Investor interest in farmland has increased steadily, motivated by the perception that it offers an attractive yield, solid prospects of capital gain and inflation protection. Recent experience supports this view. Over the period shown in the first chart below, U.S. “dirt values” have increased by a compound 3.7% a year. The series is too short for statistical significance, but for what it’s worth, its standard deviation was 6.6%, which is comparable to corporate bonds. Lease rates on cropland (i.e., land that is not under lower-value pasture) have risen by a compound 2.8% annually over the shorter period shown in the second charrt. Note that these averages mask wide dispersions: average cropland values per acre differ by 28X between largely unirrigated New Mexico and potentially sub-divisible Rhode Island.
Whether commodity prices are strong or not, increasing production is the main way that a farm operator can grow its business. Farming has a high fixed cost component, so the pursuit of economies of scale is critical to commercial success, except in a few niches. American agriculture is already among the world’s most productive, so investments in increased intensity offer only diminishing returns. Thus increased scale requires increased acreage. With mortgages cheap, farm balance sheets (as shown below) healthier than they have been in a generation and fairly encouraging prospects for commodity prices, operators’ demand for farmland competes with investors’ interest in acquiring it. Farm operators are, in the nature of the case, advantaged bidders: in effect, investors compete against insiders. It seems likely from the uptick in farm leverage that they are competing with them quite actively.
In the U.S. and especially elsewhere, the yields on passive agricultural investment and the potential capital appreciation that it offers remain attractive relative to corporate bonds. But the U.S. case is no longer strongly compelling. The opportunity to buy U.S. farmland at prospective total returns comparable to those available in 1987 is unlikely to recur. Consequently, the inflation-protection argument is crucial in order to make a strong case for farmland investment. That is, price expectations for agricultural commodities must be optimistic to justify investment. Otherwise, investment success in U.S. farmland must rely on opportunistic and very judicious purchase.
There are many reasons to be optimistic about the demand for agricultural commodities over the intermediate- to long-term, but given the relative inefficiency of much of the world’s farming, supply is fairly elastic. Granted, it lags demand by several years. Malthusian arguments in support of farmland investment should therefore be discounted, at least on a twenty-year view. Investors should assume that supply will be able to meet demand within the life of their investment, in the process clawing back any extraordinary gains. Since farmland is a long-tail investment, with substantial transaction costs, it should not be purchased as a short-term speculation. Although there will inevitably be supply interruptions that bolster short-term returns, such as the current Russian drought, investors in an illiquid asset are unwise to assume that they will be able to exploit them. This does not argue against investment in farmland, but given that its returns and apparent risk profile are not extraordinary, it argues very strongly in favor of strict price discipline. For most farmland investors, this means that they must rely on a highly qualified agent to handle the purchase and management of their investments.