6 4 Associated CointreeAlex on 01/02/2022 - 14:07 cointree.com (142...Read More
Benefit from providing food for the people - what could feel better?
Photodjo/iStock via Getty Images
Historically, portfolio construction has been about equity vs. bonds. The famous 60/40 portfolio is testament to this approach. However, more recently, other asset classes have made their entrance. From private equity over cryptocurrencies to classics like commodities, a wide variety of other asset classes have gained prominence.
Similar to many retirees that look for consistent returns to fund their living expenses, endowments are tasked with a similar challenge. Famously, Yale under David Swenson has been pioneering branching out to non-traditional asset classes with huge success. Private investors are well advised to take note.
While Yale was mostly known for their exposure to private equity, they also invest in what they call real assets. Infrastructure assets and real estate are part of this class. In this article, I want to talk about why farmland as a distinct subclass of real estate is a wonderful addition to most portfolios. Just to be clear: this means owning farmland and leasing it out to farmers and not operating a farm as a business.
Farmland has historically performed on par with equity returns while exhibiting lower drawdowns and low correlation to major asset classes. After several years of stagnation, it seems that stars align right now for another likely upcycle in farmland prices.
Finally, I will discuss how to best get exposed to farmland as a retail investor and what my preferred vehicle would be.
While one could consider farmland as just another real estate asset, there are several fundamental differences that sets it apart from the broader real estate category:
Farmland produces food. It does not get more basic than this. An ever-increasing population needs to be fed. While some neighbourhoods become unfashionable, retail properties are at risk from e-commerce, or cinemas are impacted streaming and COVID restrcitions, food will always be in demand.
While buildings are generally in need of regular refurbishments, many tracts of farmland can be used for long periods with only limited Capex. This is especially true for row crop farmland or pastures. With permanent plantings, however, it unfortunately is evident that they are far from permanent and need replacing every 15-25 years depending on the type of produce.
farmland a near zero vacancy asset (Farmland Partners investor presentation)
As Farmland Partners (FPI), a farmland REIT, points out in their latest IR presentation, farmland can be considered a near-zero vacancy asset. Unlike with real estate, there is nearly always someone to take on a land lease for a planting season and grow produce on a piece of good farmland. As leases are often short term, there is little commitment from either side, but at least there is no vacancy even during a major economic crisis. This again might be slightly different for permanent plantings where leases also tend to be longer term and need more of a committment.
Farmland has proven to be a popular investment in recent years. High profile buyers like Bill Gates and increased demand from institutional investors are testament to this. Why this interest in farmland specifically? Just how good is farmland really? Is it just a recent hype or is there a long-term opportunity in it? Let's first look at its historic performance based on a recent TIIA study:
Farmland relative return characteristics (Oct. 2020 study by Bruce Sherrick, Ph.D, Director of TIAA Center for Farmland Research)
As one can clearly see, not only does farmland have the second highest annual return after listed real estate, but also by far the lowest negative return of all non-fixed income asset classes, as well as the lowest standard deviation. To be fair, the latter two might be partially artificial due to the limited price observation during market panics, as farmland is not really traded at public markets. On the other hand, fixed income is looked at with their respective rate one can expect to earn when holding to maturity and not based on price movements that should most likely show bigger drawdowns. Overall, it seems that on its own, farmland is an excellent asset class with high returns, low downside risk and low volatility.
But also in a portfolio context, farmland performs exceptionally well. It provides sizeable diversification benefits to an equity-heavy portfolio due to its high negative correlation, while on the other hand not compromising the portfolio's overall return as one of the highest-performing asset classes. Interestingly, it also exhibits a negative correlation to US-listed real estate. As many retail investors use REITs as a proxy for real estate, this highlights why farmland should be seen as not just another real estate investment, but rather as a distinctive asset sub class whose properties deviate from the standard real estate asset.
Admittedly, the 70s were a horrible decade for stocks, but extremely strong for farmland and that period somewhat distorts the picture. But even in more recent periods, the main characteristics remain:
more recent performance of farmland (Oct. 2020 study by Bruce Sherrick, Ph.D, Director of TIAA Center for Farmland Research)
Here, we still see high standalone returns, low downside risk and low correlation to other asset classes, although not quite as negative with regards to stocks as before. Therefore, while the concrete numbers change over time, the overall characteristics seem stable and very benign.
"Buy land, they are not making it anymore" (Mark Twain)
The above quote is often used to justify why land should work as inflation hedge similar to gold, art or more recently cryptocurrencies like Bitcoin. It is of limited supply and as the amount of paper money increases, so should the value of those things expressed in paper money (i.e., USD). Unlike many of the other inflation hedges, farmland also serves an economic purpose and generates regular income.
After decades of declining inflation, the trend has reversed which is why investors look for ways to protect their purchasing power. From the table above, it seems that the inflation hedge properties of farmland have been declining over time. From the 1970s to now, we see a positive correlation with CPI of 0.65. Whereas in the more recent time frame from 1991 onwards, correlation to CPI is barely positive at 0.15. This makes some sense as the 1970s were a spectacularly good period for farmland as the Soviet Union opened up its markets and farmers took on leverage to consolidate their farms and reap the benefits of scale. This coincided with high inflation leading to a very positive correlation with CPI, which might not have been justfied fundamentally.
What we also see from the more recent data is that correlations with rates (mind you, the table shows rates and not prices) have shifted from positive to negative. Therefore, as rates increase, farmland returns tend to drop. This makes intuitive sense as farmland is a very long-term asset. It has been around for often more than one hundred years and might be around for ages. As the value of an asset is its discounted cashflows, a very long duration asset like farmland will be strongly negatively impacted by higher rates as those increase the respective discount rates to value the cashflows assuming those stay unchanged.
Is farmland, therefore, not really the excellent inflation hedge it is touted? Might it rather be at risk from rising rates? Not so fast! Our assumption above was to hold everything else equal, that famous "ceteris paribus" you find so often in textbooks. However, reality is not a steady state but always in motion. Things never stay the same. If inflation is generally widespread in the economy, it normally means that food prices also go up which leads to higher income for farmers. This would also increase their ability to pay higher rents to landowners. As rental agreements on annual crops tend to be fixed short term (1-3 years), this might take a bit initially but will eventually flow through to the landowner's bottom line. This could counter the negative valuation effect on farmland. Is there evidence for such a behaviour? Luckily, there is:
farmland 3-year correlations (Oct. 2020 study by Bruce Sherrick, Ph.D, Director of TIAA Center for Farmland Research)
As one can see, the correlation of 3-year rolling returns with inflation measures CPI and PPI are very high. Higher than the 0.65 of the first table, even though it covers the same time period. Unfortunately, I could find these returns for more recent periods. This indicates that over the medium term, inflation protection should be stronger than a just very short-term, one-year correlation would indicate. While there might be an inital negative effect of higher rates, it tends to be countered by increased rental payments over time. Looking at how farmland returns were over the last 50 years and how that compares to CPI paints a much rosier picture:
farmland return spread vs. CPI (Oct. 2020 study by Bruce Sherrick, Ph.D, Director of TIAA Center for Farmland Research)
The blue line in the above chart shows the spread between farmland returns and CPI - basically the real return of farmland. It only dipped into the negative in the mid 80s during the big farm crisis and then shortly touched zero in 2009 during the financial crisis. In all other periods, the returns remained positive both nominally and in real terms. As such, farmland seems to be able to conserve one's buying power very well.
farmland real returns (Oct. 2020 study by Bruce Sherrick, Ph.D, Director of TIAA Center for Farmland Research)
One can see that the 70s strongly distort the picture to the positive side and during such times as the mid 80s even such a great asset class as farmland can struggle if several factors combine negatively. But still, farmland was able to produce inflation beating returns during all periods. More recently farmland has proven to be a steady but by no means stellar performer with reasonable real returns. Putting it all together over the medium to long term farmland seems to be a very good inflation hedge while short term it might sometimes be impacted by eg. rising rates or unfavourable conditions. It is therefore suited as a strategic portfolio component that helps preserving one's buying power in the face of rising inflation over the medium to long term.
While farmland has performed well historically, more recently, it would have been a drag on a more equity-focused portfolio in terms of total returns (while still providing good diversifaction benefits). Therefore, it seems sensible to check the current backdrop on farmland or more specifically, cropland (i.e., no pastures) as that is what we can buy with the farmland REITs, which I will discuss later on as my preferred way of investing in farmland. The US Department of Agriculture provides some useful data.
Cropland Value Development (USDA)
As one can see, cropland values have been fairly steady in recent years and only really gained momentum last year. While this data ends August 2021, more recent data points indicate continued momentum. In some of the top performing regions, land prices seem to have jumped by more than 20% last year. This is supported by increases in farm income as shown by the Minneapolis Fed for the 9th district:
Farmer's income in 9th district (Minneapolis Fed)
The outlook for the current year is also very favourable. The prices of the main agricultural commodities also shot up after Russia invaded Ukraine as both countries are major exporter of agricultural goods. This is most apparent for wheat prices.
Soybean futures (Seeking Alpha)
Corn futures (Seeking Alpha)
Wheat futures (Seeking Alpha)
Prices have now reached the levels they had ten years ago. Back then was such a favourable pricing environment that cropland prices rose 50% from 2010 to 2014. Other initiatives like Biden's proposal to allow the sale of E15 this summer only add to the favourable backdrop. Unfortunately, not only produce prices soared but also input costs like fertilizer or gasoline did. And while I doubt ag-related prices will stay at that high levels, I do believe the income outlook for farmers should probably be positive over the next few planting seasons.
All things considered, the environment for annual crop farmland seems very favourable at the moment and I believe we could be at the start of a new upswing in cropland prices over the next few years, similar to the 2010-2014 period after prices mostly moved sideways since 2014. This should help overcome the negative headwinds from rising rates. The Ukraine war has also highlighted once again the strategic importance of domestic farming. Therefore, I do expect political support for farmers to continue for the foreseeable future which also limits some of the underlying volatility of farming.
Above performance data is as always only true for the aggregated asset class. However, farmland is a highly diverse asset class with major differences between the individual properties. Thus, individual farmland performance might deviate a lot from the average which makes it all the more imperative to invest in a fairly broad portfolio of farmland assets to capture the defensive characteristics of the asset class. The big farm crisis in the 80s lead to many bankruptcies and foreclosures. Land prices dropped by 50% in some areas:
The average value of farmland per acre in Minnesota fell nearly 40 percent from $1,165 in 1982 to $700 in 1987. Jackson County farmers experienced the sharpest decrease in land values in Minnesota during this period, with prices falling nearly 54 percent, from $1,991 to $921 per acre.
Thus, while one can now invest in individual properties on some sites like FarmTogether, I would argue that from a portfolio point of view, a broader more diversified investment makes more sense. One of the main attractions of owning farmland is its defensive property as a portfolio diversifier and long-term inflation hedge. To fully capture this, the holdings should be well-diversified geographically as well as by produce. Even if corn or wheat farmers struggle, almond farmers might thrive and vice versa. The graph below shows how distinct land values and their price developments are within the US. Unless one is an expert on the field, I would, therefore, suggest to invest in broad portfolios of farmland rather than individual properties. Just like with real estate, publicly listed companies that own large tracts of farmland would make an ideal investment vehicle due to this reason.
Cropland Value Development (USDA)
Unfortunately, I only know of two listed REITs that specialise in farmland. Gladstone Land (LAND) on which I recently wrote an article and Farmland Partners (FPI) on which I plan to write a more in detail article. Right now, I prefer FPI over LAND. FPI trades at a lower valuation, is internally managed which provides better operating leverage and is more exposed to annual row crops which should provide better leverage to an upswing in agricultural prices, rent increases and land values. With FPI, one gets easy access to a diversified portfolio of farmland.
Farmland Partners in a nutshell (Farmland Partners IR presentation)
According to my estimates, at $14.50 FPI currently trades at around the fair value of their land holdings, which means one can get access to a large diversified farmland portfolio, without having to pay a premium. As they employ leverage gains in land prices will be amplified by holding FPI. I recently sold out of Gladstone Land on valuation grounds and invested in FPI. However, as Gladstone Land's share price has been coming down recently, I do get more constructive on the name again and look forward to possible getting back into it at some stage as both companies supplement each other very well.
Investing always has risks attached to it. Investing in farmland is no different. Farmland might be more negatively impacted by rising rates than I foresee or maybe rising input costs, in terms of fertilizers and gasoline, pressure farmers more than anticipated impacting their willingness to accept rent increases. In addition to this, there is always the unpredictable weather and politics that can have a profound impact. Investing in a publicly listed vehicle like FPI comes with its own additional risks. Unfortunately, there is no big choice when it comes to investing in farmland-focused REITs. Therefore, idiosyncratic company risk is unavoidable when chosing to go down that route which is why I recommend adding those stocks as an addition to a well-diversified portfolio rather than a major standalone investment. FPI has been trading well below NAV for a very long time and there can be no guarantee that it will reflect rising land prices adequately.
Farmland has proven to be a high return asset class that exhibits low correlations with other asset classes. It, therefore, makes an excellent addition to most portfolios. Furthermore, current conditions with increasing inflation as well as high agricultural commodity prices might point to a favourable entry point right now. Farmland prices have already started increasing strongly and that might possibly continue for an extended time period. As individual farm performances greatly vary, I suggest getting into the asset class by investing in a strongly diversified portfolio. Unfortunately, options are very limited. As the publicly listed REIT Farmland Partners currently trades at around NAV, I think it provides a good way to gain exposure to the sector. Alas, individual stock risk remains. FPI is thinly traded and occassionally swings around wildly during the day. Therefore, please make use of limits.
This article was written by
As I have always been intrigued by the dynamics of the broader economy and stock markets in particlular I am personally invested in the stock market since my youth for over 30 years now. I followed my calling and studied economics and finance to work in the financial industry. I stuck to the buy side to avoid conflicts of interest and as I am more interested in analyzing stocks and markets than selling my views. I worked as fund co-manager and analyst for a leading mutual fund company responsible for long-only stock market investments especially in financial companies. The investment style was strongly fundamentally driven but also with attention to newsflow and upcoming catalysts impacting stock prices short term. Later on I widened my area of expertise by working as an analyst at a multi billion dollar multi strategy hedge fund. There I learned to appreciate the importance of capital structures when analyzing investments which is still often ignored by investors. Furthermore I gained experience in analyzing arbitrage and MA situations. Ever eager to get new insights and admittedly also to get a better work life balance I changed jobs to work at a financial regulatory authority. In this position I was responsible for developing international regualtion as well as supervising specific companies. I loved the international aspects and the position gave me good insights into the workings of regulation as well as into the politics behind it. In those functions I had extensive contacts to corporate executives of all levels and departments via 1:1 or group meetings, IR events or sometimes week-long on-site inspections. This gave me invaluable insights into companies that is otherwise very hard to get. Due to this experience I also learned how to read between the lines and know very well that messages are made for a specific audience and therefore need to be taken with a grain of salt. I always enjoyed a fruitful discussion which is why I have now decided to round off my career by sharing my views and discussing investment ideas with the broader public and in turn benefit from their feedback. Due to compliance reasons I will however refrain from explicitely writing about concrete experiences gained during my career and will limit my contributions to publicly available information while drawing upon my experience from my diverse background in the financial industry.
Disclosure: I/we have a beneficial long position in the shares of FPI either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am an independent individual investor that shares his personal views based on publicly available information. Nothing in this article nor any published commentary by me is intended to be investment, tax, or legal advice or an offer to buy or sell securities. Tags used by Seeking Alpha like "buy", "sell", or "hold" are not an invitation or recommendation to do so but only signal my personal view on a stock and are required by Seeking Alpha for the article to be published. Information presented is believed to be factual and up to date, but I do not and cannot guarantee its accuracy as mistakes might always happen. Opinions and judgements can always be wrong. Given the limited space of an article, it should not be considered a complete discussion of all relevant factors and risks. Furthermore I am under no obligation to update the content of the article and it therefore should be seen as a snapshot of my views during the time of the publication which might have since changed without further notification. Therefore readers and investors invest at their own risk and should not rely on the content of this article when making investment decisions. Any investment in any stock mentioned could result in a 100% loss. Readers and investors should do their own research and seek investment advice before investing.
6 4 Associated CointreeAlex on 01/02/2022 - 14:07 cointree.com (142...Read More