Ricardian Rents Prevail

David Ricardo in his theory of rent emphasized that rent is a reward for the services of land, which is fixed in supply.  Secondly, “it arises due to original qualities of land which are indestructible.”  As a result, the basic tenets of Ricardian rent and its empirical definition have been the subject of contention in the farmland valuation literature for many years.

So, while commodities produced on farmland are the primary determinant of its value, other returns associated with land can be capitalized into farmland prices.  Some of the distinctive characteristics of farmland markets are its thinness and immobility .   The fact that a very small portion of total farmland is sold in a given year defines a thin market.  Land is immobile, so market interactions are local and the nature of personal relationships between landowners and farmers alters the outcomes of individual transactions.  Furthermore, multiple year rent contracts may lead rental rates to react sluggishly to market shocks.

Farmland Real Estate Investment Trusts

A contemporary institutional arrangement that best illustrates Ricardian rent theory is the triple net lease. Under a triple net lease, a tenant pays all of the operating expenses associated with a property in addition to the payment of rent to the landlord.  Suppose that an individual owns a piece of land and leases it to a tenant, with the tenant paying for all improvements (including the construction of buildings), maintenance, insurance, taxes and other costs. The amount that this tenant pays to the landlord could be considered rent in the Ricardian sense, for the only contribution of the landlord to the real estate project is permission to use the land.  Farmland Real Estate Investment Trusts (REITS) almost exclusively utilize the triple net lease in their management of farm properties.  There are two real estate investment trusts (REITs) involved in the ownership of agricultural land, Gladstone Land and Farmland Partners.

Gladstone Land is a publicly-traded (NYSE: LAND) real estate investment trust that invests in farmland located in major agricultural markets in the U.S., which it leases to farmers, and pays monthly distributions to its stockholders.  The company reports the current fair value of its farmland on a quarterly basis; as of December 31, 2017, its estimated net asset value was $13.96 per share.  Gladstone Land currently owns 73 farms, comprised of 63,014 acres in 9 different states across the U.S., valued at approximately $534 million.  Its acreage is predominantly concentrated in locations where its tenants are able to grow fresh produce annual row crops, such as berries and vegetables, which are generally planted and harvested annually; as well as permanent crops, such as almonds, blueberries, and pistachios, which are planted every 10 to 20-plus years.  The Company also may acquire property related to farming, such as cooling facilities, processing buildings, packaging facilities, and distribution centers.  LAND invests heavily in specialty crops. As of the 2017 10-K, in terms of revenue LAND is 65 percent in produce, 15 percent in permanent crops such as nuts and only 10 percent in primary cash crops like grains. The remaining 10 percent rent is attributed to farm related facilities.

Farmland Partners Inc. is an internally managed, publicly traded (NYSE: FPI) real estate company that owns and seeks to acquire high-quality farmland throughout North America.  The company was founded by farmers, and its management team has hands-on farm operations experience.  As of February 27, 2018, Farmland Partners owns or has under contract over 166,000 acres located in Alabama, Arkansas, California, Colorado, Florida, Georgia, Illinois, Kansas, Louisiana, Michigan, Mississippi, Nebraska, North Carolina, South Carolina, South Dakota, Texas and Virginia.  The land is currently diversified across more than 125 tenant farmers who grow more than 30 major commercial crops.  At the end of 2017,
approximately 75 percent by value, of the acres in the portfolio were used to grow primary crops, such as corn, soybeans, wheat, rice and cotton, and approximately 25 percent were used to grow specialty crops, such as almond, citrus, blueberries, vegetables and edible beans.

Since they both enjoy geographic diversity, one of the primary characteristics that distinguishes these farmland REITs is the composition of the commodities produced on the managed land.  Farmland REIT values should reflect rental rates on managed land.   More specifically, they represent the discounted value of expected future returns. These rents, in turn, reflect the  expected returns from commodities produced on the land.  In the case of Gladstone Land, the returns are predominately made up of specialty crops in contrast with Farmland Partners where a larger share of  production on managed land is for traditional row crops.

Figure 1. Comparison of trends in stock prices for farmland REITS since May 2017.

So far so good, but here is where the stories diverge. One year ago (May 9, 2017) these REITS had a similar valuation of about $11 per share. Since then, their values have moved in opposite directions. Have the expected future returns deviated that much between specialty commodities and traditional row crops? USDA’s Agricultural Resource Management Survey (ARMS) provides farm real estate values as a component or the reported balance sheets by production specialty. This allows some evidence of how real estate values have grown over time for specialty crops in comparison with row crops such as corn and soybeans (Figure 2).

Figure 2. Comparison of trends in the total value of farm real estate for selected production specialties.

The data do suggest that since 2013 the growth of farm real estate values have been quite different for specialty crops versus corn and soybeans.   The value of farm real estate on farms that produce specialty crops increased by 40-percent from 2013-2016.  In comparison, the value of farm real estate on farms that earn 50 percent or more of their total value of farm production from corn saw almost a 2-percent decline.  Similarly, after peaking in 2014, soybean farm real estate value is down almost 6-percent.  The 3-year moving average values represent a longer-term, expectation view and would suggest increasing values going forward for specialty crops and stagnant growth for corn and soybeans.

Farmland total returns consist not only of price appreciation, but also the earned income stream from the land. One estimate of the cash returns to farmland is cash rental rates less property taxes and other ownership costs.  Using this approach, the rate return attributable to income can be computed by dividing the cash rental rate by the market value of land in the same year.  The Hancock Agricultural Investment Group provides a regional breakout of the return components for their managed farmland portfolio (Figure 3).

The income returns (rent) to farmland within the Hancock Farmland Services portfolio show much less annual variability than does price appreciation.  Those regions where permanent crops such as fruits and vegetables are predominant (Pacific West) have the highest percentage income returns, although declining since 2015.  In fact, there is no region represented where income returns have grown since 2015.  Furthermore, as is the theme of this article, the relative differences in the income returns between regions should reflect the configuration of commodities produced.

Figure 3. Regional components of the total returns to farmland for the Hancock Agricultural Investment Group framland portfolio.

As in any investment situation, there are likely additional factors at play in explaining the divergent nature of these REIT valuations.  These include, but are not limited to, revenue growth, dividend rates, dividend coverage, and operating costs.  Many of these are discussed in detail at Seeking Alpha.  No doubt that tariffs, rumors of tariffs, and potential trade retaliations have dampened the outlook for row crops and soybeans in particular.  Beyond the sentiment, details of these tariffs are an important consideration.  Fundamentally, though, farmland REIT values reflect the potential income stream from rents and not the appreciation of land itself.

Rents Versus Value

The relationship between farmland value and cash rents remains dubious. Whether rents follow or lead land valuation could be argued either way. Cash rents would follow land prices since rents are longer term and take longer to change. Earnings are capitalized directly into land values rather than cash rents. The cash rent as a mover of land value argument would view returns per acre as setting the cash rent. Land values would follow based on a capitalization of those rents. In either case, the relationship or ratio between cash rents and land values warrants monitoring.

There are a variety of ways to evaluate the relationships between rents and value. This relationship should remain relatively consistent over time regardless if cash rents or land values react first. The stability stems from the balancing of renting versus purchasing in the market. Simply dividing farmland value by rent gives a quasi price-to-earnings ratio (Figure 4). A 10-year moving average calculation allows for comparison with alternative investment returns ( Shiller PE-10 and reciprocal of the 10-year treasury yield ). The imbalances in the U.S. housing market during the late 1990s to early 2000s is easily seen along with the impact of historically low interest rates in recent years helping to push PE values above 30 for some states.

Figure 4. Comparison of implied price-to-earnings (PE) for farm real estate

Another way to evaluate the relationship between cash rent and farmland value is to compare the amount of a 30-year fixed rate mortgage payment to rent (Figure 5). The extreme imbalance that occurred in the early part of the 1980s is readily apparent regardless of which State you measure. A sharp run-up in interest rates pushed the mortgage payment associated with farmland to a multiple of 3 in Illinois and higher in Kansas during the peak interest rates in 1981. Subsequent to the correction, rents and the cost of owning farmland track pretty closely in most states.

Figure 5. Cash rent in comparison with 30-year fixed rate mortgage payments for farmland.
TakeAways
  • Effectively functioning land markets have an important role to play in the performance of U.S. agriculture.  Proper development of land markets requires secure land tenure agreements and low transaction costs.
  • REITS may be an effective hedge against inflation for current farmland owners.  Moreover, farmland assets are a particularly attractive diversifier because they have a long documented history of generating returns that have low or negative correlation with traditional asset class returns.
  • Overall, farmland return expectations for 2018 remain muted; just outpacing inflation for the year.  The main driver is the likelihood of a fourth consecutive year of commodity price declines, leading to declining on-farm profitability and tighter operating margins.  Farmland markets are further susceptible to potential trade disruptions (NAFTA, trade relations with China).
  • One of Ricardo’s chief contributions (arrived at without mathematical tools) is his theory of rents, which has withstood the test of time.

 

Note that this article does not constitute investment advice nor do I own shares in any farmland REITS.  The author also appreciates the helpful comments from Dr. Todd Kuethe.