An Open Letter To Farmland Bears

|
Includes: AFCO, FPI
by: Jussi Askola

Summary

I remain bullish on farmland for the long run and address all the main critics one by one.

Every asset class including farmland is highly valued today – it is not a reason to stay all cash.

There is no risk free equity driven asset class in the world - Don't mind cycles and remain invested.

Farmland prices do not correlate with commodity prices over the short run.

Click to enlarge

I have recently written several articles on farmland explaining why I believe it to be an interesting asset class deserving a place in your portfolio. In my 3 previous articles, I have been happily surprised that lots of constructive and thought-provoking conversations took place in the comment sections.

In this article I address all the main bearish arguments that I have received to date. All these points are very reasonable concerns; however, I do not believe them to be appropriate reasons to be generally bearish on the asset class.

Farmland is overvalued…

This is the argument that I get the most: it is too late to buy farmland. But then please tell me which asset class isn't it too late to buy today? Is the timing appropriate to buy stocks or bonds? Are they perhaps undervalued?

All asset classes are today overvalued relative to historical averages. It is not a surprise when interest rates are close to 0. Against normal interest rates, I agree that farmland cap rates would be very low, however in this low interest rate environment, it is justified that cap rates decrease and 5% remain reasonable in my view. It is exactly the same as when earnings multiples of stocks expand.

Buffett recently said this on an interview for CNBC:

Interest rates acts on asset values like gravity acts on physical matter. If you had 0 interest rates and you knew you were going to have them forever, stocks should sell at 100 times earnings or 200 times earnings as the alternative is absolute 0.

What you can say now is that the market against normal interest rates is on the high side of valuation, but not dangerously high. On the other hand, if these interest rates were to continue for 10 years, stocks would be extremely cheap now. The one thing you can say is that stocks are cheaper than bonds, very definitely. We don't try to guess which way the market will go, we have no idea what the market will do next year, Charlie and I never talk about it. If these low interest rates will prevail for the next 5 to 10 years, you'll look back and say stocks were very cheap, if interest rates normalized, you'll look back and say they were not so cheap.

Buffett references to stocks here, but you could well replace it with farmland. Both are equity driven asset classes that are affected by the low interest rates. People often forget that the valuation of an asset class has to always be considered relative to other opportunities in the market. If bonds yield 15% and farmland cap rates are only 5%, it is clear that farmland is overvalued relative to bonds. However, when bonds yield close to nothing, it is more difficult to say that farmland is unattractive on a relative basis. Bonds are today trading at some of the lowest yields ever and are generally considered as being very overvalued relative to other asset classes including stocks. In many cases, they do not provide any real return after inflation and taxes to their investors and provide no protection in case of severe unexpected inflation.

So are stocks materially undervalued relative to farmland? I don't think so. While bonds are extremely overvalued, remark that stocks are also expensive relative to their historical average valuations. The market is currently pricing the S&P 500 at about 25 times its earnings. The historical mean is only 15.6 times or 40% cheaper than today. According to Ray Dalio, the founder and co-chief investment officer of the world's largest hedge fund, Bridgewater Associates, believes that the expected returns for stocks is about 4% at current high valuations and that volatility will be above average.

Get ready for lower than normal returns with greater than normal risk. Take current bond yield (less than 2%) and cash (0%) and compare that to something like a 4% expected return on equities. Because of volatility, the 4% expected annual return pick up of equities over cash, or 2% over bonds, can be lost in a day or two. Ray Dalio

So if you say that farmland is overvalued, then you should probably also argue that stocks and bonds are overvalued. Do you still invest in them? Yes, you do because what matters most for the long term investor is time in the market, not timing the market.

Commodity prices are too low for such high valuations…

Sure commodity prices are low today… But are commodity prices the only driver of farmland values? No they are not: farmland prices have historically consistently outperformed soybean prices for instance.

Click to enlargeSource: Bloomberg, USDA

The main driver that causes farmland to appreciate over time is the increasing world grain area as presented below.

Click to enlargeSource: Bloomberg, USDA

It is clear that commodity prices affect the value of farmland, but that is not the only factor. Commodity prices will move through up and down cycles, but according to my analysis, the demand will grow faster than the supply in the long run which should result in commodity price increases. At the end of the day, it is close to impossible to know where the agricultural commodity prices will be in the next 3 months, 6 months or even a year. They are very difficult to forecast, and perhaps they might be soon much higher and justify higher rents already in the near future.

Can you time commodities? I cannot, my original investment thesis on farmland was suggested to true long term investor who do not seek to time the market. Who really knows where the corn or soybean commodity prices will go next year? Just as oil prices, it is almost impossible to make reliable predictions for these commodities.

But Robert Shiller said…

Over the century from 1915 to 2015, though, the real value of American farmland (deflated by the Consumer Price Index) increased only 3.1 times, according to the Department of Agriculture. That comes to an average increase of only 1.1 percent a year - and with a growing population, that's barely enough to keep per capita real land value unchanged. What all that amounts to is that neither farmland nor housing has been a great place to invest money over the long term. Robert Shiller

This argument made by Robert Shiller in his latest article which was published in the NYT lead to lots of confusions. As I explain, in one of my more recent articles on farmland, Shiller's statement is very misleading and misses many aspects of farmland investments.

Shiller does not mention the fact that this value appreciation is only one part of the return. A major component of farmland investment returns comes from the rent paid by the farmer. Historically yields have been as high as 10% during certain periods of time. Today, even in a very low interest rate environment, farmland still yields about 4-5% from rents alone.

Then let's point out again that Shiller is talking about real returns which means after inflation. Between 1915 and 2015, the U.S. experienced inflation at an average rate of 3.21% per year. The nominal capital appreciation per year would have hence been 4.2% per year according to Shiller's data.

So alone based on this you see that the nominal historic returns have often exceeded 10%.

Supply will increase faster than demand…

This is the eternal question that nobody can answer with great certainty. However, let's note that demand increase is certain, but the supply growth is uncertain.

There is lots of research that demonstrate how the demand will be outpacing the supply growth in the future. Despite productivity and capacity increases, it is very difficult to keep up with a fast growing population and the ever increasing consumption of meat in emerging countries which create tremendous demand for more feed grain.

There is no shortage of land in the world. There are approximately 550 million hectares of potential rain-fed cropland globally, excluding forests, protected and urban areas, with 75% in Africa and Latin America. However, a strong price signal would be required in order for that land to be developed and converted to crop production. Even then, it is unlikely that the supply response can catch up to demand given practical constraints, such as infrastructure, capital, property rights, farming expertise, etc. It requires a significant investment to clear the land and improve the highly acidic soil - a process that takes up to three years. Moreover, the new areas for agricultural expansion are often more than 1,000 kilometers from the ports and often only accessible via dirt roads. The expense of transporting a crop of soybeans grown in Mato Grosso to market is 45% more than in Iowa. So the issue is not to find land, but land that can be cultivated in a cost efficient manner. (You can find more on this through the AEW Research papers)

On the other hand, the United Nations forecast that global population will increase to 9.55 billion by 2050. This represents a close to 30% increase from today's 7.4 billion and over 2 billion more people to feed. We were only 2.7 Billion in 1955. Today, we are 7.4 Billion and by 2050, we are expected to approach the 10 Billion. The potential impact on values and rents of farmland is substantial as all these people will need to get fed.

It is likely that in the future, the productivity of farmland will keep on increasing at a similar rate as in the past, however this productivity improvement, alone, will not be enough to meet the global demand growth and therefore new capacity should be added to keep the market in balance. According to AEW Research, to meet the anticipated demand for ten major crops, an additional 65-85 million hectares of farmland would be needed over the next decade. Moreover, the Food and Agriculture Organization notes that the world should increase capacity each year by 10-12 million hectares globally just to replace the farmland lost to urbanization and desertification. Consequently, adding 65 to 85 million hectares over the next decade seems quite unrealistic.

Although farmland values have substantially increased in the last decades, the long-term fundamentals remain the same and support further increases as the demand growth is likely to outstrip the supply growth over the long run.

Interest rates increases will kill farmland REITs

I have in previous articles mentioned several Farmland REITs including Farmland Partners (NYSE:FPI) and American Farmland Company (NYSEMKT:AFCO) which I recommend to gain exposure to this asset class. I cannot predict what would happen if interest rates started to increase, however studies from NAREIT actually shows that share prices of listed Equity REITs have more often increased than decreased during periods of rising interest rates. In the 16 periods since 1995 when interest rates rose significantly, Equity REITs generated positive returns in 12. The reason is that changes in the level of interest rates often reflect changes in the level of economic activity. A better economy results in a higher occupancy, rent growth and overall superior business fundamentals for REITs. Again, I do not know how Farmland REITs will perform when interest rates increase, the evidence however shows that they should not suffer materially more than other asset classes.

Final Thoughts

If we always decided to stay out of the market and wait, we would have historically missed many bull markets and had enormous opportunity costs.

Farmland prices will move up and down in cycle like other assets. Note however that they do not perfectly correlate with commodity prices in the short run, because the commodity prices are very volatile and the risk is undertaken by farmers in many cases, not the property owner. If the low commodity price sustains in the long run, then the value of the land will have to be adjusted. Given the strong fundamentals, I don't see that happening. You will certainly have farmland periodically loose value but I am unable to forecast how long the down cycles will last and prefer to remain invested for the long run.

Additional sources: NCREIF Farmland returns, CFA Institute, AEW Research,Business Insider, NAREIT, and Farmland Partners

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.