Changing income assumptions in row crops suggest a major shift is underway
During the past decade the farmland asset class has experienced steady growth and attractive performance. Rising global demand for food and fiber, and a reduction in the relative value of the U.S. dollar, bolstered both agricultural commodity prices and farm income. In addition, falling interest rates propelled farmland capital prices to unprecedented levels. As a result of these factors, the NCREIF Farmland index posted a 17.6% annualized total return for the 10-year period ended Sept. 30.
Now, however, falling prices for row crops, like corn and soybeans, which often account for more than 60% of the typical institutional portfolio, suggest farmland investors will need to consider other strategies for generating attractive returns in the future.
The NCREIF Farmland index tracks the performance of nearly $5.5 billion in institutional row crop and permanent crop investments in the U.S. alone, but institutions actually might have invested between $8 billion and $10 billion in the asset class, and some estimate at least $5 billion more has been allocated for future investment. The value of institutional-grade farmland in established investment regions like North America, South America, Europe and Australia is estimated to be in excess of $500 billion. This means there is still strong interest in farmland and ample opportunities for investors to increase their participation in the asset class.
There is a strong appetite for hard asset exposure, but the farmland investment sector is maturing and evolving as large-scale inefficiencies are wrung out of the market and as competition for deals increases. These factors, coupled with the slackening conditions in commodity markets, should be causing farmland investors to re-evaluate both the composition of their portfolios and the passive “buy-hold-lease” approach investment managers typically employ on their behalf in the row crop sector — an approach that entails leasing land to tenant farmers.
As of the third quarter, row crop values represented about 57% of the NCREIF Farmland index, down from 67% at year-end 2013. The remainder of the index consists of permanent crop investments like fruit orchards, nut and olive groves, vineyards and cranberry bogs, which tend to be directly operated to protect the investor's interest in the commodity-producing trees and vines. Investors that lease their row crop holdings to independent farm operators, which, again, is the case with most institutions, typically enjoy predictable cash flows because they are shielded from short-term commodity price and yield swings. They also are protected from the natural risks inherent in production agriculture, such as weather and pests. This means income returns from leased row crop land investments are typically lower and less risky than income returns generated by owner-operated permanent crops.
Over the past decade, row crop investments tracked by the NCREIF Farmland index have generated a total annualized return of 15.1%. Based on an informal survey of projections offered by prominent farmland investment managers, it appears that many expect such assets to continue producing annualized total returns of at least 8%. These projections are usually based on the notion that farm rents will continue to accelerate in the years ahead. However, the computational methodology that underlies this assumption is fundamentally flawed.
Because row crops are leased to tenant farmers, the rents those farmers pay not only represent the annual cash flow component of a row crop investment – but also they drive underlying land values because land price appreciation is a function of expected future cash flows and the opportunity cost of capital. The National Council of Real Estate Investment Fiduciaries reports that row crop land appreciated at an annualized rate of 10.5% during the past decade. However, in 2013, rent-based income only accounted for 25% of row crop total returns. This is largely because farmland price appreciation has begun to outpace rent appreciation, which has compressed cap rates. In a new, lower commodity price environment, tenant farmers will be less willing or able to pay higher annual cash rents for row crop lands, which, in turn, means row crop land appreciation will slow or cease in the coming years. This suggests institutional owners of row crop assets will be almost completely reliant upon the income generated by those assets to produce their returns. According to NCREIF, row crop income was just 4.1% in 2013. This was well below the 8% total return expectation that, again, is commonly touted for row crops and which continues to be used to underwrite many row crop acquisitions.
In short, it appears assumptions about row crop land values are surging ahead of evolving investment fundamentals.
Row crop assets can continue to play a role in institutional farmland portfolios because they can generate steady and predictable cash flows and provide diversification. However, for the reasons just outlined, it is unrealistic to expect row crop investments to generate total returns of 8% or higher in the upcoming years. Given the prevailing circumstances, row crop assets should only be acquired and held if an investor is very optimistic about future row crop commodity prices or is willing to accept very modest returns from those investments.
Institutional investors that are focused on maintaining or expanding their hard asset exposure by investing in agriculture, and that hope to produce returns consistent with those generated by farmland over the past decade, will need to step away from passive “buy-hold-lease” strategies that have characterized the row crop sector for the last two decades. They will need to invest more heavily in permanent crops, in niche and developing global markets and perhaps even in “greenfield” crop establishment opportunities.
They also will need to move downstream in the supply chain and consider structured, hybrid agricultural investments. These private equity-like opportunities entail capitalizing integrated agricultural operations that include both quality farmland assets as well as processing infrastructure and, or distribution resources — outside the farm operations that prepare and bring agricultural commodities to end-use commercial and consumer markets.
Cody Dahl is an agricultural economist and senior investment strategist at AgIS Capital LLC, a Boston-based private equity firm that makes investments in farmland and agricultural assets. Brent Gloy is a member of the firm's advisory board.