If you ask people about inflation-proof investments, the answers are most likely energy, real estate, precious metals or nowadays maybe even cryptocurrencies or rare whisky bottles. What is less obvious and very underestimated is farmland. It has proven to be not only a very effective hedge against inflation, but also over the last 25 years outperformed the S&P500 while being less volatile. What about farmland stocks?
Summary and key takeaways from today’s Weekly
– Farmland has been a very good investment over the decades, even beating the S&P500 index (without dividends) over the last 25 years.
– Also, farmland was a big winner during the high-inflationary environment of the 1970s where a farmland investor could effectively double the money.
– Farmland stocks on the other hand are a chapter on their own. They are promoted with the farmland fundamentals, but the companies are highly leveraged.
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Already several times have I written about topics and investment opportunities on the subject of inflation as well as potential crisis investments. Especially in the current highly inflationary environment, a critically thinking investor needs to think outside the box in order not to become a victim of falling purchasing power and asset prices.
It is safe to say that holding cash-only and waiting for the crash that may never come while inflation eats away your purchasing power is not an option.
Prior to the inflationary shock that slowly set in when the inflation rate exceeded the FED’s 2% target without looking back starting in April 2021, many thought that stocks in general were a good bet against inflation.
They have proven wrong as it seems.
The majority of businesses are currently suffering from shortages of materials, products and labor, which naturally leads to higher operating costs. In most cases, these costs could not be passed immediately to consumers, who in turn began to cut back on spending and focus on the bare essentials.
A looming recession and job cuts in many sectors did the rest.
This leads us again to inflation-resistant investment opportunities.
Two weeks ago I published a Weekly about rising food protectionism (see here) which led me to write my latest research report for my Premium Members about an agricultural company with land masses in its books that already nearly covered the entire equity market cap. However, the main business was one about commodities.
Should you be interested in this particular as well as my other research reports, consider becoming a Premium Member by registering with a click here.
Today, we are going to look at two US companies owning and leasing agricultural land masses to farmers, i.e. pure.-play farmland real estate companies. Luckily for us, we don’t have to buy entire land masses, but can participate via stocks – if the companies pass my filter and turn out to be attractive.
Let the games begin.
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Land is a winner during inflationary times
Inflation always cripples businesses and hurts the weakest individuals of society. It can be seen as a hidden and unannounced special tax for those that can afford it the least, anyway.
Why so? Due to rising prices the coffers of governments are becoming fuller without official tax increases – at least in nominal terms.
The two main reasons for the burden on the latter are
- essential spending takes percentage-wise bigger parts of their budgets and
- the lack of investments in assets that appreciate with inflation
Income from labor is not rising in the same dimensions. Income from investments, however, could, if you place your investments properly.
The goal should be to at least break even and actually not lose any money. If you have a nominal performance of +/– 0% this year, you are already comparatively good. However, you would have suffered a real loss in this case, due to inflation devaluing your purchasing power.
If you achieve a real zero (returns in line with inflation) you are already among the best in times like these.
Not losing already feels like winning – this seems to be the current motto.
In prior articles, I have shown and explained to you that energy is THE big winner during times of inflation. Without energy, we simply could not go on as we do currently with our modern lifestyles (see here). Energy is the main building block and pre-requisite for most of our daily products.
At this point, I want to write some lines about another big winner during such times which is land. Land can be used for different purposes. The main use cases are farmland and construction.
We are looking at the former today.
To evaluate my statement, let’s have a look again at the 1970s period that is comparable (but not perfectly!) to the current situation. We have weak economies and high inflation now as we had back then.
Two charts to prove my point.
First, we see the consumer price index from 1970 until 1985. Look especially at the period from 1970–1980 where this index doubled. This means that overall consumer prices have doubled during this decade.
Or in other words: Purchasing power has halved.
This was no easy-going walk in the park for most people. It was a guarantee for becoming poorer in real terms without protective investments into appreciating assets!
And now, compare this to the price developments of farmland (or farm real estate as it is called). There are two lines. Blue is in nominal terms and orange is inflation-adjusted:
The more you go back in time, the higher the difference between these two lines, because inflation / devaluation becomes bigger if you look back more into the past. This means that currently farmland is as expensive as it has ever been for the last 50 years in real terms, not only nominally, measured in devalued money.
But back to history.
In nominal terms (blue) – measured by eye – farmland values have risen between 3–4 fold between 1970 and 1980. Taking inflation into this equation (orange), we see that farmland has not only kept its value on an adjusted basis, but even achieved a double in real terms during this period.
This means, with farmland you would have more than preserved (doubled) your purchasing power and taken it into the next decade.
But be warned, after 1980 farmland fell in price. It was after the severe recession of the early 1980s and after peak interest and inflation rates when a new economic boom started. On an inflation-adjusted basis, prices even nearly halved again. Thus, it is not an ever-ascending one-way play.
Quite the opposite if you invested – theoretically – in those times in the S&P500 index. It would have taken you twenty years (yes, 20!) to just break even on an inflation-adjusted and sustainable basis, with a one-time investment made in 1970:
Needless to say that you would have lost more than 50% on an inflation-adjusted basis from 1970–1980 while also suffering two dire bear markets.
Here is the chart of the S&P500 in nominal terms:
I had to shorten the timeframe a bit, because the first half would be too flat. You see that the drop in nominal terms wouldn’t have been as severe (it is an illusion). But remember that this was a high-inflation period. Don’t forget the purchasing power!
It is nice to be a millionaire, but not if you only can buy a cup of coffee for it – don’t overlook purchasing power!
After having seen this, I hope you will run for the hills if some inexperienced “investor” tells you he / she is “investing for the long-term, no matter what” or he / she “can sit out the losses and wait for a turn”.
I am not sure that those people will have the stomach to sit one or two decades on losses. You can be more clever, if you understand the basics behind history and some investment-101.
Barron’s recently also published an article with a plea in favor of farmland as an inflation-proof investment:
They say that in the 25-year period between 1996–2021 farmland has achieved an annual return of 11.2%. At the same time, the S&P500 has “only” grown by 9.6% p.a. (however, without includind dividends).
What sounds like peanuts (1.6% difference), makes a very big difference over many years.
A one-time investment of 1,000 USD over twenty years compounds to:
- 6,255 USD with an interest rate of 9.6%
- 8,357 USD with an interest rate of 11.2%
What a difference a few percentage points can make, when just 1.6% can be 33% more…
Add to that the fact that farmland is an uncorrelated asset class to the overall market and has no daily nervously fluctuating quotations and only half of the price volatility that the big index has. You see, why this is an attractive investment for some people.
Also, during times of ecominc recessions, farmland tends to be a robust and especially tangible asset investors have trust in:
Especially with more extreme weather conditions like heavy rain or droughts in certain areas, those unaffected places will become even more valuable.
But, remember that prices in this sector can fall, too, as we have seen above.
I am aware that this is a very simplified look at things. Farmland is not farmland. Cropland is more valuable than pastureland (see here). The value of farmland also depends on location (weather, transportation distances, etc.) and demand.
But that’s why I am on the look for a diversified and also more liquid bet, as I am not a farmland expert.
This leads us to a quick-check of two well-known “farmland stocks”.
Are farmland stocks still investable?
So far, we have only talked about farmland in general. With the information provided above, it should be a self-fulfilling prophecy to invest in farmland stocks, shouldn’t it?
Unfortunately, this is not so easy.
Listed farmland companies, respectively their equities, are fluctuating stocks like any other. Not only that, they are also businesses where management can do brilliant things the same as it can sink a business in an otherwise favorable industry.
This means we have to check each business individually and look at balance sheets and valuations.
The two stocks we are having a look at today are
- Gladstone Land (ISIN: US3765491010, Ticker: LAND)
- Farmland Partners (ISIN: US31154R1095, Ticker: FPI)
Both stocks are listed and have market capitalizations of between 700–750 mn. USD. Likewise, both CEOs are founders and have still respectable ownership stakes in their businesses.
Gladstone (see their investor presentation here)
Gladstone Land (don’t confuse it with the other Gladstone entities like Gladstone Capital or Gladstone Investment) was already founded in 1997 and is still led by its founder David Gladstone. It owns 169 farms with a total landmass of 115,000 acres or about 465 km2 in 15 US states.
To convert acres into square kilometers, divide it by roughly 250 (247.1 to be precise, see here).
Their business model is to buy farmland and lease it back to farmers that not only pay rent, but also all other costs like insurance, maintenance and taxes (so-called “triple-net”-rents).
According to their presentation, Gladstone focuses on high-quality land with above-average appreciation options. To achieve this, they buy farmland in good-weather locations where growing seasons tend to be longer. Plus, there has to be enough water-supply.
Broadly speaking, the business is a real estate business. They do not buy, sell or lease properties alone, but mainly farmland which in many cases also has buildings on it. However, the value of the land in comparison to the properties is way higher than in a usual city real estate business.
These businesses are operating with debt to part-finance their expansion. They take on debt to buy more assets and grow. Their operating cash flows – or big parts of it – are paid out in dividends to shareholders.
The stock of Gladstone is listed since 2013. It has so far generated a price return of 35% plus about 5 USD in total dividends (about another third contributing to total returns) over roughly a decade:
So far, so unspectacular, I would say.
The stock did what it was supposed to do. Paying reliable dividends while slowly appreciating. Between 2020–2022 suddenly, the stock rose massively and peaked in the first half of 2022.
The peak and subsequent strong drop coincide with the FED aggressively hiking interest rates. Gladstone is not the only company suffering massively since then. My attentive readers will already smell the rat I am pointing at: Debt and possible problems around the corner.
It is the same picture with highly leveraged companies. Due to rising interest rates, their refinancing becomes more expensive. The trouble will likely be bigger for those companies that are capital-intensive in nature.
Gladstone is such a company.
In the following chart, you see Gladstone’s market cap in light-blue and their enterprise value in black which includes its net-debt position. Over time, debt has risen massively, because it was cheap – no one can blame them to have used it:
As a company becoming public, Gladstone had barely any debt. With time, to finance their growth and using the ultra-low interest rate environment, management accumulated lots of debt to finance their expansion.
To put it into perspective, LAND has total net debt of 652 mn. USD currently. This is only slightly less than their current market cap of 720 mn. USD.
Cash flow from operations – i.e. before investments – has grown consistently over time, but only was 35 mn. USD, most recently. This is a leverage ratio of nearly 20x, assuming the whole operating cash flow – without any other use cases – would be used just for repayments of financial liablities.
A more common debt-metric used is net debt to EBITDA (remember, EBITDA as a rough cash flow approximation, however, without taking into account cost of debt). Here, we have absurdly high nearly 10x. Already half of it would be a heavy backpack to carry in this fast-rising interest rate environment.
The reasoning of management to use long-term leases to repay their long-term debt is fine, as the next chart from their presentation shows:
However, the problem is interest costs. The dramatically higher interest rates that are now on the table, could bring this calculation out of balance. Not the fact that we have higher interest rates is the issue, but the pace with which they have jumped. Every refinancing will become much more expensive, as there is no smooth transition to adapt to the new environment.
LAND’s average cost of debt (interest payments / net debt) are already now 4.3%. Will they be able to stomach 6% or even 8% as lenders require higher margins of safety?
Also their dividend, which they pay in twelve monthly installments, increases have been minuscule already since 2018:
This seems to be another case for me where management placed a bet on “zero-interest rates forever”. It was a hot gamble. Plus, the company has not proven that it is able to go through a whole business cycle as a public company. So far, it only surfed on the wave of low and declining interest rates.
The maturity test follows only now.
Part of financing was to use the issuance of new stocks. With lower share prices, the dilution will become higher. In just eight years, the total share count has gone up 5x. The effect is that operating cash flow per share has “only” doubled since being listed, while total operating cash flow has gone up 10x.
Don’t forget this dilution which weighs also on the stock price.
I know that such business have automatic leasing rates increases that are oriented on inflation data. This will increase revenues, but the cost basis increases also – operating and especially financing which is a main building block of the whole business.
Management also said in their latest earnings results press release and in the corresponding conference call that they are slowing down on acquisition speed to be more defensive on the capital side.
What sounds great and reasonable is forced due to harder market conditions.
To finish our check, a look at the valuation of the stock after the rather spectacular drop from 40 USD to under 20 USD in just a few months (remember, farmland being stable?). The dividend yield is low with only 2.7%. Enterprise Value to EBITDA still is high with nearly 20x. EV to operating cash flow only fell slightly under 40x.
The company reports a net asset value (NAV) of their business of 16.56 USD as per 30 September 2022. This is still a downside of around 15–20% from current levels.
Although, management is optimistic to not only sail comfortably through the current environment, but even to benefit from it, I am somewhat skeptical concerning the financing side.
So far, markets haven’t believed it either with the stock down this much from the highs.
No, thanks. I’ll pass on this one.
Farmland Parters (see their investor presentation here)
Farmland Partners, or in short FPI, is the biggest US farmland REIT by acreage. It has direct ownership of about 40% more farmland than Gladstone, in total 160,000 acres (Gladstone has 115,000 acres). Plus, further 30,000 acres owned by third parties are managed by FPI.
The company went public in 2014 and besides leasing farmland, they also provide financing opportunities to farmers for properties or equipment.
Similarly to Gladstone, FPI also has become more cautious with their acquisitions, because capital has become expensive very fast. In the most recent earnings call, management said that they focus mainly on the upper-value farmland which has risen even faster in price than average farmland.
Higher asset prices, together with tighter capital conditions, are akin to a strong step on the brakes while driving on the highway (or Autobahn in Germany).
Farmland Partners has in my view also high leverage ratios. Their net debt is around 400 mn. USD compared to the current equity value of 740 mn. USD – here the spread is higher compared to Gladstone which seems more conservative at first glance.
But, in comparison to operating earnings, the net debt to EBITDA ratio stands at 11x and more than 25x to operating cash flows. This is in both cases even higher and not a ratio where I feel comfortable with, personally.
You see on the following chart that debt has risen hand-in-hand with assets:
Average interest rates are 3.8%. You can expect them to rise further.
What is a sign of more aggressiveness is the nearly 25% of total debt being floating. That means, this part is ultra-sensitive to changes in interest rates and financing conditions.
We can make it rather short here. Farmland Partners will have – like Gladstone – to dramatically slow down their former aggressive acquisition strategy and focus on debt repayments. Even with rising revenues due to automatically escalating rents, the company will face higher costs of debt.
Plus, higher leasing income is lagging and more slow-moving, because it is usually adjusted on a yearly basis or with renewals of leasing contracts. Cost of debt, however, changes with one or two decisions of the FED committee.
They will have to refinance debts at higher costs which will likely eat away the higher income from rents.
FPI’s stock did comparatively better than Gladstone’s, as it is not far below its all-time highs and didn’t crash by 50%. This is also the reason why the debt is equity capitalization seems more favorable. The stock just did better.
Management could use the high stock prices to raise capital for debt repayments. But you already see it, dilution is on the horizon.
To conclude here, the debt situation together with a dividend yield of only 1.8% and high valuation metrics do not make it a screaming buy. It is difficult for me to see the positives outweighing the negatives. There is too much leverage, i.e. risk in this game.
Conclusion
Farmland has been a very good investment over the decades, even beating the S&P500 index (without dividends) over the last 25 years.
Also, farmland was a big winner during the high-inflationary environment of the 1970s where a farmland investor could effectively double the money – already taking nasty inflation into this equation.
However, farmland can also fall in price, as the subsequent early years of the 1980s have shown.
Farmland stocks on the other hand are a chapter on their own. They are promoted with the farmland fundamentals, but the companies are highly leveraged. Expect them not to perform in line with farmland over the next years, because they will face much higher refinancing costs. At the same time they will have to slow down their prior aggressive acquisition strategies.
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