By Tom Schenk, Director of Business Development for TerViva
Back in 2006, when people were trading the stock and the real estate markets like rock stars, few people cared about a quietly obscure asset class called farmland. However, the economic collapse that began in 2008 changed all of that. At the same time, grain prices soared to a new plateau at 2x the prices seen in the 80’s and 90’s due to increased demand from middle class consumers in emerging markets and ethanol production, as well as supply shortages created by crop failures from violent extremes in weather patterns globally. On the demand side, the industrialization of emerging market countries has brought millions of people into the middle class in those countries who demanded – and could afford – better diets of meats, vegetables, and grains.
At the beginning of the farmland investment boom in the US, every $1 of farmland value only carried about 5¢ of debt. Ownership was in strong hands. It was this obscure statistic relating to the low levels of farmland debt that was one of the greatest factors that contributed to the fact that this asset class being a wonderful placeholder for wealth during the financial hurricane that slashed stock and residential and commercial real estate in half in a period of months. Asset classes that were highly-leveraged were the same ones that deflated the hardest. When collateral for loans decline in value, lenders demand more collateral. If that other collateral is falling, it creates fire sales in a rush for liquidity and thus a vicious feedback loop ensues.
Today, debt-to-asset ratios in some of the major farming states are back to 30% and higher. These are levels not seen since 1979 which, along with sharply rising interest rates and falling commodity prices, led to the great farm crisis of the 1980’s. Today, alarms are being sounded that we are in a similar setup and an imminent crash could be ahead.
However, few things in the financial world are that linear in reasoning. There are many moving parts involved in calculating the future stability of this asset class if we enter a period of rough financial weather. For example, while debt levels in dollar terms may have increased 2x, land values (on paper) have gone up 3x to 4x times in many instances. Another major variable in this calculus is that production costs for farmers have come very close to doubling in this period also. Additionally, farmland has historically had a very high inverse correlation to the 10-year US Treasury rate. The enormous impact on farmland values from the Federal Reserve’s financial engineering of interest rates cannot be overstated. Where investors could find 7% – 9% cap rates back in 2006, today those rates have dropped to a range of 2% – 4¾% depending on the quality, yields, and location in the US.
Nevertheless, traditional farmland investing is considerably more vulnerable to adverse shocks than it was in 2006. Creighton University’s Farmland-Price Index is a monthly survey of 200 rural communities in major grain growing states. The most recent survey show that the rate of farmland price appreciation is has been decelerating since late 2012. Clearly land prices are flattening out. Unfortunately, commodity prices and land values can drop by the speed of light compared to any declines in production costs , and this can put a farm’s balance sheet in a bind almost overnight. A strong case can be made that interest rates may have hit a long-term (30+ years) cyclical low. If rates begin to rise, there is little question that farmland prices can come under immediate pressure. There has always been a historically strong inverse correlation between 10-year Treasuries and farmland prices.
The purpose of this article is not to sound alarms about the imminent demise of farmland asset values. In this past decade, we have seen “bluechip” stocks and “AAA-rated” bonds go to zero, as well as commercial real estate like shopping centerss can become vacant or obsolete. But what was unique about farmland is that it has an imbedded put option; if you lose a crop, you still have the land and you can try again. In this crazy world of abstract derivatives with notional values priced at hundreds of trillions of dollars worldwide, there will always be a demand for an real asset like farmland; it cash flows and the demand for its output is relatively inelastic. People have to eat.
However, it should give investors pause before they pay $12,000 for that next Illinois acre.
Large scale/institutional farmland investors have always diversified geographically and with different crops, but in cyclical commodity downturns, the income streams of these “diverse” yet traditional agricultural properties will have as much non-correlation as a squadron of Blue Angels at a summer air show. In other words, that cotton property in Mississippi will go in the same direction as corn land in Iowa or the potato farm in Idaho.
So what’s a farmland investor to do in what appears to be a relatively deflationary economic climate?? One idea is to borrow a page out of what traditional money portfolio managers have done for decades which is to apply the principals of Modern Portfolio Management – namely, diversify into property types with diverse return profiles in order to reduce overall portfolio risk. Over the years, I have seen small cap and micro cap managers rescue overall portfolio returns by exploiting those overlook and under-researched companies where fundamental analysis ran circles around index managers by finding those opportunities that returned comparatively out-sized returns from some overlooked niche. In the 80’s, Microsoft was one such company. The underlying attraction in small cap stock investing is that few, if any, analysts are researching these companies.
To that end, there is a quiet little company out of Oakland, CA called TerViva that has been establishing plantations of a hardy tree crop called pongamia. Pongamia trees are native to Australia and India. They produce a nut crop that is virtually a first cousin of soybeans – but grows on a footprint where soybeans generally cannot. An annual harvest of the nuts can produce over 400 gallons of oil and a couple of tons of residual “seedcake” that can be used as a high-protein animal feed or as a high-nitrogen fertilizer. In a given year, a producer has the ability to direct that oil to biodiesel, bio-jet-fuel, bio-chemical (it is high in oleic acid and other valuable long-chain carbon compounds), or even biopesticides markets, depending on what is determined to be the highest best use downstream markets. Pretty cool. The oil has been tested by Dynamic Fuels, REG, and Shell as a great feedstock worth about $3.50/gal. I recently spoke to an organic grower who has successfully used pongamia oil as an adjuvant in his pesticide sprays for the last 7 years. His supply comes from India. He proudly informed me that he had recently got the price of his oil “down” to $17/gallon!
However, the most compelling aspect of this tree crop is that these trees can thrive in marginal soils such as south Texas or the challenging sandy fallow soils southern Florida where citrus trees used to grow before HLB disease marched through the state. Instead of passively collecting x in revenue like typical farmland investors, you can proactively generate 5x-10x on these lower grade properties. And as a result, you will obviously get a sharp appreciation in the underlying land value in addition to the improved income stream that is arguably on par with the richest Iowa or Illinois farms.
Is this too far-fetched of an idea? Not for three major citrus growers in Florida (plus a fourth grower planting this month) who conducted extensive research on the tree and this concept before planting on their own properties. So far, they are more than pleased with what they are observing. The trees are growing almost twice as fast as citrus and require a fraction of the inputs. Moreover, for investors who want to grow this tree crop, these citrus companies will act as the operators for planting, maintenance and harvesting.
Sometimes is you cannot find any gems in the rough, you just have to make your own.
Tom is TerViva’s Director of US Business Development, and works every day with agriculture growers to explore opportunities with new crops.