Quick Market Update
Flourishing Farmland and Bumper Crops
November 22, 2013
H. Cameron Hinds, CFA®
Regional Chief Investment Officer
Luis D. Alvarado
Investment Research Analyst
In this Quick Market Update:
An update on agriculture, farmland, and commodities
Farmland has seen strong returns through the last decade.
Agricultural commodity performance has been more mixed.
Despite some near-term headwinds for agricultural assets, our longer-term outlook is positive for this sector.
It’s as basic as survival and as complicated as modern-day derivatives markets. Long ago, societies formed as people began to understand how to gather seeds, use soil, and develop irrigation techniques in order to control their food production. Yet agriculture has become so much more than simply growing food for survival’s sake. The production, harvesting, and distribution of agricultural commodities eventually evolved into large-scale businesses with one big uncertainty—the weather. The uncertainty of prices and yields contributed to the creation of the Chicago Board of Options Trading (CBOT) where “futures” contracts are traded. Today, through the advent of options trading, farmers wishing to hedge their risk, speculators hoping to make a trading profit, and investors wishing to enhance their portfolio returns all have the capability to invest in agricultural commodities. Investors can also participate in the agricultural markets through direct or indirect ownership of farmland. In this QMU we look at the attractiveness of agricultural assets as part of a globally diversified investment portfolio.
Farmland vs. agricultural commodities
In recent years, investors have become more interested in both farmland and agricultural commodities—perhaps as a reflection of the stability and consistency of returns relative to other asset classes, such as traditional real estate investments and equities. Through the end of August of this year, farmland prices in the U.S. were up 9.4 percent on a year-over-year basis.1 The increases in farmland values have been considerably stronger in the heart of the U.S. agricultural community. As an example, farmland prices in Iowa rose 20 percent year-over-year as of August, with a three-year average annual return of 23.1 percent. Nationally, farmland price performance since 2000 has been especially strong, rising from an average of $1,000 per acre in 2000 to over $3,000 per acre this year.
Farmland Prices Rising: Average Farm Real Estate Values, 1950-2013
Source: U.S. Department of Agriculture (USDA), National Agricultural Statistics Service, 11/13; not inflation adjusted
Unlike farmland, the prices of certain key agricultural commodities have fallen significantly this year. The current year’s corn crop, for example, is likely to be the largest in U.S. history—but such success can bring with it certain challenges. The large supply of corn, combined with a modest slowdown in demand, has pushed corn prices down more than 34 percent over the past 12 months. While lower agricultural commodity prices might be expected to hurt farm income levels, it appears that this year’s abundant harvest will offset most of the price drop.
Agricultural Commodity Performance Has Been Mixed
Source: DJ-UBS Commodity sub-indices; Bloomberg, as of 11/20/13
Typically, farmland prices and agricultural commodity prices are closely related, but, as we’ve seen recently, there are periods of time when commodity prices and land prices do not move in tandem. However, diverging price trends are most likely unsustainable on a longer-term basis. So why have farmland prices been rising so rapidly while key commodity prices have been tumbling?
There are several specific factors that we believe are contributing to higher farmland prices:
It is difficult to measure a “pure” farmland price, as approximately 20 percent of farmland is subject to “urban” influences, resulting in higher values due to city proximity.
Farmland prices have benefited from the trend of declining interest rates over the past 30 years. From 1978-85 and from 2005-08, farm income was not sufficient to service debt; this is not so today.
Farm income gains have largely kept pace with farmland prices over the past few years. Technological advances have led to gains in productivity and efficiency. The potential for future gains in farm income levels is sizable.
Perhaps most importantly, farmland often only changes hands when a landowner who does not have the ability to transfer the property within the family dies or retires. It has been estimated that farmland turnover in the U.S. is potentially below one percent per year. That is akin to a 100-year holding period for stocks. Even equity index funds typically have higher annual turnover rates than farmland. This creates a “scarcity” value for farmland not seen in other asset classes.
Farm Sector Net Income, 1950-2013 (Forecast)
Source: USDA, Economic Research Service, 11/13; not inflation adjusted
While these factors appear supportive of current farmland prices, we acknowledge that there are some near-term headwinds. For example, policymakers in Washington D.C. appear ready to make cuts to farm subsidies which could dampen farmland prices. Also, our current outlook for modestly higher interest rates in 2014 may have a negative impact on farmland prices. But even this risk may be offset by a reasonable level of outstanding loans on farmland (especially relative to the high agriculture-sector debt levels of the late 1970s and early 1980s). Despite some short-term uncertainty, we believe the longer-term outlook for the agriculture sector looks healthy.
From a long-term perspective, the most significant positive factor for the outlook of commodity prices is the continued growth of demand from emerging market economies for food-related products. The USDA estimates that over 80 percent of additional food demand will come from emerging economies over the next 10 years. That growth is in excess of emerging countries’ internal production growth potential. Therefore, the U.S. farm belt is expected to provide much of the supply for this demand. In particular, the USDA estimates that as emerging-sector income grows, demand for meat will increase substantially, positively influencing commodity prices as well as land prices.
While the longer-term outlook for agricultural commodities is very attractive, just as with farmland, there are some potential near-term negatives. In particular, the Environmental Protection Agency (EPA) has proposed a reduction in the required ethanol blend targets on a national level, potentially denting future demand for corn and other grains.
At present, we are tactically underweight commodities. Our outlook remains cautious for agricultural assets in the near term, but more positive over the longer term. Currently, agricultural commodities may be suffering from oversupply and the potential for adverse regulatory policies. These negative factors are contributing to our tactical underweight of the broader commodities sector.
Furthermore, it is certainly plausible that farmland prices today may be modestly ahead of their underlying fundamental price levels and the recent trend in declining commodity prices. Yet fundamentals in the agriculture sector remain healthy from a longer-term perspective. Farm income continues to grow, technological advances are positively influencing production levels and debt levels do not appear excessive in the sector. Interest rates are likely to trend higher but remain attractive from a historical perspective. Strong global demand trends should ultimately have a positive influence on both agricultural commodity prices and farmland prices. We will be closely monitoring the trends in interest rates, farm income, news from Washington D.C. on farm subsidies, and emerging market growth to determine the potential future trends in both agricultural commodity and farmland prices.
All data for this Quick Market Update was sourced from Bloomberg Finance, LLP, unless otherwise noted.
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1 United States Department of Agriculture (USDA) Statistics Survey, 09/13