Looking for Dirt (The Fertile Kind)
By Ian Prior, U.S. Trust | Jan 09, 2014
Wary of investments they struggle to understand, more investors turn to perhaps the most basic asset of them all: land.
The U.S. economy, it seems, is on the mend. Not so the psyches of some investors.
They remain guarded about complicated investments, especially the kind that reportedly helped fuel the economic crisis, such as the credit default swap, the collateralized mortgage obligation and the mortgage-backed security. These wary investors are looking instead at asset classes that are less complex and more easily understood, yet still potentially profitable. According to Dennis Moon, head of the Specialty Asset Management (SAM) group at U.S. Trust, some have found just that in productive land. “As the economy recovers, some of our clients want to avoid something that’s so exotic they can’t understand how it works,” says Moon. “Many have become interested in farmland and timberland in part because they are a relatively uncomplicated asset classes and in part because these are assets they can actually touch and even walk on.”
Returns and Correlation
Fruitful land has long been a go-to investment, prized by investors for its relatively stable returns and its measurably low correlation to the stock market.
“That’s certainly what’s drawing some crisis-weary investors to the asset class: the lack of correlation to the Standard & Poor’s 500 stock index and returns that have historically averaged about 10% — as a combination of land appreciation and income — over the past 20 years,” Moon says, citing information from the National Council of Real Estate Investment Fiduciaries, or NCREIF. Yet when it’s a new area of investment for them, he notes, “investors often ask us how an investment directly in land differs from an investment in agricultural commodities such as corn and soybeans.”
Farmland vs. Farm Product
That’s an important distinction. The prices of agricultural commodities invariably fluctuate, but they have been volatile in recent years due to extreme weather events, rising global demand and other factors. (See Exhibit 1: Agricultural Commodity Prices.) Speculation and hedging in the agricultural commodities markets can lead to even greater volatility and complexity. “Basically, investors want to know if farmland values are going to be as volatile as agricultural commodities prices,” Moon says, “and whether investing directly in land is perhaps more complicated than it seems.”
The answer on both counts, he believes, is no.
“There is certainly some relationship between land values and crop prices,” says John Taylor, national executive for SAM’s Farm & Ranch group. “Many farmers lease from property owners, and what they can afford to pay per acre is a function of the gross income they expect from the land. That price in turn is related to the expected market price of the commodity they produce.” Yet land generally offers notably lower volatility compared to the commodity it produces. This is apparent in Exhibit 2, Land Values and Farm Sector Net Income (from the U.S. Department of Agriculture [USDA]), which compares land values per acre and farm sector net income per acre between 1980 and 2009.
One reason for farmland’s lower price volatility is what Taylor calls the asset’s intrinsic value. “Unlike the case with a stock or a bond, the chances that farmland will have zero value are extremely low,” he says. “Unlike commercial real estate, productive land rarely has a ‘vacancy’ factor. From everything we’ve seen, almost all of the nation’s arable acreage grows crops year in and year out.”
Granted, productive acreage has undergone an 8% decline during the past 20 years due to “development,” according to the USDA. Productivity can also be affected by droughts and floods, which could worsen with climate change. Yet American farmland should remain plentiful and productive for the foreseeable future.
Land, Land, Land
Investing directly in farmland, Moon says, can be a fairly straightforward process:
“You don’t need to know anything about crop rotation, cattle feed or any other aspects of farming. A team of experienced farm managers, such as the ones in the SAM group, can do essentially all of the work for you, from inspecting a farm before a purchase to reviewing potential farm tenants to helping to ensure that a farm runs smoothly post purchase.” In fact, Moon adds, “the SAM group can make buying farmland almost as easy as buying securities.”
Need to Feed
Both Moon and Taylor think that several trends will be key to U.S. farm values and incomes remaining stable, or potentially rising, over the long term. (For more on some of these trends, see “The Big Five” in this issue of Capital Acumen.)
Land area is fixed. According to data from the World Bank, the total available arable land worldwide is set at about 3.4 billion acres.
Food is consumed. The USDA estimates that most of the world’s crops are consumed. “The supply of and demand for corn, wheat and soybeans are pretty evenly matched,” Moon says. This is evident in the table from “Supermarket America” in issue 21 titled Supply and Demand 2011.
Population is increasing. The global population rose to 7 billion in 2011, the United Nations (U.N.) says, and could reach 8 billion within a decade. As Taylor notes, “There will be many more mouths to feed in the years ahead, yet the amount of food the world produces is basically fixed.”
Demand for meat is rising. “As U.S. Trust Chief Investment Officer Chris Hyzy and others have noted, emerging markets economies are growing stronger. As people become richer they are demanding not only more food but also higher-quality food than in previous decades — and meats such as chicken, pork and beef require more grain to produce,” Taylor says.
America’s Green Acres
What does the emerging world’s growing appetite have to do with U.S. farmland? It turns out that “the United States has about 12% of the world’s arable acreage and not quite 5% of the population,” Taylor says, citing World Bank estimates from 2012. “This ratio is significant when you compare it to similar ones in countries such as China, which the U.N. calculates has 8% of the world’s arable land and 20% of the world’s people.” As a result of these proportions and of efficient farming techniques, “American farmers in 2011 produced almost 40% of the planet’s total output of grain, as well as more than half of all corn exported globally,” Taylor says. It’s little wonder that the United States is often dubbed “the breadbasket of the world.”
As Taylor notes, “This abundance is largely why investments in U.S. farmland have historically produced an average annual return of about 10% — as a combination of land values and crop values — over the past two decades, and it’s why we think U.S. farm investments could see similar returns, or higher ones, in the decades ahead.”
Forests, it might be said, have their own rhythms. Whereas corn must be harvested annually, trees can grow for years before they are harvested. But investors in timberland don’t have to wait years for their investments to produce income.
“Trees take far longer to grow than crops,” says Roy D. (Doug) Donnell, a national executive for SAM’s Timberland group. “But when we construct a portfolio of timberland properties for a client, we can ‘ladder’ the ages of the trees so that we can begin harvests of mature trees early in the life of the investment.”
At the same time, he says, trees require little of the attention that crops demand. “With corn and other agricultural commodities you usually have to till the soil, use fertilizer and ensure proper irrigation. With timberland, once saplings are planted you basically let the sun and rain do all the work,” Donnell says. Granted, a forest requires some occasional culling to allow other trees better access to sunlight, but “what is felled can usually be sold,” he adds.
Falling for Timber
In this post–Great Recession period, timberland is attracting more investors for a number of reasons. Like farmland, it’s an asset that is relatively easy to understand, and forest property has the kind of “touchability” investors often prize. “You can walk on it, camp on it and hunt on it,” Donnell explains. Timberland can increase portfolio diversification because of its low correlation to other asset types. With inflation rising, or likely to rise, investors also appreciate that timberland can be an effective hedge against inflation. “The asset has a correlation to inflation that’s second only to Treasury bills among common asset classes,” Donnell says. “And correlation can be an indication of an asset’s ability to serve as an inflation hedge.” (Both types of correlation are apparent in the Exhibit 3: Correlation With Inflation With Asset Classes, 1960–2012.)
Timberland’s relationship to inflation exists in part because timber prices themselves have an effect on the inflation rate, albeit on a lagged basis. Because of manufacturing times, changes in the price of timber can take a year to be reflected in higher furniture and paper prices, which are components of the inflation rate.
The Old Tax Tree
Oak, pine, ash and other types of wood can be attractive from a tax perspective, as Donnell explains: “Timber sales are taxed as capital gains, not ordinary income, and the cost basis in the timber can be used as depletion against the capital gain. That being the case, owning timberland can also help you defer taxes, because any gain on that investment is not recognized until trees are harvested.”
Time is important to timberland for a number of other reasons:
- As the years pass, more trees can grow on your land.
- You can harvest less valuable trees and replace them with more valuable ones.
- As trees grow, they can become more valuable. Younger and thinner trees can become inexpensive pulpwood. Older and thicker ones can be made into costly veneer.
- When lumber prices are low, you can simply delay harvesting until they improve.
The supply-and-demand picture for timberland appears poised to improve for the same reasons that farmland can be a promising long-term investment. (See “The Big Five: Global Real Estate” in this issue of Capital Acumen.) “A number of metrics point to a pickup in the U.S. housing market, which bodes well for timber sales,” U.S. Trust’s Moon says. Here are some of those metrics:
- Housing values have risen almost 10% this year alone (see exhibit, Case-Shiller 20-City Composite Home Price Index), giving some owners the equity they need to complete renovations.
- Existing-home sales rose almost 10% in the same period, says the National Association of Realtors, which tracks home sales, with homeowners often renovating their new houses.
- The number of houses under construction (using wood) climbed 35% between April 2012 and April 2013, according to the U.S. Department of Housing and Urban Development.
- The Millennial generation is reaching an age at which members are likely to buy houses.
- Some baby boomers are selling their large houses and buying smaller ones.
- With the economy recovering, more people are likely to purchase second homes.
Earth and Wood
Then there are the economic and demographic changes sweeping the planet. “Just as rising living standards and growing populations are pushing up demand for food in emerging markets, so too are the expanding middle classes in China, India and elsewhere looking into buying new or used houses and apartments made in part with wood products,” Moon says.
There are also some seeming constants in the world of wood. “Among the factors that helped support timber prices over the past five years, perhaps the most significant was the nation’s fairly robust pulp and paper industry, which helped to mitigate the downward effect of the recent housing slump,” Donnell notes.
Donnell has some closing words on timberland. “This is the way I look at it,” he says. “If you invest in 100 ounces of gold, in 10 years you’re still going to have 100 ounces of gold. But if you invest in 100 acres of land, and you plant trees on it, in 10 years you’re going to have that 100 acres of land and tons of a material that will have market value and that will grow irrespective of what’s going on in the world.”
This is a shift in perspective that more and more clients appear comfortable with, he says. “Some look forward to walking in their forests. Others like the idea that the trees they own act like a ‘carbon sink,’ sucking carbon out of the atmosphere as part of photosynthesis. For most, it’s a long-term investment that has the potential to provide steady returns, portfolio diversification, tax efficiency and a hedge against inflation.”
Productive land has the potential to provide stable returns, perhaps even gradually rising returns, for many years, judging by the economic and demographic changes occurring around the world. With their low correlation to most other asset classes and their high correlation with inflation, both farmland and timberland can provide portfolio diversification and a hedge against inflationary forces. And land’s relative simplicity as an investment is an enduring attraction.
If you are considering an acquisition of productive land, be sure to talk with your U.S. Trust advisor and other investment professionals. They can help you determine important factors such as how much land to buy and what kind might be suitable for your overall investment strategy. SAM’s Farm, Ranch and Timberland groups can help you purchase and manage properties almost anywhere in the United States.
For more information, go to ustrust.com/sam.
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