Nonprofits eye farmland investments
Foundation & Endowment Money Management | June 2008
NONPROFITS EYE FARMLAND INVESTMENTS
The cooling domestic equity and bond markets has prompted endowments and foundations to give niche alternatives, such as farmland, a closer look. FEMM recently discussed such investments with five proponents of farmland investing: Brad Farquhar, v.p. of Agriculture Development Corporation, Bruce Graham, managing director at consulting firm Shields Associates, Stephen Kenney, senior investment analyst at Hancock Agricultural Investment Group, Kent Muckel, senior portfolio manager at the University of Colorado Foundation, and Murray Wise, chairman and ceo of Westchester Group.
FEMM: What are the benefits and/or risks of investing in farmland?
Farquhar: Farmland is not correlated with stocks or bonds, and is an excellent hedge against inflation. Over the long haul, farmland has consistently provided real returns of 2% or greater. This is because farmland is a real hard asset with inherent value. There are risks in farmland ownership, but these can be mitigated through good management. The greatest risk is that the farmer farming the land uses unsuitable practices that do not continuously replenish the nutrients in the soil.
Muckel: Arable land per capita is in decline across the globe, while the competition for arable land is increasing. Combining this trend with the demand for higher protein diets puts added pressure on the supply side of the equation. The risks of investing in farmland are unique and more difficult to mitigate. Weather is an example, where we are now seeing floods in the mid-western U.S., but drought in Australia. The rising costs of inputs such as fuel and fertilizer are starting to have a negative impact on farm incomes, which could pressure valuations over time.
Kenney: The benefits of investing in farmland include attractive risk/return features, diversification potential, inflation hedging potential and flexibility. The risks associated with farmland investing are economic. A strong dollar is one of the biggest threats to U.S. farmland investments. A strengthening of the dollar relative to other currencies could make U.S. agricultural exports more expensive in the global markets, reducing U.S. export volume and ultimately crop prices.
Graham: Another benefit is that farmland can be considered a yield vehicle and the total returns include both a principal and yield component to them. Investors do not need a sale to generate returns. Overall volatility is relatively low and it has provided very attractive returns on a risk-adjusted-return basis. Unlike some other commodities, it also has minimal ongoing capital expenditures and carrying costs. The drawbacks are the limited number of managers that actually invest in this class, the few consulting firms/advisors that really understand the asset class and the illiquidity of investing in the asset. It is also difficult to benchmark and to get sufficient diversification, both geographical and in terms of crop type.
FEMM: What level of interest do non-profits have in farmland and how has interest changed in the past few years?
Muckel: Non-profits are aggressively seeking inflation-hedging assets, especially in the current economic environment. However, many traditional inflation-hedging asset classes such as core real estate, TIPs, timber, etc., are certainly not cheap. This has led investors to look at other more niche assets such as farmland.
Graham: The boom in commodity prices and increased interest in real assets have inflated interest among non-profits looking to invest in farmland. It is hard to quantify this interest but we are seeing an increasing number of funds and limited partnerships that focus on farmland investing. Typically, only the largest endowments and foundations are comfortable investing either directly or through a fund in farmland, as it is a very narrow market and difficult to get sufficient diversification.
Kenney: Non-profit interest in farmland has been growing over the last few years due to endowments and other non-profits seeking to diversify their investment portfolios into alternative assets. We think interest in farmland will continue to grow for non-profits due to the benefits that farmland brings to a diversified portfolio.
FEMM: What should non-profits look for when selecting a farmland manager?
Graham: For institutional investors, we look for a manager with experience in farmland and the infrastructure in place to handle the reporting demands and administrative needs of the institutional marketplace. There are very few who meet those criteria.
Muckel: We look for proprietary access in securing attractive properties, the operational capabilities of the manager, their experience in the sector, and their ability to “professionalize” the industry from a local, family operator model to a larger scale operation. In many respects, it isn’t too different from selecting managers operating in other asset classes.
Farquhar: We like to say that we’d rather rent mediocre farmland to a good farmer than rent good land to a bad farmer. It’s no different when selecting farmland managers.
FEMM: How are food prices affecting farmland? Is economic growth in China and India affecting these investments?
Farquhar: Food prices are definitely affecting farmland. In our view, these higher commodity prices are being driven by demand from consumers in China and India. Those two countries are developing rapidly, and with 40% of the world’s population, any shift in the diets of their exploding middle classes has a huge global impact on demand for food. In China, changing diets are leading to higher meat consumption. It takes something like 10 pounds of grain to produce a pound of meat, so it’s not hard to see where the increased demand for grain is coming from.
Graham: The growth in China has been and will be a major contributor to the interest in investing in farmland. China is buying farmland in Africa and South America to feed the expansion, literally. As China moves to a more urbanized and wealthier country, it will increasingly lose its ability to be self-sufficient in food. Also, the shift to a more urban society is changing the Chinese diet to meat, versus one dominated by rice. China will have to import large amounts of feedstock to provide for this need, largely due to the fact that they only have 9% of the world’s arable land. India is a very similar story and the important aspect to remember is that this is not a cyclical but a secular change.
Wise: Obviously, higher grain prices are having a positive impact on the price of U.S. farmland. But you also need to keep in mind that the farmer only receives 19 cents out of every retail food dollar. It is further exacerbated in the example of a $5 box of corn flakes, which contains less than 10 cents of corn. The value of corn in a pound of beef or pork is approximately 30 cents. The economic growth in China and India are the real drivers in what is happening to global agricultural commodities. Poultry production has increased more than 400% in China in a 20-year period of time and vegetable oil consumption has increased from approximately six million metric tonnes to over 22 million metric tonnes per year today.
FEMM: How has the push for alternative fuels, like ethanol, affected farmland?
Kenney: The push for alternative fuels has affected farmland, but not as much as the demand for increased food production and higher commodity prices. Alternative fuels use a relatively small portion of grains for production. Contrary to what has been in the press lately, alternative fuels are not the contributor to higher food prices.
Wise: This situation is like the expression “one tide lifts all boats,” and yes, ethanol is consuming some of the U.S. corn, but keep in mind that the increase in U.S. corn used for ethanol is miniscule in comparison to the increase in corn being utilized to raise livestock in Southeast Asia.
Muckel: Obviously, this puts pressure on the demand for agricultural commodities, which should lead to an increase in value for farmland. However, I am skeptical on the ethanol story and would not include it in a long-term thesis on investing in farmland. One should be wary of investing in an industry where governmental policy can change the economics rather abruptly.
FEMM: How is the farmland marketplace evolving? Are there any regulatory changes that will affect it?
Farquhar: The farmland marketplace is changing. More investors are taking an interest in farmland as a long-term investment opportunity, and many farmers are coming to the conclusion that long-term rental relationships with farmland owners are as good or better than owning the land themselves. A good portion of our business revolves around buying land from farmers and leasing it right back to them through long-term leases. This gives the farmers the working capital they need.
Kenney: Some regulatory changes that we may see coming down the road will center around water. Water is a huge issue, particularly in the western U.S., where the majority of crops are irrigated by either well water or from federal water (canals, dams, etc.). There have been some water rights issues in the High Plains.
Graham: The big question is one of national pride and security. Will the U.S., or any other developed country for that matter, allow the Chinese to buy domestic farmland? And will they allow Chinese workers to farm the land? In addition, farmland has often been favored by government subsidies. Could there be growing sentiment against these subsidies and tax breaks as the market becomes even more institutionalized and ownership extends to foreign holders?
Muckel: The regulatory environment is truly a wildcard and runs the gamut from subsidizing production to trade agreements. Given the recent press on food shortages and food inflation, you can bet that policy-makers will be getting involved, and not necessarily for the better.
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