November 6, 2014

By Cody Dahl and Brent Gloy

Introduction

Investment in row crop farmland provided investors with an annualized total return in excess of 15 percent during the last decade. Despite the strong, sustained performance of the asset class, and the changing landscape of the agricultural economy, many farmland asset managers continue to state that they expect leased row crop farmland investments to generate a nominal annualized total return in excess of 8 percent. For the foreseeable future, farmland will continue to be an attractive contributor within diversified institutional portfolios, but it is imprudent for investors to expect passively managed row crop farmland assets to generate such returns given today’s prices.

Return Expectations

Many farmland asset managers state that they expect row crop assets to generate a nominal long- annualized total return of at least 8 percent over the long term.[1] Frequently, current income from annual lease payments comprises half of their total return expectation while land price appreciation comprises the other half.

One implication of these expectations is that farmland capital prices must achieve a 4 percent annualized growth rate. A second implication is that if farmland prices achieve such growth, the absolute value of cash rents also must increase 4 percent each year to maintain a 4 percent income rate of return. A third, and perhaps the most important, implication is that the underlying activity supporting farmland economics, row crop farming, must become 4 percent more profitable each year.

Current Farm Economy Doesn’t Support Row Cropland Price and Cash Rent Growth

The landscape of the US farm economy has changed significantly in recent months. The average price US farmers received for a bushel of corn in August 2014 was $3.70, which was down $0.35 (-9 percent) from the average price received in July of this year and $2.51 (-40 percent) below the price received in August 2013. The average price received for a bushel of soybeans in August 2014 was $12.20. This was $0.90 (-7 percent) lower than in July 2014 and a $1.90 (-13 percent) lower than in August 2013. At the time of this writing, prices for both commodities continued to drift lower toward the 20-year monthly averages of $3.34 per bushel for corn and $8.16 per bushel for soybeans.

Without higher commodity price expectations, tenant farmers will not bid up land rental rates.  Without increases in rental rates, farmland market participants will not bid up the price of farmland capital and farmland capital will not appreciate. In the short-term, some farmers remain flush with cash and therefore may be willing to continue buying farmland at current prices, but this money eventually will dry up if commodity prices stay at current levels for a sustained period.

Future Row Crop Income Expectations

In response to high commodity prices, farmers across the globe have increased the amount of land area they have under production and through their use of new technologies and capital investments, they have also managed to increase commodity yields. For example, in September 2014, the United States Department of Agriculture (USDA) released its global production estimates for a number of row crops. The aggregate yield of a selection of these crops is projected to increase 22.5 percent, from 2.7 metric tons per hectare in 2000 to 3.3 metric tons in 2014. Furthermore, the total land area in farm production is projected to increase 13.7 percent from 745 million hectares to 846 million hectares during the same period.[2] Global production of these commodities is expected to achieve a record in 2014 and this will result in a stocks-to-use ratio of 23.3 percent. An increasing stocks-to-use ratio indicates production is outpacing consumption. Therefore, prices tend to correlate inversely to the ratio.

The combination of increased yields and expanding acreage appears to be outpacing demand growth. While short-term supply disruptions could temporarily increase row crop prices, prices should remain suppressed for a sustained period of time, which will put downward pressure on row crop income and farmland valuations in the United States.

Row Crop Farmland Priced at Low Capitalization Rates Offers Little Upside

Farmland prices have grown more rapidly than farm income in recent years, driving row crop farmland capitalization rates to historic lows. These low rates reflect today’s low interest rate environment as well as optimism about growing incomes in the farm sector. With normalization of the stocks-to-use ratios, and falling commodity prices, income growth seems unlikely at this point in the cycle. The prospects for reduced income will likely place substantial downward pressure on farmland prices.  With capitalization rates falling below 3 percent, it is also unlikely that the trend of increasing land values through cap rate compression can be pushed much further – unless long-term interest rates continue to fall.  

Conclusion

Farmland investment managers soliciting investors for capital contributions often emphasize strong long-term demand and supply fundamentals as a reason for investing in row crop farmland. There is no disputing the fact that the demand for food and fiber increases annually.  Whether these fundamentals translate into an attractive row crop investment outcome depends largely on the present value of farmland and the required rate of return. Given the recent reduction in row crop commodity prices, the supply response by farmers around the globe, and the current price of row crop farmland, passively managed row crop farmland investments do not provide investors with attractive risk adjusted returns relative to other investment opportunities that are available along the farmland investment continuum.

Institutional investors must realize that certain sectors within the asset class may provide less opportunity than others because of prevailing and anticipated economic conditions. Given the recent performance of US row crop farmland assets, and both current and projected fundamentals, farmland investors may be rewarded for reducing their exposure to row crops and seeking alternative ways of investing in farmland and related agricultural assets.

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Cody Dahl, Ph.D. is the Senior Investment Strategist for AgIS Capital.  Brent Gloy, Ph.D. is an Advisory Board Member for AgIS Capital.

AgIS Capital is a Boston-based private equity firm that invests in farmland and agricultural operating companies.  The principals of the firm have decades of experience in the farmland investment sector and have completed billions of dollars of transactions during the last 20-plus years.  The firm focuses on $50 to $100 million transactions in the United States and other mature markets.   For further information, please visit the firm’s web site at www.agiscapital.com or contact Jeffrey A. Conrad, CFA, President and Founder at 617-350-9891 or jconrad@agiscapital.com. 

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To read the full version of this article check out Volume 9 of the Global AgInvesting Quarterly, to be published on December 17. Volume 9 will also feature a look at investmentin permanent crops, opportunities in CIS and CEE countries, a profile of Elizabeth O'Leay of Macquarie, Tech Corner and deals of the quarter. For more information email Sarah at gad@globalaginvesting.com.