Thin returns from the fat of the land

Compared with investment-grade bonds and commodities, it doesn’t look bad. The average investor in US farmland is now 6.15 percent richer than a year ago, according to NCREIF, which published its quarterly update on Monday. Meanwhile, the S&P 500 Investment Grade Corporate Bond Index’s one-year return currently stands at 1.95 percent.

But look just a bit further and the picture is less encouraging. Trailing performance over the last 12 months doesn’t match returns achieved over the previous period, with US farmland generating 8.56 percent in the year to Q3 2016. What’s more, growing incomes appear to be the only driver behind the timid returns posted over the last quarter, since land values actually fell 0.31 percent in Q3 2017. While some regions fared better, nearly half experienced depreciation. Values fell 1.54 percent in the Lake States.

This up-and-down has been characteristic of land values since mid-2016 (in Q2 2017, they were actually up by 1.06 percent). The yo-yo comes on the back of a leveling off since 2014, after rapid growth over the previous five years. That explains why, despite expectations to the contrary, widespread distress has not materialized among farmers. Prior to the slowdown, farmland values were driven by strong earnings; these allowed operators to store cash for leaner years.

Signs indicate that profitability is not really picking up pace, though. In a report looking back at Q2, Farmer Mac found that an increase in the value of farm buildings, rather than cropland, was the primary driver for the 2.3 percent growth it observed in 2016. “The strengthening US economy may have helped lift farm real estate values by placing upward pressure on the value of farm dwellings,” co-authors Jackson Takach and Ryan Kuhns said last month.

The resulting impact on farmers’ coffers is starting to bite. At the Agri Investor Forum in Chicago two weeks ago, panelists observed that funds raised in the expectation of major distress had found few opportunities to disburse their cash, but that operators’ working capital was finally starting to dry up. This may be compounded by the fact operators are increasingly leveraged: US farm real estate debt is set to hit a historic high of $242.4 billion in 2017, according to the USDA.

In part, this is driven by positive factors. The bump in mortgage loans owes much to low interest rates, solid balance sheets and strong crop yields. But it is also linked to the rising propensity of farmers to use land and facilities as collateral for non-real estate debt, the agency says.

And part of this rising debt burden appears exposed to interest rate increases. As Red Reef Partners’ Suzanne Petrela noted during the Agri Investor Forum: “Most farmers are taking floating-rate debt for their operating loans, and those numbers are enormous.” Bottom-lines will suffer from even a 100 basis point increase in interest rates, she argued. “In some cases, we are seeing operators who are going on three years of very thin profits; that will hurt. That may put them over the edge where they can no longer service their loans.”

Investors are clearly circling. It used to be that farmers competed with them for land purchases; now some of them look like they could do with selling some of their assets. Fund managers contend that auctions that used to witness 20 bids now attract three to four times fewer. This state of affairs is drawing new investor types to the space: in Chicago, we spoke with a hedge fund on the lookout for distressed situations.

It is possible that investors of this kind will be disappointed. While some expect land prices could fall lower, others say a bottom is in sight. What’s more, stiff competition remains for the best lots on the block. That’s good news for those already invested in the sector; it also indicates farmland is likely to remain more of a diversification than a capital-gains play. In an era of dampened returns, farmland still has much to offer as an inflation hedge.

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Write to the editor at matthieu.f@peimedia.com