Farmland investing in California: Withstanding a historic drought

California is the nation's most productive agricultural state and is home to a $35 billion agricultural industry. It is also bone dry.

After three consecutive years of below-normal rainfall, California Gov. Jerry Brown declared a drought emergency in January. B. Lynn Ingram, a professor of earth and planetary sciences at the University of California, Berkeley, says the state might be on track for the worst drought in 500 years.

Investors with direct or even indirect exposure to the agricultural sector are paying close attention to headlines like these and wondering if the drought will affect their portfolios. While agricultural investments typically remain stable during extreme weather, this drought highlights the need for a farmland investment process that incorporates sound risk-management principles to mitigate the potential harm caused by events such as droughts.

Investments in farmland offer significant benefits that make them a solid choice for a well-diversified portfolio, including current cash income, appreciation over time and inflation protection. Consider this: From 1970 to 2009, agricultural land values, as measured by the U.S. Department of Agriculture's Economic Research Service database, outperformed both domestic stocks and bonds on an annualized basis, returning 10.25% compared to 6.24% for the S&P 500 and 7.3% for 10-year Treasuries. Land values also handily outpaced inflation, which averaged 4.36% during the period. What's more, farmland diversifies a portfolio in two important ways: Farmland prices are uncorrelated with stocks and bonds; and farmland is globally dispersed across continents and hemispheres, providing geographic diversification.

Several powerful, long-term trends bode well for farmland value: a growing global population, changing dietary habits; and a shrinking supply of arable land. The world's population grows by about 25 million people a year; to keep up, agricultural producers will have to nearly double their output by 2050, when the world is expected to have 9 billion people. Meanwhile, as the world has more mouths to feed, people in the developing world are becoming more prosperous and consuming more meat, which requires that they buy even more corn and grain to feed livestock. In addition, alternative fuel production — primarily ethanol and biodiesel l— is boosting demand for arable land.

Of course, every asset class has its risks. As investments, real assets such as farmland are subject to fluctuations in property values, as well as higher expenses or lower income than expected. They sometimes do not have sufficient cash flows and might need additional capital. Other risks include a lack of liquidity (i.e., few potential buyers), and investing in emerging markets can carry higher political and financial risks than in developed markets. However, expertise, local connections and a long-term investment horizon can significantly reduce these hazards.

Pests and weather also pose risks to crop yields, but a season or even several seasons of drought should not have a long-term impact on farmland investing. In fact, farmers are used to dealing with droughts, pests and floods. Drought is a well understood, age-old risk that can be anticipated and mitigated. The stability of the water supply should be a primary focus of due diligence during the property acquisition process. At TIAA-CREF, this review includes research on the following water-related subjects:

• historical rainfall;
  


• stability of the underground aquifer in the area of the property;
  


• availability and reliability of surface water from state, federal, or local water districts;
  


• the willingness of water districts to work with land owners to buy, sell and store water;
  


• availability of banked water supplies (water stored or “banked” underground);
  


• presence of “excess” land with water rights that could be used for the benefit of permanent crops; and
  


• riparian water rights.
  

Where possible, investors should seek to acquire properties with multiple sources of water, such as reliable groundwater wells that supplemented by the right to receive surface water from water districts. Properties that are not serviced by water districts are located in areas with historically reliable ground water supplies. Furthermore, for those properties that typically receive most of their water from water districts, which are likely to have very limited supplies available in 2014, building large supplies of banked water should ensure availability.

In addition to acquiring land with fundamentally strong water supplies, actively managing farms may offset, to the extent possible, the impact of drought conditions. Strategies to accomplish this may include the installation of water-conserving technologies such as drip and micro-sprinkler irrigation systems; acquiring and banking water when possible; and winter transfers of underground banked water to above-ground storage to make the water more readily available to the farm during dry periods.

We view the current drought in California as essentially a westward expansion of drought conditions that have plagued more eastern parts of the country for several years, particularly in the Midwest where the water table has been dropping steadily. But it's important to note that these droughts have had no material negative impact on farmland values in the Midwest. That doesn't mean the danger of droughts, pests and floods are to be ignored; indeed, planning for these hazards is critical to maximizing returns and managing farmland investment risk. We believe that farmland is among several private investments in real assets that offer the potential for competitive risk-adjusted returns, a hedge against inflation and improved portfolio diversification.

Tim Hopper is TIAA-CREF's chief economist. Biff Ourso is a TIAA-CREF portfolio manager. Bruce J Sherrick is director of the TIAA-CREF Center for Farmland Research.