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Why The Bull Market In Farmland Is Sustainable

In recent years, farmland has received a lot of attention as the most basic element in an increasingly stressed world food supply system. The recent market letter by Jeremy Grantham of GMO focused even more attention on what is likely to be long-term problem. In commodity related investing, when demand is greater than supply the price rises to adjust - farmland acts the same way, rising now to reflect the imbalance and adjustment taking place in all food commodities. Those that identified this situation early and were able to find a way to invest in farmland were rewarded by very large gains. Looking forward, I will argue farmland is still a very good investment, even at current price levels (though it will pay to seek out the locations with the best value).

There are three major factors that contribute to the value of farmland. (1) The most basic driver is farmer incomes. If a business is earning consistent profits, confident this success will continue, they will not hesitate to expand. In this case it means buying more land. Investors may be the ones paying the high prices at Iowa auctions, but farmers are scooping up everything else that makes strategic and economic sense for their operations. (2) Like any business with a balance sheet, leverage can be added to boost expansion. This was a big part of the 1980's rally in farmland prices but is not so much a factor now. (3) Even though many traders will deny it, money flow will tend to temporarily push up prices beyond the pure economics; this is true in stocks, commodities and even farmland. In the bigger picture though, there is sea change occurring in how farmland is owned; it is becoming an asset class with much greater institutional and retail participation. Let's look at each of these factors closer and also address how and where to purchase farmland at this stage of the bull market.

Farm incomes are the main driver of land values. Farms are more efficient now; they tend not to be as leveraged, labor intensive and are generally run more like a company. They are therefore in a much better position to take advantage of today's high crop prices. Look at this year's drought; many farmers will not produce any crop to speak of, yet proper use of insurance, government support and hedging has nearly eliminated severe business losses. There will continue to be seasonal swings in crop prices, but even the casual observer can see that food and grain prices are much higher on average now than a decade ago. The growth and quality of middle class diets around the emerging world has increased demand in a huge way and will continue to exert pressure on the system for years. Export markets are robust and offer plenty of profitable outlets for big producers. The opportunity for farmers to earn high incomes will continue for many years, which will support land prices.

Tied into farm incomes is the use of leverage. Today's ridiculously low interest rates would seem too good to pass up, but farmers in the U.S. apparently learned from their experience in the 80's when excessive use of bank borrowing was instrumental in pushing up land prices that ended in a big bust. Besides farmers not trying to borrow much, banks are still reeling from their own recent crisis and are not readily offering loans anyway. Looking at today's farm economics, it is regularly high crop prices that underpin farm profits. In 80's there were government price supports and export programs that kept prices artificially high, once these were removed prices dropped. Today is different; the demand from world emerging markets is real and will not disappear overnight. At some point interest rates will move higher, but the lack of high levels of borrowing and stable demand for farm products will greatly reduce the negative effect of leverage and interest rates on farmland prices.

The last big driver is rather new, money flow from investors. Institutions have expanded their appreciation for hard assets beyond timberland to include farmland. Retail investors are now seeing the opportunity too, but they have always had a tougher time finding avenues to access the market. This is where the permanent change will come; private placements offering direct investment opportunities will continue to expand and become more professional; some of these will evolve into private and then publicly traded REIT's. There is no reason why farmers need to own the vast tracks of land required for today's commercial operations. Leasing from investors instead of taking huge loans to buy land makes more business sense. Investors are attracted to the cash flow and a very direct way to invest in commodities and a hard asset. Prices will sometimes get temporarily distorted by excess money flow but the big picture points to a change in ownership structure. The bull market driven by growing world demand will support this change for a number of years to come.

Looking forward, investors in farmland at this stage of the bull market need to be more selective. Even though the long-term demand imbalances should continue to raise all boats for years to come, there are some markets where prices have gotten ahead of current conditions. Land in the big farm states in the U.S. Midwest are the obvious example; they are the easiest for investors to access and prices there are clearly in need of a correction (or some consolidation at least). Taking the extra leap to emerging market farmland is worth the effort. There are not as many options for the retail investor or even small institutions and family offices, but because these markets are not as easy to access is one reason why their prices are not as frothy. There is huge potential for the fertile Black Sea farmland belt in Eastern Europe to produce more food. Land consolidation, better infrastructure and larger more efficient farms will produce much more in time and thereby increase in value substantially. This region is my firm's area of expertise, but there are similar opportunities in Africa, South Asia, and Central and South America. When investing in farmland in the U.S. it might be practical to buy directly yourself, but in an emerging market a professionally managed fund or a large scale farming operation is much more advisable for obvious reasons. In making your selection, be sure your choice is well operated, reliable and has modest expenses. Farmland, especially in emerging market locations, should continue to be solid a addition to investment portfolios for years to come.