Sunday, October 12

Week 171 - Thinking of Owning Farmland As An Investment?

Situation: Here on the Great Plains, owning farmland is the Great Game. Throughout the midwest, 60% of the land being farmed is rented. With corn prices down 50% from their 2012 peak, fixed rents are having to be renegotiated to reflect the falloff in farm incomes. “Custom financing” is becoming more prevalent, meaning that instead of a fixed rent the landlord gets half, 40% or 1/3rd of the revenue generated from crop sales at the end of the growing season. The tenant farmer pays all expenses other than property tax and insurance. 

Over very long time periods, farmland appears to be a better asset class to own than stocks. For example, farmland in southwest Iowa (Audubon County) that sold for $266/acre in 1963 was worth $9466/acre in 2013 for a price return of 7.4%/yr. Compare that to 6.6%/yr for the S&P 500 Index. You also need to consider that both asset classes produce income (rents or dividends) and are hammered by inflation, which averaged 4.2%/yr across that 50-yr interval. Farmland rents stay close to 5% of land value, bringing total return to 12.4%/yr. Reinvesting dividends on the S&P 500 Index over the past 50 yrs brings total return to 9.9%/yr. Accounting for inflation, those numbers drop to 8.2%/yr and 5.7%/yr. Farmland prices also show less volatility than stock prices, so farmland looks to be the hands-down winner!

Prime farmland in Eastern Nebraska or Western Iowa currently costs ~$9600/ac and is sold in quarter section (160 acre) parcels. You’ll need a big mortgage for that $1,536,000 price tag, even if you can come up with the $307,200 down payment. But unless you are yourself a farmer, this is not as wise an investment as it appears to be. Why? Like investing in gold, it predates and is outside the built-in benefits of capitalism: There’s no accrual accounting or compounding of interest (see Week 157). More importantly, you'll lose money when crop prices collapse like they did in 2013 and have continued to do this year.

For both tenant and landlord, the Great Game is to bet on the weather cycle as opposed to the economic cycle. The farmer can always tune in to a local AM radio station that will provide instant pricing for “futures” on farm commodities. As he’s driving his tractor, he can trade futures on the Chicago Mercantile Exchange (CME) by using his smartphone. When prices spike upward, farmers (and their landlords) can reap windfall profits if they act quickly. When prices spike downwards, the crop insurance that is built into every US Farm Bill will likely prevent efficient farmers from having to “cash out.” Farmers also have the option of buying grain bins to store their crop until the market recovers. And, most farmers “hedge” 20-30% of their crop against the risk that prices will fall, agreeing to sell at a pre-set price when the growing season ends by entering into a futures contract on the CME.

Farmers are gamblers, as are those among their landlords who take a cut of crop sales in lieu of a fixed rent. More often than not, their gambles pay off. Why? Because planet-wide protein production can’t keep up with the demand created by population growth and rising incomes, and weather-related crises are out of sync with economic crises. Now you know why Omaha came through the Great Recession better than any other American city.

For our readers, we’d better stress that owning farmland is another way to gamble on a commodity (see Week 163). Yes, big profits can occur but they’re a hit-or-miss thing with long dry spells punctuated by some bad years, such as 2014. That being said, the prudent move is to take the time-proven route to commodity profits, which is to invest in companies that service the producer (e.g. farmer) rather than the commodity itself (e.g. farmland and crop futures). In this case, it means investing in stock issued by companies that provide inputs (and outputs such as railroads) to “production agriculture.” Then add a couple of food-processing companies. Why? Because those companies supply food to grocery stores and can pass commodity costs on to the consumer.

How then might you make a farmland investment that benefits from the insights of capitalism (accrual accounting and compound interest)? That would be through dollar-cost averaging your stock purchases then reinvesting your dividends. We find only 10 companies that meet our criteria for inclusion in a retirement portfolio (Table). Our benchmark is the Vanguard Balanced Index Fund (VBINX) at Line 17 in the Table; red highlights denote metrics that underperform VBINX. Our criteria are:

        1) the company is an S&P Dividend Achiever, i.e., one that has raised its dividend annually for at least the past 10 yrs;
        2) the company has an S&P bond rating of BBB+ or higher;
        3) the company has an S&P stock rating of B+/M or higher;
        4) the company’s stock has a dividend yield of 1.4% or higher.

Now let’s see how those 10 stocks have done over the past 14 yrs as opposed to returns on owning farmland in Audubon County, Iowa, the benchmark we used above. Farmland values have grown 12.4%/yr and inflation has been 2.4%/yr. Adding 5%/yr in rental income and subtracting 2.4%/yr inflation leaves 15%/yr. For our 10 stocks, total return is close to 15%/yr, which makes after-inflation return ~12.5%/yr.

Bottom Line: Farmland has been the most stable and rewarding asset class to own for many decades, if not centuries. But is that extra 2.5%/yr (compared to Ag-related stocks over the past 14 yrs or the S&P 500 Index over the past 50 yrs) worth all the trouble and disappointments of being a tenant farmer's landlord? Property taxes are high, and slow to reset; fixed rents leave you with insufficient funds (after paying interest on the mortgage) to pay property taxes. But, if you have the patience of Job, live near the land you'd be renting, and want to gamble a million dollars, it probably is worth the trouble and disappointments. But to come out ahead you’ll need to have your tenant farmer pay you a revenue-based “custom” rent instead of a fixed rent. That saves him from having to pay you any rent at all in bad years like this one, so try to get him to settle for a 50:50 split of revenues (from crop sales at the end of the growing season).

Risk Rating: 8

Full Disclosure: I own shares of MON, HRL, GIS, MKC, PEP, and DE.

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