthening of land values and economic conditions of the farmers as well, with bankers tightening credit parameters and mixed perceptions from ag bankers on forecasts for repayment capacity. The survey banks reported having more extensions and workouts of credit conditions compared to the previous year. The Chicago Fed also reported its agricultural banks, “the District’s average interest rates on new operating loans, feeder cattle loans, and farm real estate loans had fallen to their lowest levels on record: 4.65 percent, 4.79 percent, and 4.24 percent, respectively.”

Federal Reserve of Kansas City

This data from the Kansas City Fed and is a data survey for various midwestern states, including Colorado, Kansas, Nebraska, Oklahoma, Wyoming, the northern half of New Mexico, and the western third of Missouri. Perhaps not as comparable to the Iowa State University survey, but still useful to track changes over time. Similarly the largest decrease in farmland prices occurred 1982-1987 and then another much less precipitous drop 2015-2018. The largest quarter over quarter drop was in 1985 with a (22.9%) drop.

Stress test 1 - 1985

During a crisis, like 1985, the market might find an annual decrease in farmland values of 30%. In this “once in a generation” drop in farmland values, it would be difficult to maintain the margin of collateralization with a 20/70 TinDrop ratio without additional capital (deleveraging). The impact would be that the MakerDAO Put Option would be able to be exercised. It should be made clear that the farm rents may be sufficient, even if the MakerDAO Put Option is exercisable, to service the debt associated with the DROP facility. Therefore, it may be in the parties interest to simply restructure or defer the exercise of the “put” and continue collecting the rents as payment on the DROP facility. Farm ground is a productive asset that should always have a positive yield and in the case of the 80’s it was higher interest rates, and debt service, not rental rates that led to the precipitous drop in farm values. The farms would still have maintained a 2% yield (based on the farm acquisition price) sufficient to pay the interest payments on the DROP facility during this time frame.

Stress test 2 - 2016

It is likely that a margin call in the more recent drop in 2015-2018 could be maintained as the sale of agricultural values would be able to stay ahead of the drop in agricultural values. Though this assumes zero transaction costs. In likelihood transaction costs typically are in the 6-8% range of a farmland sale.

Stress test 3 - Cash Rents Retrospective Analysis

Here is a Iowa cash rental dataset that shows cash rents from 1994-2020 to illustrate the market cash rent as a percentage of market price. The cash rent yield percentage has been trending lower from 6.5% of market price to around 3.2% for the last few years as interest rates have dropped with expected returns. To backward test if rents fell to 1994 value of $98.60 per acre, with 2020 prices of $7,170 per acre, then the yield would be 1.38%. Therefore even with the current market value of farms, and the 26 year lowest rent, the yield would remain positive but not sufficient to service a 2% stability fee. This would be an extremely unlikely calamitous event, whereas farm market prices were $1,517 in 1994. This is meant to demonstrate that farms do produce income, and with a long term investment horizon are a reliable investment class.

Industry analysis questions

What are the additional soft metrics that the MKRDAO team could use to monitor the credit conditions in Iowa?

Obviously, the AgConditions and Outlook from the Chicago Fed might be the canary in the coal mine that would allow a credit team to monitor conditions in the area where the farmland is owned to maintain the appropriate collateralization. This is not a substitute for the “appraisal” of the actual farmland. But typically, appraisal market data has a lag. The market approach requires completed farmland sales and is often a “retrospective” of where the market was at the completion date of the appraisal based on market data in the rear view mirror.

What is a shorter term outlook in the Agricultural industry?

The Covid crisis has resulted in shorter term shocks to certain agricultural industries, especially in food processing. The primary driver of real estate prices in the corn belt, is corn and soybeans. Farmers in this region will normally substitute between these two commodities. Both commodities are quite in an uptrend lately.

CORN

Corn prices after Covid have seen a strong recovery from a period of years where they have bounced at or below the cost of production for many Midwestern farmers. Since the beginning of the year commodities prices are rebounding and optimism has increased as corn is well above $4.

One market indicator is the futures price for corn as traded on the CME. Futures going into 2021 are above $6, which should be very profitable for farmers and tractor dealers in the region.

SOYBEANS

Soybean prices are more trade dependent with China as a large world importer of the commodity. After Covid, and similar to corn, farmers have seen a strong recovery from a period of years where they have bounced at or below the cost of production for many Midwestern farmers. Looking at futures prices for soybeans as traded on the CME.

Looking at futures prices for soybeans as traded on the CME, we can see an exponential rise that indicates that farming should be well above trend for profitability in 2021.

GOVERNMENT SUPPORT PAYMENTS

With Covid has come unprecedented governmental support, which agriculture has also benefited from. For an example of expected farm support it is useful to look at the Farm Bureau report and likely support to US agriculture. The bill is anticipated to provide 11.2B in direct farm supports. These additional supports are in the range of $20 per acre for corn/soybean growers. $20 doesn’t sound like much, but on top, after all variable inputs are covered it goes directly to the farmer as “net profit”. Profits lead to expansion of operations, and flow into prime real estate prices and cash rents.

Conditions 2021

Overall, it appears that 2021 is setting up to be a strong year for the Midwestern farmer with profitable commodity prices, ample government support and low interest rates. Therefore, the next 12-18 months should be a good recovery from a sustained period of prices where some farmers have struggled a bit.

Analyzing the futures going into 2021 it is clear that the prices are looking better for Midwestern farmers and should be a year of stronger returns. More on this can be read from the Kansas City Fed (in charge of regulating lending in the 10th district which includes Midwestern states). Where they see improving credit conditions in agriculture as well. “Better profit opportunities for both crop and livestock producers, as well as additional government support across the sector, created more favorable conditions for farm finances in 2020 than earlier in the year.” Farm Financial Outlook Improves, Nathan Kauffman, Vice President

REMEDIES

What remedial measures might be undertaken?

There are two issues. One is that the farmland tenants are unable to service the debt. In which case, Alternative Equity Advisors would need to find a new tenant with the net change in farm cash rents. At some point it is possible that the cash rents would not be sufficient to service the MKR facility(see stress test #3). In which case, assets may need to be sold and partially released from the credit facility to make the payments, reduce the LTV, etc.

The second issue is one where the farmland values decrease, and the margin is not maintained. The issue is that the SPV through Alternative Equity Advisors will need to market and sell real estate and net the margin enough to repay the debt. As MakerDAO has a senior tranche with a 30% credit enhancement provided by the SPV equity and the TIN tranche, the situation should be quite dire to impact the MakerDAO position. Nevertheless the equity and TIN position will be impacted.

It is in the interest of all parties to find an arrangement of maintaining margin like adding SPV equity when needed.

What are the historical default rates in this industry?

We didn’t find statistics on the default of a similar SPV capacity and therefore analyzed the credit conditions at large in the owner/operator market. The farmer real estate loan delinquency rates have trended downward as rates have decreased. We can use the realized default rate from credit ranking as a proxy. The chart below from USDA ERS illustrates the point for delinquency rates in the Commercial Banks, Farm Credit and FSA loans.

What is the average cap rate of the agricultural farmland assets?

The cap rate is currently around 2-3% based on industry information. It would be necessary to have the appraisals for the farmland in the SPV demonstrate the cap rate as part of the income approach. One rough estimate is using the USDA ERS data with average farmland value for cropland in the corn belt at $6,110 and cropland rent of $202. With a 10% management fee. Therefore we have $181.8 net rent/divided by $6,350 value or a cap rate estimate of 2.86%. As MakerDAO is asking for a 2% stability fee and financing 70% of the property, which would mean that the rent should cover almost 2x the stability fee (meaning the rent can decrease by 50% before hurting the senior position of MakerDAO).

Is there liquidity in the market?

The market for prime farmland is actually fairly liquid but requires timeframes to set auction, market and close. Oftentimes, as is now the case, the market is cash buyers that are able to close quickly upon an auction or an all cash offer. This removes the “financing” contingency, which requires a loan underwriting, appraisal etc. Therefore it is common in market based appraisals to value the farmland under the marketing condition of a 12 month timeframe to reach “market” value for the farm property. Similar to other asset classes, when times are hard, the market can freeze and there is a flight to quality. This is similar to other commercial property with quality farmland usually falling at a slower rate than farmland on the margins, or “marginal farm ground”. It is just a fact that some farmland can be farmed for a profit while others that are more marginal can only be profitable under higher commodity prices or lower inputs.

Asset originator analysis

About Alternative Equity Advisors (“AEA”)

Alternative Equity Advisors is an affiliate of Peoples Company. Per the MIP

“Peoples Company’s history began in the 1960s and was established in the farm management department of Peoples Trust and Savings Bank in Indianola, Iowa.

In 1972, the farm management department and real estate brokerage separated from the bank into what is now known as Peoples Company. In 2002, the current ownership team acquired the majority interest of the company.

Peoples Company operates one of the leading farm land brokerages in the country, with annual transaction volume of over $400 million. Peoples Company offers land brokerage, land management, land investment, and appraisal services in 26 states throughout the US. The company has consistently been named a “Top Brokerage in America” and a “Top 30 Auction House” by the Land Report, an industry-leading publication targeted toward the American landowner.”

It should be noted that the recourse to the proposed arrangement is not to Alternative Equity Advisors, its owners and affiliated companies “Peoples”. The recourse is to the special purpose vehicle that holds the farmland fee simple title. Therefore, this analysis does not perform a credit analysis of Peoples, but only as far as to demonstrate their knowledge and experience in buying, improving, appraising, and managing farm real estate assets.

When was the asset originator incorporated?

AEA was founded in 2014 as a farmland investment affiliate of Peoples Company.

What is the background of the asset originator managers?

See AEA and Peoples Company websites for bio’s on key farm originators and managers.

Team | Peoples Company and Alternative Equity Advisors, including:

(1) Steve Bruere – President and principal owner of Peoples and AEA

(2) Dave Muth – Managing Partner of AEA

(3) Hunter Norland – Acquisitions Manager

(4) Peoples Company has a Land Management team that AEA leverages for farm

management and tenant management. This team has several people and is headed by

Kyle Walker

What is the link between AEA and Peoples Company?

AEA and Peoples are affiliates, with Steve Bruere being the majority shareholder of each company. AEA is the asset management arm providing full range investment services for investors (strategy creation, sourcing, due diligence, closing, asset management, divestment) and Peoples provides land management services along with brokerage and appraisal services.

How many deals has the asset originator already done? What is the notional amount?

This information is not publicly disclosed but the current assets under management and origination are larger than the scope of this pool.

Has the asset originator experienced a default? What is the plan in case of default?

The Asset Originator never experienced a default so far. Leases are generally on a year-to-year basis with renewals if rent is paid in full and on-time. This puts pressure on the farmer to pay rent if he anticipates renewing and gives the Asset Originator flexibility to find a new lessee if there is a problem. Also, most leases require 50% - 100% rent payment at the beginning of the crop season. The Asset Originator also focuses on high quality farms that have strong lease demand.

What is the due diligence they use to accept an asset?

From the Asset Originator, the process is the following:
i) Technical reports and maps (soils, fertility, land use, etc.)
ii) Farm visit and aerial (drone) inspection, photos
iii) Yield and production histories
iv) Market analysis including lease rates, farmer interest, crop opportunities, and potential for additional income opportunities (e.g., hunting leases, wind power leases)
v) Assessment of on-farm and nearby infrastructure (roads, utilities, water access, irrigation)
vi) Assessment of potential property improvements
vii) Water analyses including rainfall, water rights, water management and wetlands
viii) Crop insurance history (coverage and claims)
ix) Completion of an appraisal to determine market value
x) FSA (Farm Service Agency) information and records including Form 156EZ, Form 578, wetland determinations, conservation plans, and any and all government programs the Property is enrolled in
xi) Schedule and documentation of land improvements including irrigation equipment, drainage tile maps, and buildings or other structures
xii) Available crop insurance APH yield history for the previous 5 years
xiii) Legal analysis on land title, easements, encumbrances, property description
xiv) Property tax reports, special assessments, zoning
xv) Title insurance

What is the valuation model used?

The valuation of a property will use a third party annual market valuation appraisal.

Issuance platform analysis

This collateral relies on a Tinlake pool as the issuance platform. It is an asset-backed financing smart contract on Ethereum. Tinlake is developed by Centrifuge.

Centrifuge is a startup based in Germany that has worked closely with Maker Foundation in POCs and community proposals and is extending its platform to integrate with Maker vaults and smart contracts. The Centrifuge platform was launched on May 26, 2020 and the company was founded in 2017. The last fundraise was in 2021, $4.3M led by Galaxy Digital.

Currently, one collateral on Maker is already using a Tinlake pool.

Implementation details

The Centrifuge model 6 is used in this case and several aspects of the model and some deviations are worth mentioning here. Readers should keep in mind that the structure is not yet live and some details can deviate from the presentation given here.

Usual Centrifuge model details

Alternative Equity Advisors will form a SPV dedicated for the acquisition of farm properties. The SPV will enter into a service agreement with Centrifuge to get support from Centrifuge while using Centrifuge’s open and decentralized infrastructure. The SPV will “tokenize” the titles of each of its farm properties into NFTs and will add those NFTs to Tinlake as collateral to draw DAI from the pool. While the NFTs bear no legal right per se, the operating agreement and other legal documents make them represent a payment obligation in Tinlake.

The SPV will utilize Tinlake to issue DROP and TIN tokens backed by the pool of NFTs that are locked in Tinlake. As usual on Tinlake, DROP is the senior tranche with a fixed interest rate and has a credit enhancement from TIN which is the junior tranche. Indeed, the value of TIN is defined by the value of the assets minus the DROP value (with accrued interest).

As usually we consider holding only the senior tranche, DROP which is the less risky tranche.

You can learn more about the tranche structure here.

Deviations from the usual Centrifuge structure

So far, Tinlake is designed for predictable cash flow assets. This is not the case here as farms have a rent that can change and it is not possible to forecast the selling price in advance. Therefore farms will be locked in the SPV and entered as NFT’s and the rent and sales proceeds will be “payment dependent” collateral in the Tinlake pool and will be used to draw a loan for a 3.1% interest rate up to 90% of the farm value. 3.1% is a bit above the expected rent yield (expected at 2.7% based on previous deals which is more than sufficient to pay the 2% Stability Fee), but the 10% buffer should be enough to sustain the difference for the duration of the investment (each farm’s intended investment horizon is expected to be 2-3 years). Also, per AEA representations, previous deals generated additional returns from land value appreciation of 8%-30% over 2-3 year hold periods.

The 10% remaining to finance the farms will be provided by the equity of the assets contributed into the SPV. For simple example a $1,000,000 farm contributed into the SPV will be contributed into Centrifuge and equity value contributed at $100,000. The maximum Financing Line will be equal to 90% of the value of the $1,000,000 (or $900,000). The DROP/TIN split would be 78/22 ratio. Or in other words DROP would be $702,000 and the TIN would fill in the rest at $198,000. Therefore, this 10% equity will be junior to the TIN tranche (on a property per property basis) and the 22% TIN ratio would be required to be maintained across the pool of assets.

Another innovation is that 10% of the capital gain of a given farm sale will be given back to the TIN holders in the Tinlake pool. In usual situations, this will not impact at all the situation of Maker that holds only DROP tokens with a fixed interest rate. Nevertheless, this can help in case of most farms losing a lot of value but some seeing appreciation (but we consider that case quite unlikely) .

MakerDAO will lend against DROP tokens. Alternative Equity Advisors will invest “at least” 10% of the SPV size in the SPV equity to have skin in the game (10% net of TIN as discussed later). Other investors may be invested in the SPV TIN tranche as well, but it will be required that Alternative Equity Advisors hold at least 50% of the TIN tranche to maintain their incentives in the structure. This makes the Alternative Equity Advisors through the SPV still have skin in the game even if the SPV assets lose 10-30% of their value.

Therefore, up to 50% of the TIN tranche can be invested by third parties. This might be proposed to certain qualified DeFi investors. The indicative yield on the TIN tranche is expected to be 7%.

The SPV balance sheet can be stylized as below.

Liquidation and the 5-year term

Another difference with other Tinlake pools is that we consent to lending for a 5-year facility for 2%. While it remains technically possible to set the Debt Ceiling to 0 (but damaging MakerDAO reputation), triggering a liquidation will have no impact on the actual properties.

After 5 years, we will be able to define a new interest rate or to close the investment. Alternative Equity Advisors will therefore sell the properties and not acquire new ones. There is a 18 month period for Alternative Equity Advisors to sell the properties before the independent director may find a new servicer to manage the sale.

The rationale behind the 5 year period is that as the properties are generating a rent that is more than DROP accruing interest, this might be less risky than lending against a collateral that should be sold in a short notice and not generating cash flows.

The possibility to invest for a significant amount of time was discussed here.

Proposed covenants

Allowed investments

Geographical limits: focus will be on Iowa but also include Illinois, Nebraska, South Dakota, Kansas, Missouri, Minnesota, Washington, Oregon

Type of crop: farms will be under row crop production already (primarily corn and soybeans but also other row crops) or exiting the Conservation Resource Program (CRP) within 12 months with a plan for conversion to row crops.

Lease: Farms will be leased to third party farmers immediately or upon expiration of CRP enrollment.

Size of the property: from 75 to 350 acres approximately

Property acquisition price: mainly between $500k to $1 million, but with a full range from $250k to $1.5 million

Collateralization ratio formula

The assets are defined being the appraisal price at acquisition. The farmland assets are then revalued annually via a third party market appraisal, but the original “book” price is maintained in the system.

Collateralization ratio proposed threshold

The collateralization is used to maintain a margin of the SPV farmland value to the debt drawn against the facility. A Loan to Value ratio of 70% is considered for the senior tranche (DROP). A mezzanine tranche (TIN) of 20% will be on top (with 50% coming from the equity). Then a last layer of 10% of equity (excluding the equity investment in TIN)

Concentration risks

The size of the farmland acquisitions are contemplated to be limited by size. This would result in diversification of a basket of farms each under 1M. This leads to 10-40 separate farms in the SPV.

Stakeholders rules

AEA, or any affiliate, will invest no less than 10% of the farm acquisition price. Some of that amount will be used to finance the TIN tranche.

The senior tranche, DROP, will mainly be owned by MakerDAO with some co-investors of which include the RWF Core Unit and more broadly MakerDAO community.

For privacy reasons, AEA did not want to share the financial statement of AEA and Peoples Company but we’ve got a comfort letter from AEA and Peoples Company VP of Finance. While we remain confident, this is the reason we ask for an Independent Director directly at the creation of the SPV.

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Extremely thorough risk analysis. We’re in good hands.

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I’m a little confused about the rate. I understand that the senior DROP note is priced at 2% on 70% LTV with 1.35 debt coverage, and the senior + mezz is priced 3.1% at 90% LTV, with sub-1.0 DSCR.

This appears to be grossly underpriced, using the details in the “Typical Lending Terms” section which calls for 50-75% LTV priced at 2.4-3.1% with 1.25x DSCR. 220-240 bps over literally any funding source should put us over 2.5% on the senior note. Please let me know if I misunderstand, or if I’m missing some significant credit enhancement that justifies a 20%+ rate discount.

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This is a good question.

The mezz is getting 7% + 50% exposure to the price increase of the land. It should be noted that the mezz is 100% financed by SPV equity at the start. We didn’t conduct a market analysis to see if there would be demand for this TIN tranche.

The rates are based on a real example but keep in mind that many of the loans were already there in December 2019. You can check here the evolution of the spread since then (for BBB but it’s similar across the range). Same for fixed rates (there is a graph in the Risk Assessment). Covid did a lot of rate compression.

From the MIP6 proposal:

The Issuer is able to obtain bank financing for a revolving line of credit at about 3.26% fixed with an 80% loan-to-value or 2.67% fixed with a 50% loan-to-value (as of November 2020).

Therefore, you can still say that we are giving a quite competitive deal with 2% and 70% LTV (not saying the maturities are the same). The initial ask was 90% LTV (and 2% SF) validated by a greenlight poll. We focused mainly to decrease it to 70% and add some safeties. Getting the risk assessment took 5 months and I can tell you that serious work was done.

I really see it as a POC with a traditional company (this is not a startup or a software-oriented company). This is a big step for them (hey, they will mint NFTs), innovative as well on the Centrifuge front (the first time the asset in the SPV is not a loan), and interesting for us (I expect good PR and I like the exposition to farmlands).

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From perspective of the potential “issuer” the “borrower of the DAI”, they would be taking some risks as well that don’t exist in the traditional finance world, including some currency risk if dai breaks peg, and the shorter term and duration of the financing. There is also additional complication with the SPV, NFT’s, etc that all things equal would make it apparent that there needs to be some enhancement to make the deal worthwhile. I could see it from a borrower’s perspective it being important to have a 30 year term and shorter rate reset periods to manage the interest rate risk.

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At the risk of sounding dumb because I lack knowledge of some known underpinnings/deal structure, but hopefully to provide some on-the-ground insight as to U.S. Midwest farming/lending:

Our actual collateral is an equity interest in the SPV that owns the real estate that can be assigned to Maker in a liquidation? The farmland itself is not collateral unless it has a mortgage in favor of the lender, and I assume from the above that is not happening? What is to stop those that direct the SPV from borrowing against the real estate that as to state law is free and clear with no mortgage on it?

Above says if tenant cannot pay then “Alternative Equity Advisors would need to find a new tenant” Well, unless the tenant files for bankruptcy and claims the lease as an asset, then AEA is potentially frozen until the completion of the lease. Are all leases just one year without automatic renewal terms?

Liquidation: as I read it, if the borrower stops paying, nothing effectively can be done until the end of the 5-year term in regards to taking/selling collateral?

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The soybean prices quoted above will certainly make for above-average profits in the U.S. this year for farmers that have fixed the price they will receive at harvest through futures contracts. Please however note the price level is a once in a 20- year event or more, and if you polled Midwest farmers many would say these prices won’t even last until harvest.

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Some of the exact legal structure is TBD, but the manner that it will work is that the farm assets are locked into the SPV and will need to remain free and clear from mortgages. The collateral is to be payment dependent based on the proceeds from rent income (to third party tenants) and farm sales. The protection is in the SPV itself where the mechanism will be to have a appointed director that can step in and monitor as well. The “no encumbrances” would need to be written into the SPV structure in all likelihood.

Bankruptcy of a tenant is potential risk and issue, but for the most part this risk is mitigated by collecting 1/2 of rent in advance. Most leases are relatively short duration (1 year) and largely even in bankruptcy farmers need to pay rent as it is an ordinary and necessary component of most restructurings. So, it is possible to get beaten out of the rent for a small period, but in my experience the Bankruptcy Code is going to make it where the debtor’s in possession will want to continue to farm the acres and pay the rent pursuant to the lease.

If the proceeds of rent and asset proceeds are not enough to maintain the appropriate ratios and pay the 2% DROP then, that should trigger the MKRDAO option to start the process to redeem the drop. That starts the clock for Alternative Equity Advisors to sell assets, or otherwise refinance the facility. In case of situation where they are not performing under the terms of the agreement, then a substitute farm servicer would step into the shoes and perform the farm management function.

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Thanks @jameskmccall @SebVentures - to summarize and make sure I’m understanding correctly, the rate discount is justified by the following factors:

  1. MakerDAO will make inroads with traditional borrowers by completing this proof of concept.
  2. The borrower is also taking a risk by going with a new and unproven lender in a new and technologically complex process with loan proceeds received in the form of DAI.

This makes sense as to the rationale behind the attractive rate, but it does emphasize the importance of the collateral in this context. Obviously you realize this and I (we?) appreciate the work you’ve done already to de-risk the deal by reducing LTV and requiring additional “skin in the game” from the borrower. It would suck to have this POC fail, and I wonder if moving into agricultural financing (which seems somewhat more complex compared to multifamily, office, retail, industrial financing) could be biting off a lot for a POC.

So there are some aspects of farmland financing and leasing that make it a little more friendly — risk of the asset being unoccupied by a tenant is very low unless very marginal land is purchased, and as stated above, the cadence of rent collection is favorable for the landlord.

While there are obvious risks — especially with farmland suited to row crops that must compete in large or global markets as opposed to specialty crops in more local or protected markets — don’t forget that some risks are fairly low compared to other classes of real estate.

As to low and aggressively competitive rates: remember that we do not have to source our funds from elsewhere, so any yield that is >0 is workable as long as the risk is not out of sync with the payment. For an ultra-safe asset (which I don’t know that I would characterize row crop farmland as, but it approaches it), any positive yield is worth considering. Our unique method of financing also makes us less sensitive to interest rate risk for the same reason.

Maker also is not sitting on a hoard of cash that must be put to work – if a deal is profitable, we can take it, and if it is not, we can pass. The physics of finance in the crypto space are a little different (flash loans, anyone?), as the cash-equivalent we provide does not exist until a deal is finalized, and cannot even be created until a deal is finalized.

This means there should (maybe?) be less emphasis on actual credit risk on a loan, as it isn’t huge in and of itself, and more that a default without a remedy would signal to other borrowers they could do the same. That moral hazard and anything that would endanger the peg of DAI <> USD would be the real risks at the end of the day. Note that this is not to minimize the importance of due diligence, but that the importance of various types of risk are different than in traditional lending.

As always, this is uncharted territory, so there are likely to be some bumps along the way. The size of this deal in the Maker portfolio coupled with the generally conservative underlying asset make me personally less sensitive to the rate than to the safety of the loan. I can’t speak for others, though. My first impressions are favorable, but will reserve final judgement for a third or fourth read through the summary.

Yes. Well everything RWA is POC yet. This isn’t about moving the needle yet for MakerDAO.

Indeed.

We don’t have an equity interest in the SPV but we are lending to the SPV against the collateral (farmlands). This is done thru Tinlake and the contractual obligations (hence the proposition for MakerDAO community members to invest in the DROP). Contractually by minting the NFTs, the asset is encumbered but this is indeed not a filling. It would be quite obvious in the financial statement of the SPV if there is another loan taken.

Regarding the lease, I would say that they have provisions to deal with issues. But indeed things can escalate, but I would this would be out of the ordinary.

We don’t take the collateral as we are not a legal entity anyway and there can be other third-party investors. If the borrower (the SPV) stops paying is getting rent payments, that would be against the contractual obligations. The independent director should be there to stop that. This is also why we need legal persons to invest in the DROP to add another line of defense.

This. U.S. tillable farmland is a stable asset in the scheme of real estate. LTV 70% which is what conventional financing from a regional/local bank on the ground would demand sufficiently covers all but once in a generation event as to the lender becoming undersecured, and even in such an event the loss for a secured lender should not be catastrophic. I am not concerned about what could be considered low rates for the reasons stated by PaperImperium and others including that the borrower is taking a chance with MakerDAO, although I would note getting nonrecourse financing is huge for the borrower and to my knowledge almost unheard of at the regional/local level of lending.

My concern and what will be driving my followup to the responses given to my inquiry is whether in the proposed structure (a) the farmland or even the equity interest of the SPV owning the farmland is too far removed from the lending and (b) a default has no real remedy that we would be effectively lending on a promise to pay - unsecured - or that the market will perceive that it is and will perceive that we minted DAI on a promise to pay rather than against hard assets.

Please feel free to critique. I continue to qualify I am new to a process you all have worked hard to develop and I respect that.

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Good point here

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One aspect of farmland that is different than other commercial investments is that they have zero to low percentage of value in depreciable assets. Therefore, there is less risk of “obsolescence” or having the copper pipes stripped from the walls thereby wasting the asset. That is why do some degree, investors in farmland are willing to accept a lower cap rate, than for example a multitenant commercial building.

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Nonrecourse is a big enhancement to the proposed issuer. But recourse is a tricky beast for MKR to enforce anyway.

This is a good point and was largely outside the scope of the risk assessment as it has to do with the legal structure of the SPV, the legal agreements and relationships amongst all the parties. The contemplated design of having the real assets owned “debt free” in the SPV, with an independent director that would make sure that the obligations are being fulfilled. In traditional lending, the “or else” is often enforced through a mortgage or deed of trust, where the lender takes back the farm and sells to recapitalize the loan. The “or else” here could be the independent director asserting that it needs to step in the shoes of SPV management. This is actually a powerful recourse as in that case, they presumably would have the power to market the real assets, collect rents, and continue to fund the payments on the DROP facility. The other “or else” is the MKRDAO put option, which would call for an orderly liquidation of assets to repay the facility.

Right, we can’t do recourse, just saying it’s as you say a big enhancement.

Thank you. Will there be such terms re: independent director power?

I think recourse ability and access to collateral by the lender while it certainly does involve deal terms is well within risk consideration. This proposal is not risky from the vantage point of a proposal to 70% LTV lend to purchase Midwest U.S. tilled row-crop land in which the land purchased is collateral for the loan. The proposal is potentially risky in my mind because the proposal is not quite that straightforward.

And your earlier response helped me walk through the tenant bankruptcy risk in my mind.

As I see it, the greatest risk is either:

  1. First half rent is not received, crops planted, tenant files bankruptcy. The trade creditors who have statutory liens for fertilizer, chemicals, etc. against the growing crops obtain a court order providing for the continued farming for the year to obtain satisfaction of their liens, without payment to SPV. SPV could be out for that year on rent or ability to re-rent with the hope it could recoup the second half as an administrative claim.

  2. Same as #1 except first half rent is paid. Same result above except trustee or DIP pursues clawback preference against SPV and SPV has to cough up part of the first half rent.

This is only a substantial risk if the property manager has for example one renter for all holdings in a state. Terms should thus provide limit on acreage rental by any one renter.

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Thanks for helping me understand.

“Contractually by minting the NFTs, the asset is encumbered but this is indeed not a filling.”

But that is just a contractual promise, not a lien, right?

“It would be quite obvious in the financial statement of the SPV if there is another loan taken.”

Well yes, but then it is too late. Is this issue handled in that lending by the SPV, or sale of SPV real estate, requires unanimous board approval and thus the independent director can stop those actions up front?

Are rent payments actually made to the SPV? If not (which I assume that is the case) how can the independent director redirect the receipt of rent by that party to payment of this loan?

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