Look Beyond Traditional Real Estate – How Farmland Can Complement Your Real Estate Portfolio

The U.S. real estate market is a mixed bag these days. While the residential sector confronts soaring housing prices and an affordability crisis, the commercial segment, particularly offices, stands at a crossroads—facing the pressures of rising interest rates and debt exceeding a trillion dollars.

Farmland, a once out-of-reach asset, now stands as a pillar for portfolio diversification and a solid complement to a well-rounded real estate portfolio, offering investors both capital preservation and historical stability in today’s uncertain environment.

Overview of the US Real Estate Market

Understanding the complexities of the U.S. real estate market demands a keen grasp of its multifaceted sectors and the current economic forces impacting residential and commercial spaces.

Performance of Residential & Commercial Real Estate

U.S. real estate market dynamics have shifted, with residential prices climbing and commercial spaces facing challenges. Let’s dissect:

• Residential Real Estate: The median existing-home sales price rose to $416,100 in Q2 2023 from $322,600 in Q2 2020. Inventory is also roughly 46% below the historical average
• Commercial Real Estate (CRE): The NCREIF Real Estate Index reported two consecutive negative quarters in 2023. Moreover, office values have dropped 31% since March 2022 as the schism between premium and secondary office spaces grows. Hybrid work patterns could further reduce office space demand by 15% from pre-pandemic standards.
• Retail: Although retail vacancy rates are below both the previous year's and pre-pandemic levels, some retailers have had to enhance their online presence and merge online and offline shopping experiences because of changing, post-Covid trends.

Impact of Interest Rates

The Federal Reserve's decision to hike interest rates 11 times between March 2022 and August 2023 has profoundly influenced the US real estate market. With the 30-year fixed mortgage rate touching 7.23% in August 2023, residential real estate faces a tug-of-war between demand and increasingly prohibitive costs. The challenges in the commercial sector are even greater, with landlords facing $1.2 trillion in debt deepened by falling property values and higher interest rates. Office spaces are most vulnerable, accounting for over half of the $626 billion at-risk debt due by 2025. There are growing fears of defaults with declining property values and higher refinancing rates. While retail shows strength, economic uncertainty in this sector remains high as well.

Real Estate Predictions: A Glimpse into the Next Decade

Leading experts from JPMorgan Chase, Deloitte, and Morgan Stanley recently weighed in on the US real estate market's trajectory. For the upcoming 2-5 years, they predict that multifamily, industrial, and neighborhood retail (small-scale shopping areas or centers that serve the daily needs of the local community) sectors will stand strong. In contrast, older B- and C-class office buildings with fewer amenities may struggle. Morgan Stanley identifies potential refinancing risks in US commercial real estate, warning of a possible 40% decline in office and retail property values if mass defaults arise. The industrial sector might see its annual demand growth rate slip to roughly 0.9% due to slower demand growth and rising capital costs.

As we look beyond a decade, the future of the real estate market might seem more uncertain, with several factors like high borrowing costs, sector disruptions, geopolitical concerns, and economic challenges potentially destabilizing the market long-term. With retail at a pivotal point and the fate of the office sector hanging in the balance, it remains uncertain how the real estate market will evolve.

Farmland: The Overlooked Real Estate Asset

Historically, the commercial and residential sectors have overshadowed U.S. farmland due to farmland's inaccessibility. However, what was once a domain exclusive to large institutions and ultra-high-net-worth individuals is now an increasingly accessible alternative investment strategy.

Amid economic uncertainties, the appeal of farmland has strengthened, offering historically stable, uncorrelated returns, capital appreciation, and a hedge against inflation. Notably, farmland has quietly outperformed many major indices and asset classes–including stocks, bonds, and traditional real estate–over the past three decades.

Market Size and Value

Spanning a remarkable breadth, the U.S. farmland market boasts over two million farms, covering an expansive 893 million acres. These farms, averaging 446 acres each, present a staggering real estate value of approximately $3.2 trillion.

Such a robust market didn't emerge overnight; Southeast AgNET notes a momentum surge over the last 25 years. The momentum was primarily fueled by technological advancements, increased global demand for agricultural products and alternative investments, and its superior performance. With rising interest from individual and institutional investors, the scene remains competitive. As Farmers National forecasts, demand will likely continue to intensify.

Spring 2023 saw the farmland market thrive, especially in the Farm Belt, where non-irrigated cropland values soared by 7%. In areas like Northern Indiana, the surge reached a staggering 23%. This growth was gradual; the momentum had been building since 1988 and accelerated in 2021 along with inflation. By 2022, U.S. farm real estate averaged $3,800 per acre, a 12.4% increase, while cropland's value rose 14.3% to $5,050 per acre.

Historical Benefits

Driven, in large part, by historically attractive land values, farmland has provided investors with many characteristics that can be attractive to investors:

• Historically Low Correlation with Other Assets: Between 1992-2022, farmland exhibited correlations to U.S. stocks at -0.05, U.S. bonds at -0.17, and U.S. REITs at -0.01. Such figures hint at a resilience independent of the standard market forces.
• Historical Resilience and Low Volatility: During the dotcom bust, the 2008 recession, and the 2018 economic slowdown, farmland returned 5.3%, 15.8%, and 6.7%, respectively, showcasing its stability even in adverse conditions. Moreover, in 2022, while traditional 60/40 portfolios faltered, farmland surged by 9.6%.
• Historically Competitive Risk-Adjusted Returns: Farmland's 1.22 Sharpe ratio and 6.64% standard deviation between 1992-2022 vastly outperform many comparable assets, indicating higher risk-adjusted returns.
• Historically Reliable Passive Income Opportunities: Through rentals, crop sales, and land appreciation, farmland offers a consistent passive income source. In 2022, irrigated and non-irrigated farmland rental rates reached $227 and $135 per acre, respectively.
• Historical Inflation Hedge:  Over three decades, farmland maintained a positive correlation of 0.17 with the Consumer Price Index, emphasizing its role in safeguarding investments against inflationary pressures.

Historical Constraints

Yet, despite farmland’s value as an asset, farmland investing has largely remained overshadowed by other investment avenues. Given that an astonishing 98% of farmland is family-owned, it led to limited on-market deals and reduced accessibility. These constraints, along with valuation challenges, discouraged many investors. Truly understanding this investment requires delving into a myriad of factors, from soil types and weather patterns to field sizes and cropping history, all while weighing potential rent returns from tenants.  

Furthermore, the U.S. real estate sector's lack of farmland specialists made finding expertise challenging, as major institutions, particularly pension funds, seized the few available opportunities.

Final Words

The world of real estate is vast and varied, and as we've explored, diversifying with farmland can offer unique advantages. It’s not about choosing one over the other but rather enriching your portfolio with an asset consistently showing resilience and growth. Amidst the dynamic currents of U.S. real estate, farmland investing has remained a stable addition to any well-rounded portfolio. From 1992 to 2022, farmland provided an average annual return of 10.71%. This robust historical performance, accentuated by the NCREIF Farmland Property Index's tripling since 2000, underscores the primary appeal of capital preservation. While its ascent to recent record price levels attests to its high returns, the potential for inflation hedging further complements the primary advantage of stability.

By incorporating farmland alongside residential and commercial real estate, investors can benefit from a broader spectrum of opportunities, helping to maximize the potential for stability and profit.