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Commercial Real Estate vs. Farmland

December 27, 2023 - Jonathan Shively

After reading yet another negative headline on the $20 trillion commercial real estate (CRE) market, I was reminded of the investment characteristic I once assumed the CRE market shared with the $4 trillion farmland market. Although I may be relatively new to Peoples Company, I am not new to investments. After working in the institutional equity market for longer than I care to admit, I jumped into both Agriculture and CRE investments taking advantage of the 2008 financial crisis. The commonality in my approach was I knew very little about either, yet I recognized the value and had developed fatigue with the financial markets. Those who remember Kevin Spacey’s character in the movie Margin Call know his poignant response to his greedy CEO’s taunt “You could’ve been digging ditches all these years.” Spacey replies, “At least I’d have holes in the ground to show for it.”

Steady income potential, long-term appreciation, inflationary hedge characteristics, increased portfolio diversification, and low correlations to traditional fixed income and equities are all tantalizing to the financial market crowd. What drew me in was being able to show my children the tangible assets their father was developing in their hometown as each new building went up, or to take them to the farm to appreciate the land and witness its productivity, just as I do. The nuances I failed to realize as a neophyte diversified investor are some of the major aspects I see now playing out on a national scale.

While all types of CRE will have vacancy risk, this decade is providing an even more dramatic secular shift in the office building segment. Employees embraced remote and flexible working models post-pandemic, but broadband set the groundwork for a more connected workforce long ago. It was only a matter of time before vacancies accelerated, especially in technology-centric cities. Following this rise in vacancies and forthcoming data points about the approaching wave of refinances, it is inevitable office properties will struggle to generate enough income to support new loans which will lead to additional required capital.

Not to say that it is all doom and gloom on the horizon. The multi-family and industrial sectors both currently enjoy low vacancy rates due to demographic and consumer trends. A lack of affordable housing and overnight goods made both apartment and warehouse developments the current darling of CRE. Even when demand remains relatively healthy, the cost to retenant a building can be considerable. Expenses related to tenant improvements, advertising, leasing commissions, tenant incentives, and the lost income during the vacant period all contribute to reducing the overall profitability of the investment.

Productive farmland has virtually zero vacancies. It has long been known that continued urbanization contributes to the scarcity of arable land. This decrease in the accessibility of fertile land adds to the ongoing demand, ensuring that viable farmland is consistently utilized rather than left vacant. As the availability of land decreases each year, production demand continues to increase with the growing global population and rising consumption of more resource-intensive foods.

CRE inherently has many more variable operating expenses such as rising upkeep, maintenance, and labor expenditures, but one drastic change we have seen recently is in insurance coverage. What was once taken for granted as a given has become a major pain point for investors and lenders as they are finding it harder to purchase sufficient coverage at acceptable terms. Insurance companies are passing along their larger-than-expected property coverage losses in the form of higher premiums. As costs rise faster than rent increases and inflation, lower net operating income can lead to reduced property values. To negate some of the premium increases, more policies are being written with higher deductibles, reduced coverage, and additional exclusions, ultimately shifting more risk to the property owner. The inability to secure reasonable coverage is making more deals unattractive due to the increased risk and lower return, resulting in deals falling through as the financial returns are no longer attractive.

Not only does U.S. farmland have significantly less risk, but it is also the only asset that has a minimum annual revenue guarantee, adding significant stability compared to other investment-grade asset classes. The Federal Crop Insurance Program (FCIP) provides a minimum annual revenue guarantee reducing risks on over 90% of all corn, soybean, and cotton acres ranging from adverse growing conditions to commodity market exposure. Insurance premiums are subsidized to encourage broader participation providing a backstop that helps ensure lease payments are made.

CRE is a higher levered market that has benefited from decades of low-interest rates and an increasing reliance on floating-rate debt. Currently facing pressure from the aggressive tightening of interest rates by the U.S. Federal Reserve, leading to the swiftest increase in interest rates in over four decades, it is projected that more than $1.4 trillion in US commercial real estate loans will mature by the end of 2024. This scenario unfolds as traditional lenders, including banks, are actively reducing their exposure to these loans. Tightening credit conditions, loan reset risk and concerns over whether borrowers will be able to refinance upcoming loan maturities are putting downward pressure on asset valuations requiring additional capital to refinance.

Conversely, U.S. farmland carries less than 14% leverage, lessening the impact of the Federal Reserve's current interest rate hike campaign. Farmland ownership requires relatively low operating expenses and minimal capital expenditures resulting in limited additional investment compared to other asset classes. Improvements like adding tillable acreage, leveling/tiling, or optimizing irrigation all increase the value of the land. Decoupling land from production benefits the landowner through cash rent agreements that limit price, cost, and production risk.

Commercial real estate valuations persist at elevated levels, despite contemporary buyers acquiring the same properties for reduced amounts. This discrepancy between valuation and actual transaction prices is motivated by lenders, landlords, and insurance companies hesitating to acknowledge that the properties no longer hold their previous values. This reluctance stems from a desire to avert the necessity of reducing the recorded values, a move that could significantly disrupt their business operations.

Farmland experiences tangible appreciation, closely tied to ongoing progress in farming practices and the continuous enhancement of yields through improvements. These advancements translate into an increase in the productivity and sustainability of farmland, which in turn, positively influences the economic value of the land. Investors in farmland, recognizing the real and measurable improvements in productivity, can reasonably expect a corresponding appreciation in the value of their agricultural holdings.

Historically, farmland earnings have resembled those of an assembly line, determined by the production quantity and the associated production costs. The future is full of external non-core income drivers that will increase the on-farm revenue potential and widen the entire agricultural economic footprint. Renewable energy, carbon sequestration, and biofuels are exciting prospects for the multi-generational landowner to add additional income streams not yet factored into land prices.

In summary, a diversified portfolio benefits from including both commercial real estate and farmland assets. While farmland investments may yield lower returns in the short term due to the decreased risk we've outlined, over an extended period, farmland has consistently outperformed other asset classes in terms of overall returns. With less than 2% transacting a year, the focus should remain less on the entry price, and more on gaining access to good, productive ground.