Why farmland now? A durable and consistent investment with upside growth potential
Increased market volatility has forced investors to search for assets that will be resilient throughout the economic cycle. Unexpected market events are seemingly becoming more common, requiring investors to revisit their asset class allocation strategies in order to pursue their long-term return targets at an acceptable level of volatility.
Farmland is gaining more mainstream acceptance as an institutional asset class, potentially providing attractive long-term annualized returns that are uncorrelated to traditional financial products such as fixed income and global equities, and low correlation to other real assets. Historically, farmland returns have been extremely resilient and consistent throughout the economic cycle.
The current low interest rate environment is a function of poor economic growth and a low inflationary environment. Government bond yields in all major developed economies have declined in recent decades. Due to the reduction in bond yields, investors have increasingly begun to seek returns elsewhere. This fact, coupled with the low cost of borrowing, which is also a product of a low interest rate environment, has significantly increased investor demand for real assets (real estate, infrastructure and farmland). The increased demand for these assets has resulted in strong value appreciation in recent years, which in certain cases has outpaced the asset’s earnings potential and has resulted in yield compression. However, despite this compression, farmland yields remain attractive relative to other financial products (See Chart 1).
WHY FARMLAND NOW?
Despite its illiquid nature, farmland continues to provide strong and consistent risk-weighted returns relative to other asset classes. When evaluating an investment, it is important to consider the return volatility in addition to expected return. Chart 2 compares the volatility of U.S. farmland returns to the S&P 500 and U.S. 10-year bonds over an 18-year period from 2000 – 2018. During the period, U.S. farmland returns have experienced a similar level volatility as U.S. 10-year bonds and, significantly lower volatility than equities. Despite its comparable return volatility, farmland has historically outperformed 10-year bonds, delivering significantly higher yields.
As a result of its risk weighted return, we believe one can view farmland as a powerful diversifier within an investment portfolio.
Farmland’s low volatility can be particularly valuable in periods of financial uncertainty.
In periods of economic adjustment, the asset, unlike other financial products, has proven to be extremely resilient, outperforming all other assets classes.
Chart 3 demonstrates the resilience of farmland returns over four decades despite periods when the U.S. and/or global economy was in recession.
The 2008 financial crisis caused severe and prolonged recessions in many of the world’s leading economies. In the U.S., the negative consequences of the financial crisis were experienced across most sectors of the economy. However, this period was relatively profitable for the agricultural sector, resulting in strong farm-gate profitability and higher agricultural land values. Kuethe et al. demonstrated that in the four-year period leading up to the 2008 financial crisis and the four-year period after the crisis, farmland consistently produced positive returns, outperforming U.S. treasuries, the Dow Jones, and the S&P 500 over the 8-year period.1
Farmland’s asymmetric return profile presents a compelling case to invest during instances of economic uncertainty. U.S. farmland has delivered only one quarter of negative returns since 1999 (-0.01% in the first quarter of 2002). Importantly, during periods in which the S&P 500 declined, farmland delivered positive returns. The durability and negative correlation of farmland returns to economic cycles is driven by the consistent requirement of a growing population to eat from a limited land resource base.
Agriculture has experienced a continuous wave of new technologies being introduced over many decades, resulting in productivity improvements. These improvements typically result in improved yields and/or a lower cost of production, positively influencing farmer profitability and underlying land values. Global agricultural total factor productivity (TFP), which measures the changes in the efficiency by which inputs are transformed into outputs, doubled in the 1990s to just over 1.5% per annum relative to what was achieved in the 1970s and 1980s. Importantly, TFP has remained at this higher pace since the 1990s through to today, supported by technology adoption. Chart 4 shows examples of technology introductions and their adoption rates. Tractors were first introduced in the U.S. in 1910 and took almost 50 years to replace horses in agriculture, reducing labour and increased efficiency of planting. In 1996, the introduction of herbicide-tolerant corn in the U.S. took less than 20 years to be adopted. The acceleration of technology adoption is a trend witnessed across many industries and will support productivity growth in agriculture.
Examples of new technologies being introduced include drones and satellite imagery, improved genetics and increased data collection and analysis. These new technological and genetic advances will help reduce the environmental impact of modern agriculture making it more sustainable, helping to produce more with less.
The durability and consistency of returns is unparalleled across other investment alternatives. Fundamental farmland return characteristics remain intact, with upside potential on the horizon in the form of productivity advancements. Farmland possesses a number of unique characteristics, including: strong yields, low volatility, negative correlation to equities, and a resilience to economic cycles. These factors create a compelling case for the inclusion of the asset class in a diversified investment portfolio.
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1 Kuethe T.H. et al. (2013): Farmland versus Alternative Investments before and after the 2008 Financial Crisis. Journal of the ASFMRA p.120-131
Recommend further reading:
Elworthy, F. (2018): Volatility to Explain High Historical Farmland Returns. The Property Chronicle. May 9th
Ibbotson, R.G.; Kaplan P.D. (2000): Does Asset Allocation Policy explain, 40, 90 or 100 percent of Performance. Association for Investment Management and Research. Jan/Feb 2000. p.26-33
Key, N. (2018): Productivity Increases with Farm Size in the Heartland Region. USDA-ERS
Painter, M.J. (2015): Assessing the Required Risk Premium for North American Farmland Investment. Journal of ASFMRA, p.15-33
Sands, R. et al. (2014): Global Drivers of Agricultural Demand and Supply. USDA ERS
Sorensen, A.A.J. et al. (2018): Farms under Threat: The State of America’s Farmland. Washington D.C. American Farmland Trust
Wang S., et al. (2015): Agricultural Productivity Growth in the United States: Measurement, Trends, and Drivers, ERR-189, U.S. Department of Agriculture, Economic Research Service, July 2015.