Happy Wednesday! I have been busy with the move this week so this is a good time to run a guest post! Today, we feature a guest post by Scott, who runs the Basic Capital Forum. I don’t really feature guest posts very often despite getting tons of proposals – my fellow bloggers probably know what I’m talking about! But a guest post about an alternative asset class with pretty cool return stats is actually something I like to publish. So, take it over, Scott…
Are the boom times back? Judging from investor sentiment, it looks like they are. Despite some recent volatility, the bull market is still in full swing and according to data from fund tracker EPFR Global, markets attracted $102b into equity funds over the past four weeks. Behind the curtain, the euphoria might be unjustified – there are a few warning signs that investors may be ignoring. Firstly, stocks are over-valued by many measures. The Shiller CAPE hit 31 in January – the same vicinity of its peak in 1929. Warren Buffet’s measure states that stocks are overvalued by 40% as of November. The most over-weights stocks are FAANGs (Facebook, Amazon, Apple, Netflix, Google) with forward-PE-ratios even higher than those in the overall S&P500.
Secondly, the level of private debt is enormous. According to the IIF, global debt hit $233 trillion this month. If global GDP is roughly 73 trillion, the global debt is 310% of global GDP. To put this in perspective, private debt to GDP only surpassed 150% in 1929 and 2008. In this time of overvalued stocks, one could make the case for investing in gold. The issue with gold, of course, is that it produces nothing and it has no inherent value. The enterprising investor, however, could invest in the 21st-century gold: Farmland.
Investing in farmland is a strategy that offers low volatility and returns that are uncorrelated with the stock market. It normally performs well in times of inflation and asset deflation. In the recent financial crisis, farmland was one of the only asset classes which had increased in value by Q4 2008. Farmland has also performed very well over the past twenty years. US farmland had a compounded return of roughly 16% in the past ten years, whereas the S&P 500 had a cumulative total return of 10%. Farmland is also low-cost in comparison to other real estate investments – tax and maintenance costs are both low. [ERN: Cool! in contrast to rental real estate, nobody will call you on Christmas Day because the toilet is broken!]
I would caution investors considering farmland in times of uncertainty without analyzing farmland values, however. A farmland bubble inflated in the US during the 1970s when investors piled into farmland to avoid rampant inflation. Their thesis was simple – food prices are tied to inflation so farmland would hold strong. This insight was probably true in the beginning, however, the number of investors entering the farmland market caused it to overheat. It is incredibly important to find the true value of the farmland you are investing in – no matter how you’re investing in farmland. The words of Buffett hold true here: “What the wise do in the beginning, fools do in the end”.
US farmland has a mild correlation of .23 with commercial real estate and a correlation of .58 with US timberland. It has a mildly negative correlation with S&P 500 index and a very negative return with US long-term corporate bonds.
[ERN: Quite interesting that farmland also has a negative bond correlation. I would have suspected that the negative stock correlation is simply because farmland with the stable yield is simply a “bond portfolio in disguise.” So, if you have a three-asset portfolio – stocks, bonds and farmland – then all three correlations are negative. Diversification Nirvana! Quite intriguing!!!]
Farmland is not just a hedge against uncertainty however, it allows investors to make a play on one market trends – the rise of the global middle class. Between 2012 and 2020, the global middle class is expected to rise from 1.2 billion to 1.5 billion. China makes up a large part of this growth, where the middle class has boomed for the past 20 years. In top-tier cities, the number of residents with income above $29,000 will double in 15 years. The global growth of these consumers will increase the demand for food by 59%-99% by 2050.
We see can see this shifts occurring in markets already. In India, the demand for beef has increased nearly 300% since 2009. According to a US Department of Agriculture report, India’s exports of beef have increased rapidly. Today they represent 20% of trade in the commodity. We see the increasing demand for high-quality consumer goods in developing nations manifesting itself in other ways. In 2000, US almond production was valued at $666.5 million in 2000. By 2012, almond production peaked at $6.5 billion in production value. From 2010 to 2014, price per pounds of almonds rose from $1.79 to $4.00.
While the demand from Asia protects investors from downside risk, there is a significant potential upside. When Michael Burry of The Big Short fame, began winding down his hedge fund in 2014, investors assumed he wanted out of the stock market. Instead, Burry has seen an enormous play by investing in farmland with water on-site. Burry’s basic thesis I simple – the world is running out of water at a rapid rate. The demand for water will rapidly outpace supply. When the coming water crisis hits, governments will not have the finances to build infrastructure to solve the issue. In his opinion, the only viable solution in this crisis period is to transport water through food.
Let’s take India as an example. India’s groundwater in the northern land-locked regions is running out rapidly. Since the 1980s, groundwater has plunged from 8m below ground to 16m. If the water table decreases at this rate, India will not be able to grow crops at all. If the Indian government decided to import the water-intensive crops instead of growing the crops, they could manage their water resources far better. They could then use the water previously allocated for farming as drinking water. Importing crops does not eliminate the problem, however, it decreases the rate of drainage significantly while the necessary infrastructure can be built. In this scenario, the value of water-intensive crops would increase in value significantly. The value of farmland with water on-site would also spike in value. Burry has chosen to invest in almond farms given their high “virtual water” content. However, investors could make this play by investing in farmland growing water-intensive commodities with a high water footprint. The trade is quite complicated; however, we have discussed it at length on the forum.
How Do I Invest In Farmland?
In the U.S., there are a number of Real Estate Investment Trusts (REITs) with a farmland focus. These companies typically buy land from farmers wishing to retire and lease it back to other farmers. Farmland REITs offer investors diversification; however, they are not necessarily a great investment. Investors must look out for solid financials and experienced management with a great track record. Not all of the publically traded farmland REITs fit this bill in my opinion. In the UK, there are a few options for investors interested in farmland – through Braemer UK Agricultural Land fund, Brooks MacDonald Funds UK Farming and the First Stellar Farming LP.
Investors can also look at Private Equity (PE) groups investing in farmland as well. It’s worth noting that almost all of these ventures typically charge a traditional “2-20” pricing model. Aside from earning 20% on all profits, they typically earn an annual 2% management fee. This means that the firm would need to rack up an exceptional rate of return to outperform index funds. If farmland has returned 10% on average in the past forty years, fund managers take 2% for simply holding the portfolio and profits are charged at 20% as well, it is hard to see how your investments will outperform index funds. The S&P 500 has earned a total return of 10% since its inception.
This fee model also calls a fund manager’s motives into question. If a manager is charging exceptional fees for sitting on a large portfolio of assets, a shareholder would have to ask themselves: is the fund manager interested in making money for me, or is he more interested in earning money for himself? In my personal view, the 2-20 pricing model does not align the incentives for the fund manager and investor. Moreover, most PE groups ask for investors to meet accredited investor status. An individual must have a net worth of $1,000,000, excluding the residence of one’s house, or have an income of at least $200,000 to be considered.
The enterprising investor can invest in farmland by avoiding PE groups, farmland REITs and buying physical farmland. There are a few stocks listed in the US, Australia and Canada with enormous portfolios of farmland. It is possible to find these stocks, however, it requires digging. I have found a few myself and have talked about some of them on the forum.
Summary
The stock market has proven to deliver returns in the long-run, short-term volatility can unnerve investors. An investment in farmland can iron out rapid changes in the stock market value, potentially hedge against inflation while providing access to an asset class which has traditionally outperformed equities. The enterprising investor would be foolish not to consider adding farmland to their diversified portfolio.
Note: I have an interest in farmland, however, I am not a qualified fund manager. Please consult a qualified financial advisor, before making any investments.
[ERN: Interesting post. In the direct comparison gold vs. farmland, I would most definitely prefer farmland. It’s an inflation hedge like gold, but land at least offers a consistent yield. I personally doubt that the double-digit performance will last forever, though. But even with single-digit returns, a retiree could consider this an interesting supplement to a plain stock/bond portfolio, just based on the correlations!]
This sounds somewhat interesting, but is this the right time? What happens to farmland REIT when the trade war starts? US food export will be the first thing they’ll slap a tariff on. Do you know any good farmland REIT we can check out?
Great point. Farming is reliant on the whims of politicians, Worldwide! It might be a good idea to diversify across different crops. But even then one could get hit with blanket trade wars and tariffs. Definitely, something to consider! Thanks Joe!
If investing directly in farmland, it’s true you may not get calls from tenants regarding a sink or toilet but the possibility of surprise expenses still exists. You may get a call that some old drainage tile has collapsed and repair is needed so part of the field won’t stay flooded all spring. Oh, and to stay compliant to current Dept of Natural Resource codes, 1000 ft of additional sod erosion control waterways will now be required. This is all hypothetical and highly dependent on your chosen location, but just wanted to raise the flag that land ownership isn’t 100% risk free.
Could be a regulatory nightmare. That’s true! But again, those costs were included in the average returns in the past.
There’s just one major problem. Farmlands hugely political policy exposes. Trade. Ethanol, and even zoning can easily break farmland pricing. If the economy for food goes into a recession farmland demand drops.
True. But I still like the inflation Hedge. Use bonds as a hedge in a deflationary recession (2008/9) and land as hedge against an inflationary recession (1974).
It would great if Scott could go into a bit more detail on why farmland REITs aren’t a great investment. I mean when I read 16% returns, not correlated to the market, low maintenance, and low tax — how do all the REIT managers screw it up? And if they screw it up … what’s keeping me from screwing it up? It seems like there must be more to the story there — it’d be awesome to hear a knowledgeable person educate us!
I would be surprised if farmland REITs can match the returns of actual farmland. In the same way that real estate REITs don’t usually match the kind of returns you can get from private equity funds that invest in the same asset class.
Great Guest Post!!! It’s always a good idea to look back at history and study what has worked and why. For farmland as an investment, I do love the fact that it has done well during the 1970’s – no matter the economic situation – people are always hungry. The rest is supply and demand. Another field I like tremendously are Cat-bonds (catastrophe bonds) as they have a super short duration (usually correlate with the 3 months LIBOR) and are less correlated with the “normal” bond market. Personally I feel it’s very timely to look into all these options besides a good long term stock portfolio. Thanks for posting this, always happy to learn more!!!
I agree: It’s wise to look at what worked in an environment of rising interest rates (1970s) because that’s in the cards for us in the future.
I think
“US farmland had a compounded return of roughly 16% in the past ten years,”
should be balanced with
“What the wise do in the beginning, fools do in the end”.
I understand that farmland is a productive asset, which is great. But “16% a year” productive doesn’t sound sustainable and in fact sounds possibly a little bubbly. When I read the linked Business Insider article it didn’t instill confidence, either. Yes, there has been and will be increased demand but that doesn’t equate to fantastic future returns. FullTimeFinance is right also – the farming industry relies so so heavily on the government that I’d be afraid to touch it. Unless you think our government is predictable 🙂
Those points aside, another great article to get us thinking. Thanks.
I’d personally expect about 3% yield from the rental income, plus capital gains from the underlying equal to inflation (~2%) plus maybe another 1-2% above inflation due to global food demand. Still a pretty decent return. But I think the double-digit returns are behind us. 🙂
I hear you about the surprisingly high returns, but much depends on the asset class and its behavior. There are many unusual asset classes, usually ones with little in the way of substitutions or alternatives (and there’s little alternative if you need good farmland!), that have produced similar returns for many decades: wine, art, quality diamonds, golden age comic books, rare books, etc. Malls and new houses are highly cyclical, but I would expect certain specialty types of land such as farmland to continue good returns indefinitely.
Sort of already covered, but a couple of things driving the recent boom in farmland (and maybe a third):
One major piece is the ethanol mandate. The U.S. converts something like half of the corn grown into ethanol. That’s a huge chunk of demand that would simply disappear if the government stopped an incredibly destructive policy. I wouldn’t bet money on the government doing something smart, but the ethanol policy is so stupid and destructive, I’d also be hesitant to bet big on that level of stupidity continuing.
Another piece is the crop insurance subsidized by the government as part of the “freedom to farm” reforms intended to reduce some of the direct crop subsidies. That has resulted in a lot of marginal land being valuable because the crop insurance makes farming marginal land still profitable. If the U.S. started charging something approaching the true cost of the crop insurance, you’d have a lot of land that is currently pretty valuable now drop considerably in price.
A third potential driver is foreign demand. Not sure how big of an impact this is, but I knew a broker who primarily focused on overseas clients who wanted to buy U.S. farmland not as an investment but as a store of value. A lot of the clients were rich Chinese, who were risk averse and just looking for a place to store backup wealth in the event the Chinese government or economy went haywire. My understanding is that a similar phenomenon goes on in your major cities, with rich foreign nationals buying extremely expensive real estate not because they intend to spend any significant time there, but because it’s a store of value beyond the reach of their government. Not sure how big of a deal this is though.
Agree with all 3! Ethanol subsidies are crazy But there is a powerful lobby that will make sure ethanol subsidies will stay.
I have a few “buy what you understand” questions. How does leasing farmland work?
In theory, a fund buys a 1000 acre corn field and puts out a “for rent” sign. The only farmers who would rent the land are the near neighbors (i.e. it would be uneconomical for a farmer several miles down the road to drive heavy equipment back and forth.). Thus the pool of potential renters might be 5 locals, half of whom are broke/uninterested and the other half of whom don’t offer a very competitive marketplace (or could easily cooperate to keep the rent low!).
Second, a farmer’s or farm corporation’s rent vs. buy math would be based on the PV of future net cash flows. They will not buy the land, or outbid the fund, if the expected PV of the investment is lower than their best alternative (e.g. a corporate bond fund, farm efficiency improvements). Thus, the fund will only get to buy land at a price the locals have rejected. Then the fund will have to rent the land to those same locals at a rate where the PV exceeds their best alternatives. Thus the PV of cashflows from rent will always be lower than the locals’ best alternative investments – many of which are available to the fund’s investors! Yields would have to be near treasuries level.
Third, ownership by the fund impairs the value of the land because the value of any capital improvements (roads, irrigation, silos, pumps/electricity, fertilizer) is lost at the end of the lease period. This makes leased land lower-yielding and limits its potential use to crops requiring minimal infrastructure. The fund could offer very long term leases (e.g. 10-25 years) to mitigate this problem but this would make the fund more vulnerable to inflation.
There used to be plenty of farms that only farmed leased land. Not sure if that’s still the case or not.
Of course, you used to could make a living farming 1,000 acres. Not sure that’s really doable anymore, so maybe it is a lot harder to lease 1,000 acres now than it used to be.
But I do think you are right regarding the yield. I think leasing farmland has basically been either a really conservative investment with upside coming from long term appreciation in land prices (and therefore rents). Or I guess maybe more accurately, long term appreciation in rents (and therefore land prices).
Good questions, all of them. Not sure, so I will defer to the experts. Another reason to not touch this as a mom & pop investor but rather go through a PE firm.
My company leases a lot of farm land, and I would classify it as a low risk, low return investment most of the time. Here are some typical economics:
You lease land worth $5,000/acre to a tenant farmer for $300/acre on a year to year lease. Since land is not depreciable under the tax code, all of this revenue is taxable. You pay very little property tax by entering into a conservation covenant and otherwise have little operating costs. That’s a sub 5% cash on cash return depending on your tax bracket (completely ignoring transaction costs, which can be substantial since you’re smart and hire a good real estate attorney).
You might see some appreciation in the land value or rent increases over the long term. Keep in mind you’re in rural America which has not seen the type of value increases as most cities. I wouldn’t be surprised if appreciation is flat or lags inflation over a 10 year period . So you’re basically looking at returns which are slightly better than bonds with quite a bit of effort and more risk (it’s not uncommon for tenants to create environmental issues, like diesel spills, burning pesticide containers, ground water contamination, etc).
The only way to get above average returns is to convert the land into another use (radio tower, solar farm, housing development, etc). That’s the option value inherent in the land, but you gotta get lucky for that.
Wow, thanks for that info! Very important to keep in mind that caution “renters might trash the place” also applies to farmland! Never thought about that!
I do think farmland is vital but I’m not sure it’s an awesome investment. First of all, most farming isn’t an overly lucrative business these days so you’re dealing with renters who probably can’t stomach large increases and betting on land appreciation which is a long term game. Second, there’s not a lot of great investment options for it out there like you mention so it’s hard to take advantage of it as an investment.
Good point! I still like exotic and illiquid investments. More opportunities for alpha. 🙂
Why wouldn’t I just buy LAND and FPI?
Another aspect of this farmland are the mineral rights that often go with it. For example, my family has mineral rights on different quarters (160 acres is a quarter….). In our family we own various plots of land that have both oil rigs on them and/or are used for farmland at the same time. It is a pretty common occurrence in parts of the midwest. It adds to the allure of farm land, but it is a also a boom and bust cycle that one has to watch out for.
True, just make sure the mineral rights haven’t been severed and sold off or otherwise convey to the state. Same thing goes for water rights, especially in arid climates. It can be really interesting to go through title on land to understand what has been encumbered or sold. A good real estate attorney and title insurance are highly recommended.
I make between .5% and 1.5% from my farmland. It’s kind of frustrating to have such a big asset perform so poorly. At the same time, I don’t know what else my family could have acquired in 1869 that would be worth much today.
Ouch! Why not sell the land then?
WAIT TILL THE REALESTATE MARKET IS AT ITS HIGHEST AND SELL TO THE HIGHEST BIDDER!
It’s so awesome that farmland was one of the only asset classes which had increased value by 2008. My uncle has been wanting to buy some farmland and build a home for his family. He’s also been thinking of raising a few animals, as that’s what his family use to do. Do you have any tips for choosing farmland?
Personally, I don’t. This is still new territory for me. I think the investment opportunity is more for buying large swaths of land and then renting them wholesale to big farms.