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Trouble In the Heartland? Rapid Rise in Farmland Values Poses Risks for Investors and Ag Lenders Alike

Reclassified as Real Estate Asset, Farmland Attracts Growing Interest from Institutional Investors, but Ratings Firm Warns On Potential Correction
October 10, 2012
Over the past two years, farmland investing has attracted major investor interest. In fact, some believe farmland investing has reached an unprecedented level of interest among institutional investors looking for higher returns on their investments.

"Back in the 1990s and 2000s, when stocks were earning double-digit returns, a farmland investment return of 7% to 9%, including income, didn't generate much interest," said Jamie Shen, senior vice president and head of Callan's Real Assets and Alternative Investments consulting groups.

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"Now, with investors looking at a bond market where the prospective yields are very low, an estimated 7% to 9% return over the next 5 to 10 years is suddenly more appealing," added Shen.

Editor's Note: This is Part Three of a three-part CoStar series on the current state of land investing. Part One: Land Sales Rising for First Time in Seven Years.
Part Two: The Great Land Price Swing.

Investor interest in farmland is also increasing because the asset class is no longer considered a stand-alone investment or part of a real estate allocation, which usually required a meaningful portfolio allocation of approximately 5%, according to Shen. Now that farmland has been re-categorized to the real assets category (which includes timber, infrastructure, private energy, real estate, commodities and TIPS), a 1% allocation to farmland is considered notable.

"Farmland returns have been remarkable and we haven't seen a correction in farmland values like we did in real estate," Shen said.

Callan's research concluded that simple supply and demand also contributes to the increased attention to farmland. The global population, which is expected to grow from 7 billion to 9 billion over the next 40 years, is likely to heighten demand for agricultural land and the goods it produces.

Another factor is the growth in global population. The number of people is increasing worldwide and farmers may find it increasingly difficult to produce enough food to outpace rising demand. Research indicates that the U.S. often fills that unmet demand and U.S. farmland provides a way to take advantage of global and emerging market growth without having to invest in those markets.

In addition to being a good portfolio diversifier, farmland is an effective inflation hedge, Shen said.

"Whenever an extended inflationary period becomes a real possibility, investors look for alternative assets that have a demonstrated record of growing in price faster than inflation rises," says Shen. "Typically hard assets are considered strong inflation hedges, and farmland is no exception."

Callan found that the greatest obstacle to institutional investment in farmland is actually getting invested. Farmers are reluctant to sell their land, and very often when they do, it is as a result of a generational change.

"With more than $2 billion in investor capital on the sidelines and ready to be invested, if a $200 million farmland portfolio came on the market today, it would likely trade very, very quickly," said Shen.

However, Shen cautioned that investors still need to be patient and committed to this asset class.

"Farmland has many implementation challenges, it's an illiquid asset class and it takes a long time to become invested. And though this investment has held a steady return track record, farmland probably won't always generate a 15% return."

His is not the only note of caution.

Rapid Farmland Appreciation Poses Risks for Ag Lenders

The sharp run-up in U.S. farm real estate values in recent years could cause credit problems for agricultural lenders should prices reverse quickly, according to Fitch Ratings.

Farmland prices continued to rise in the first half of 2012, particularly in the Corn Belt and Northern Plains, despite the fact that these regions have been hardest hit by this summer's drought. The U.S. Department of Agriculture (USDA) reported that farm real estate values nationwide increased by an average of 10.8% year over year, to $2,650 per acre as of June 2012.

Land price increases in the Corn Belt and Northern Plains have been far higher than the national average, with estimates of 17% and 26%, respectively. This comes on the heels of similar price increases in the 2010-2011 period. Cumulative increases since 2000 in the Corn Belt and Northern Plains regions have been 188% and 225%, respectively. Some subsegments of these regions containing prime cropland have seen increases far in excess of regional averages.

The critical drivers of the surge in farmland values over the last decade have been low interest rates and high commodity prices. Tight supply of available for-sale farmland is also driving up prices, as the commodity price boom has had a large positive impact on agricultural sector wealth in recent years. As a result, farmland owners have had few incentives, other than high prices, to sell.

This has created a market where there is a relative abundance of wealthy farmers and agricultural companies with comparatively few investment options bidding up farmland values to potentially unsustainable levels. Importantly, buyers are using limited leverage in their purchases, given their wealth and the fact that banks, on average, appear to be reluctant to lend at standard loan-to-value terms against potentially inflated collateral.

"In the event that the long-term trends of low interest rates and rising commodity prices reverse themselves relatively quickly (a scenario not considered unreasonable), we would expect a large correction in farmland values," Fitch analysts said. "Lenders with significant exposure to the agricultural industry in general, and those with substantial amounts of farmland serving both as collateral and as the primary repayment source, would likely report large credit losses in such a scenario."

The four Farm Credit System banks dominate the U.S. agricultural lending space. Roughly half of their combined loan portfolio consists of long-term real estate mortgage loans that are secured with farmland. Of the four system banks, AgriBank is the most exposed to a farmland price correction, as its footprint includes the Northern Plains and Corn Belt regions, according to Fitch.

Recognizing these risks, AgriBank and its related association lenders have been lowering their loan-to-value limits substantially below their 85% regulatory limit. In some instances, acreage value caps are being implemented, whereby the Association will not lend against values in excess of a predetermined sustainable value, according to Fitch.

"These are important risk-mitigating tools," Fitch said. "However, given the high levels of price appreciation over such a long time period, a large correction could leave many loans secured by farmland underwater and negatively affect cash flows on a large segment of the system banks' loan portfolios."

Keep up weekly on national news, trends and property leads with the Watch List Newsletter, a weekly pdf that includes other news and leads not found on the CoStar Group web news pages. Sign up for the Watch List E-Mail Alert. A new issue is published late each Wednesday.

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