Investment in Farmland

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.

The increase in farmland values and lease rates is generally ascribed to commodity price developments. Most investors avoid operating farms, and since most leases renew annually, investors tend to purchase properties used for growing annual crops, so that they do not actually own the biological means of production. For obvious prudential reasons, owners of property under perennials such as trees or grapevines prefer to operate the farms or employ tied agents to do so. Although some leases include a participation feature, most investors avoid such arrangements. So in fact, most investors’ returns have no direct relationship to commodity prices. However, if it has no “higher better use” (i.e., as a subdivision), the price of farmland derives from the value of what it can produce. The rental that it can command is also a function of anticipated commodity prices. So the perception that investors’ returns are largely determined by commodity price developments, with some but not excessive lag, is largely correct.

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.

This provides additional incentive for investors to look for non-U.S. opportunities, where “dirt value” may not be so firm and where competitive bidders may not have such financial resources. However, investors generally confine themselves to regions where agriculture is fully modern. Farm operators who can still gain scale from increased expenditure on fertilizer or hybrid seed will weigh the cost of doing so against the cost of leasing or purchasing acreage. In those regions, “dirt value” and lease rates are likely to stagnate. Investment in “emerging” farming regions is best left to owner-operators, who have the skill, resources and incentive to increase the productivity of properties that they can buy comparatively cheaply there. It is best avoided by passive investors.

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.