Amber Waves of Gain

Farmland is a path less traveled to solid returns and portfolio diversification, but institutional investors are beginning to take notice.

Sophisticated investors have long recognized the diversification benefit and return potential of real estate. Yet one fertile opportunity has yet to be tilled: U.S. farmland, which exhibits low to zero correlation with most asset classes, including other kinds of property. Collectively, U.S. farmland is worth about $1 trillion, according to a recent estimate by the U.S. Department of Agriculture. But a farmland index created by the Chicago-based National Council of Real Estate Investment Fiduciaries (Ncreif), which includes most institutional investment in the sector, accounts for only about 0.1 percent of total land.

“Overall, I wouldn’t say farmland has been overlooked by institutional investors; I would say it’s been undiscovered,” says Richard Wollack, co-CEO of Premier Pacific Vineyards, a developer and fund manager in California’s Napa Valley that oversees a portfolio of high-end vineyards in California, Oregon and Washington. That could soon change: Buoyed by farmland appreciation and the high price of crops, the sector returned 33.9 percent last year, its best performance since 1992.

Still, there are several barriers to investment. U.S. farmland remains largely fragmented into small parcels with lots of different operators. Unlike a timber investment, which is typically composed of huge land parcels, a farmland portfolio must be assembled piecemeal. “The fact that you can’t get capital deployed in a short time is a big hurdle,” says R. Brian Webb, chairman of Ncreif’s farmland committee and managing director of UBS AgriVest, a major institutional farmland manager based in Hartford, Connecticut. In addition, appropriate diversification in the sector requires a relatively steep investment of $50 million to $100 million.

William Howard of the institutional investment consulting firm Callan Associates, headquartered in San Francisco, points to additional constraints. He says only three large institutional fund managers — UBS AgriVest, Cozad/Westchester Agricultural Asset Management and Hancock Agricultural Investment Group — are currently accepting new investments. In addition, nine mostly Midwestern states restrict institutional investment in family farms. Farmers themselves have traditionally been reluctant to sell, preferring to own their land rather than rent it. Farmland is also largely a U.S. play: Only Hancock, based in Boston, manages investments abroad, in Australia.

Yet there are signs that some of these deterrents are fading. UBS, for instance, is rolling out an open-ended “commingled fund” that will offer access to a pool of farmland assets — along with the diversification that has traditionally been difficult to achieve with a single investment. Meanwhile, Ncreif reports that increasing numbers of farmers are beginning to sell their land and lease it back to channel more capital into operations.

Even if these developments don’t spark an immediate land rush, farmland seems certain to generate increased institutional interest, particularly in light of the sector’s historic role as an inflation hedge — not to mention those recent eye-popping returns. “Farmland today is where commercial real estate was 30 years ago,” says Ncreif’s Webb. “Institutional ownership will only continue to grow.”

Diversification may be the biggest draw. “In general, farmland has little to zero correlation with stocks or even other types of real estate,” says Webb. According to Ncreif, its 30-year correlation with conventional real estate is only 0.11. And farmland has a negative correlation with bonds, because its price rises with inflation, a characteristic that also makes it a useful hedge. In a report recently published by Callan Associates’ Howard, the firm concludes that “farmland should capture the attention of large institutional funds that are sensitive to inflation, seek to boost returns and want alternatives to fixed income.”

Several large pension plans were early pioneers. The Teachers Retirement System of the State of Illinois, in Springfield, has been investing in farmland for more than 20 years. As of June 30 the pension fund had $348 million allocated to farmland investments through Premier Partners III, a $387 million fund based in Champaign, Illinois. Returns last year were 39.88 percent.

The California Public Employees’ Retirement System uses farmland “primarily as a diversification vehicle,” says spokesman Brad Pacheco. Sacramento, California–based CalPERS has long been a buyer of conventional real estate, such as office, industrial and retail properties, but about four years ago went out to pasture, so to speak, to diversify its specialty real estate portfolio.

In 2002, CalPERS made a $72 million investment in Premier Pacific’s first fund, Premier Vineyard Partners, which is focused on properties in California and Oregon. In 2004, CalPERS invested an additional $40 million in Premier Pacific’s second fund, Meriwether Farms, which is composed of vineyards in California, Oregon and Washington. The California pension fund is committed to allocating up to $100 million to each of these offerings.

The strategy for both funds is straightforward. Premier Pacific purchases what is known in the industry as terroir, or land with strong potential for yielding grapes for fine wines, and sells the property to producers once the vines it has cultivated are mature. This investment thesis is based on the premise that premium terroir is in limited supply, while global demand for top-quality wine is growing stronger. It’s too early to gauge performance: Premier Pacific’s oldest property is only four years old. Although the firm’s first sale could happen by year’s end, co-CEO Wollack says it’s more likely to take place in 2007 or 2008, when the property achieves peak value.

Institutional investors typically invest in farmland through a third-party manager who purchases and administers the property, often renting it to a local farm operator. “It’s really no different from investing in commercial real estate,” explains Jeffrey Conrad, president of Hancock Agricultural Investment Group, the largest U.S. institutional manager specializing in agricultural real estate. Hancock and other managers typically work with investors to create a farmland portfolio based on a target asset allocation of property types.

Broadly speaking, there are two: row crops and permanent crops. Row crops, such as lettuce, corn or soybeans, typically pose less risk and offer lower returns — since they are essentially one-off bets, a farmer can start over each growing season. Permanent crops, such as apples, almonds and grapes for wine, pose greater risks and offer higher potential returns. Ncreif statistics from March 2006 show a three-year real return on permanent crops of 23.74 percent, compared with 14.46 percent for row crops. Nonetheless, the cyclical nature of the industry means that returns may vary substantially.

As with commercial real estate, the tenant bears most of the operating risks, which for farmers may include biblical-sounding scourges such as locusts, drought and hail. When it comes to permanent crops, though, large managers often take on the role of operator as well, bearing those risks themselves. Conrad points out that some hazards, such as pests, can be mitigated through crop diversification. What keeps him up at night are two issues over which he has no control: a potential climb in the value of the U.S. dollar and the possibility of a trade spat. That’s because Hancock’s sizable almond and pistachio crops are largely exported. “I would hate to see one of our commodity groups selected as a target in a trade war,” says Conrad.

Farmland investors are also at the mercy of potential imbalances in global supply and demand, such as a bumper crop or surges in imports. Hancock’s foray into citrus is a case in point. In the 1990s the firm invested several million dollars in lemon orchards in Arizona, only to see the U.S. market become flooded with Argentinean exports. “You have to ask yourself, ‘Are the problems cyclical, or is there a structural change?’” says Conrad. His firm decided that the U.S. market had fundamentally weakened, and sold off the venture.

Another uncertainty facing investors is the future of U.S. farm subsidies. These government programs support row crops like corn, soybeans, cotton and rice. Over time the subsidy payments have been reflected in land values, which could dip if they disappear. Still, managers of top-tier properties are sanguine. “If you remove the subsidy, some marginal farmland might go out of production,” says Conrad. “But our ag holdings will hardly go out of business.”

As with other types of nontraditional investments that are relatively illiquid, allocating to farmland can require a patient hand. For instance, Premier Pacific expects its vineyards to take five to seven years to sell or lease, and cash flows are negative for the first four years. Start-up costs can run higher than expected. Still, Wollack predicts that annual returns may ultimately surpass 20 percent. “We are really closer to a private equity play,” he says.

This much seems clear: If managers can consistently deliver such bountiful returns, more institutional investors will be happy to start betting on the farm.