July, 2014 White Paper
Julie Koeninger
Farmland is a real asset that combines solid investment fundamentals with the potential for attractive cash yields, inflation hedging, and consistent returns from biological growth. Furthermore, farmland total returns tend to be uncorrelated with financial asset returns, offering genuine portfolio diversification for institutional investors. While institutional ownership within the asset class has grown steadily over the past few years, it still accounts for less than 1%1 of total global agricultural land ownership, presenting significant opportunity for sustainable yield enhancement through targeted farmland investment in certain regions.
The pages that follow present an overview of the key characteristics and potential risks of farmland investing, consider the routes for implementation, and make the case for a diversified, cross-regional approach to the asset class.
Farmland Investments Defined
Farmland investments consist of direct investments in rural land along with crop and livestock assets that produce food, fiber, and energy. Farmland investments focus on the productive capacity of the land base, and returns are based on the biological growth of crops and livestock, as well as appreciation of land and related assets. By their nature, farmland investments are long-term illiquid investments in real assets.
Investments are grouped into three general categories:
1.Row crop investments include annual crops such as corn, soybeans, cotton, wheat, and rice.Management Style: Leasing vs. Direct Operation
2.Permanent crop investments include perennial crops such as fruit and nut crops, which have both pre-productive and mature periods. Pre-productive or “greenfield” investments where trees or vines are planted on bare ground have a “J-curve” return profile. Some mature permanent crops, like almonds, peak in productivity and then decline, so orchard age is an important factor in estimating productivity and value.
3.Livestock investments include land leased to local operators for grazing or direct livestock ownership and operation.
Institutional farmland investing typically focuses on globally competitive agricultural sectors including:
■Corn, soy, wheat, rice, and other bulk commodity row crops that can be produced most efficiently at scale.
■Relatively storable permanent crops such as nut crops or wine grapes.
■Large-scale livestock production, including dairy and beef cattle operations.
Efficient global producers, such as U.S. corn, soybean, and nut crop, New Zealand dairy, and Australian beef producers, benefit from participation in export markets, and receive a globally determined price for their output.
In many regions of the U.S. and some other parts of the developed world, row crop properties can be leased to high- quality local farm operators at fixed or variable rents that provide attractive yields to the investor. These farmers leverage the scale and productivity of their operations by owning some land, but also leasing land from investors in order to maximize their return on investment. In other geographies lacking a robust farmland rental market, particularly in developing regions, a lack of leasing demand from qualified farmers makes direct operation the best approach to maximize returns. In direct operation, the farmland investment manager employs a farm manager to operate the farm. While direct operation involves a higher risk/return profile because the investor assumes both price and yield risk, it is often the preferred management style for permanent crops and livestock as it ensures that the long-term asset is well-managed and value is maintained.
Property Management
Like most real estate investments, farmland investment requires specialized property-level management. While more intensive property management is required for direct operations, property managers also provide critical oversight of tenants operating leased farms. Property management may be vertically integrated with investment management or outsourced to third-party providers. Outsourcing allows the investment manager to hire the property manager best suited to manage each type of investment in each region and can be more cost effective as the fund manager need not invest in property management infrastructure in multiple locations. Utilizing a third-party property manager enhances transparency, as it allows for a true separation of fund- and property-level expenses.
Investment Vehicles
Investors can participate in the farmland asset class through direct investments or through the use of a specialist farmland investment manager, that may offer funds, co-investments, or separately managed accounts. For most investors, developing a well-diversified portfolio of direct investments is prohibitively complex and time-consuming. Investing in farmland through a farmland investment manager can provide the benefits of diversification, experience, and scale. Closed-end funds have a fixed term with some potential for extension, but are generally illiquid for the term. As with private equity, fund terms can vary widely. Open-ended funds and publicly-traded REITs provide more liquidity, but valuation at entry and exit can be an issue in open-ended funds, and the performance of public REITs can be influenced by capital market trends and other factors apart from the underlying farmland investment. Co- investments and managed accounts often require a larger minimum investment, but offer investors a greater measure of control.
Sources of Return
Returns typically consist of current income from annual lease payments or from annual crop or livestock sales, plus land and related asset appreciation. Appreciation reflects the income-producing capability of the investment based on anticipated future crop/livestock prices and yields. While soil quality and climate/water availability are relatively fixed determinants of a property’s potential yield, technological and management improvements can be brought to bear on individual properties to enhance yields and returns to investors. Capital improvements such as irrigation, laser leveling, and drainage can increase current income as well as future value, as improvements that permanently increase productivity are eventually capitalized into land values.
The timing of cash flow distributions from farmland investments is dependent on both the investment vehicle and the actual investments in the portfolio and how they are managed (leased vs. direct operation). Cash flow available to distribute will depend on the relative proportion of developmental (pre-productive) properties and cash-flowing properties in the portfolio. Lease payments are typically received before the farmer enters the field, while revenue from direct operations is received as crops are sold over time. A leased U.S. row crop property may produce a relatively consistent annual income return of 3-5%, depending on its quality and location, while some directly- operated permanent crop properties can produce double-digit annual income returns, but with significant variability due to annual fluctuations in price and yield. Closed-end funds typically distribute cash flow net of working capital reserves and cannot reinvest income in additional properties, while evergreen funds and separate accounts may choose to reinvest a portion of income and realized gains. A REIT must distribute at least 90% of its taxable ordinary income to shareholders annually in the form of dividends.
How Farmland Fits in an Institutional Portfolio
Farmland has historically generated attractive returns, with excellent capital preservation and portfolio diversification at a low to moderate level of volatility. Some institutional investors allocate to farmland in the context of a diversified real asset portfolio that may include investments in real estate, infrastructure, forestry, and farmland. Others may include farmland in private equity or other illiquid asset categories. The exhibit below shows the 20-year realized correlation of U.S. farmland to other asset classes. While exhibiting low correlation to financial assets like stocks and bonds, farmland investments can provide a bond-like current income stream from lease payments or more variable income from direct operations, along with the potential for capital appreciation. In addition, through thoughtful portfolio construction, the risk/return profile of a farmland allocation can be varied to meet different risk/return preferences.2
Portfolio Diversification
Farmland portfolios can be structured as a balanced mix of row crops, permanent crops, and livestock or can be focused on a particular strategy/sector or other variations across the spectrum from fully-diversified to targeted investments. Portfolios may include ongoing farming operations or developmental “greenfield” or timber conversion strategy investments. As described above, leased row crops offer the lowest risk/return profile because the farmer takes on the price and yield risk, paying the investor a modest bond-like rate of return before beginning to farm each year. Participating or crop share leases allow both the farmer and investor to participate in some portion of annual upside/ downside. Directly operated permanent crops and livestock can provide higher returns, but the investor is exposed to both price and yield risk, thus increasing return volatility and potential for operating loss. Mixing low-risk leased investments with higher-risk directly operated strategies (including developmental/conversion properties) can provide current cash flow along with upside potential. Focused portfolios invested in a single sector such as leased row crops or livestock may fit a specific investor objective such as a desire for stable but modest returns (leased row crops), or an interest in higher income and appreciation potential (livestock and permanent crops), but more diversified strategies can help mitigate non-systematic risk.
Geographic diversification is also related to strategy choice. For example, globally competitive dairy and beef production might dictate investment in New Zealand and Australia, while leased row cropland is the norm in the U.S., but not necessarily in other geographies. In some regions, mixed-use properties that may include crops, livestock, and timber offer value-oriented opportunities relative to pure single strategy investments. Investing in emerging countries can provide greater upside potential, but at higher risk levels than developed country investments. Portfolios can be tailored to desired levels of diversification, but relative value and opportunity across sectors and geographies should be considered as well.
Investment Performance
Historical returns to direct farmland investments have been relatively high over the past two decades and particularly over the past decade as farmland investing has gradually gained popularity among institutional investors. Initially a long-term investment utilized by a small number of insurance companies and large pension plan investors, farmland investing has become more mainstream due to a convergence of factors: favorable supply/demand fundamentals, globally low investment yields in traditional “safe” assets like bonds, and increasing investor interest in diversifying real assets capable of providing an inflation hedge.
The National Council of Real Estate Fiduciaries (NCREIF) reports nominal annualized time-weighted total returns of 12.5% for its Farmland Index over the past 20 years and 17.5% over the past 10 years. On average, over the 20-year period, income has provided at least 50% of Farmland Index returns. Over both time periods, farmland, as represented by the Farmland Index, has generated higher returns than equity indices, with less volatility. It should be noted that this reduced volatility reflects in part the fact that farmland investments are not daily valued, but are typically appraised annually.3 The Farmland Index reflects the investment performance of a large pool of individual agricultural properties acquired in the private market for investment purposes only, and held in a fiduciary environment for the benefit of tax-exempt institutional investors, primarily pension funds. It includes property-level returns to U.S. farm properties only and is net of property management fees, but gross of fund-level fees. Given its tax-exempt, property-level focus, only the effect of property taxes is included in the Farmland Index. Despite its shortcomings as a benchmark for global agricultural investments funds, the NCREIF Farmland Index does provide evidence of trends in investment-quality farmland performance and is currently the only available index of its kind.
Supply-Demand Fundamentals...MUCH MORE (9 page PDF)
Given the strong performance of farmland in recent years, the question as to why today is a good time to invest is a reasonable one. The answer depends on global macroeconomic forces, but also on the specific global strategies employed and locations targeted for investing in farmland today....
HT: Abnormal Returns
