Real estate values have been in sharp focus over the last two years, as inflation has caused many central banks to adopt a restrictive monetary stance, leading to rapid increases in the cost of debt across all sectors. This has started to impact property values in Canada, although probably not yet to the degree expected, as value adjustments depend on a number of factors, including the lag in time it takes for in place financing to mature and be replaced. Nonetheless, we are seeing the expected effect of higher interest rates on property markets, with prices for assets such as unimproved development land starting to soften, and with lenders requiring equity injections on some refinancings, and overall higher levels of equity in new financings.
It would be natural to expect farmland to be affected as well, and while it is clear that farmers are facing similar challenges to real estate investors when attempting to refinance farm property or arrange new debt for farmland acquisition, agricultural property does not exhibit the same characteristics as other classes of real estate. Non-farmland real estate is generally correlated to the broader economy, with interest rates, job growth, disposable income and other factors all playing a role in the direction of rents and values. Farmland, on the other hand, is less correlated to both the broader economy and the other main drivers that affect real estate values. The biggest factor impacting the value of farmland is food commodity prices, which are driven by macro global factors more so than particular domestic economic circumstances.
In the medium and long term, farmland demonstrates a high degree of predictability, low downside volatility, and excellent inflation and diversification hedging characteristics. We analyzed data in Canada comparing farmland to residential real estate (for which a long data record exists) and the S&P TSX Composite Index. Looking at data back to 1970, we found that over the past ~50 years, farmland had the highest rate of value appreciation, the lowest percentage of years in which value declined, the lowest downside value deviation, and the lowest correlation with interest rates.
We further compared farmland to commercial real estate and the S&P 500 in the US, going all the way back to 1955 and observed similar patterns. We don’t show US residential real estate data in this analysis, but its performance roughly mirrors that of Canada, albeit with a higher degree of downside volatility.
Canadian Farmland, Residential Real Estate and Bank of Canada Policy Rate
US Farmland, Commercial Real Estate and Federal Funds Rate
Understanding Why Farm Values Declined
It is noticeable that farmland values declined in both Canada and the US during roughly the same period (early to middle 1980s). It is important to note that in the data set analyzed, this is the only period of time in which farm values declined for more than 1 year. The decline in values was caused by a broad failure of the agricultural banking system in both countries, in roughly the same timeframe, slightly compounded by a cyclical decline in agricultural commodity prices, which, on its own, may not have had much effect on farm values. Farming goes through commodity price shifts all the time, but these rarely last more than one to two years, and the evidence would suggest that these price cycles alone do not cause farmland to decrease in value, perhaps merely muting its upward growth.
Dating back to the 1970s, most farms in North America were financed by small savings and loan companies in the US and small rural banks and trust companies in Canada. Rampant inflation in the 1970s and the resultant higher interest rates led to quickly rising cost of capital in the financial system and duration related losses on the long-term loan books of these institutions. This began a process of liquidity problems in these small institutions, which came to a head in the mid-1980s.
As these small lenders began closing their doors, and as the remaining lenders were focused on the health of their own loan books, financing for farms started to dry up. A corresponding period of low commodity prices starting in 1984 and lasting until 1987 made farm financing appear risky, which exacerbated the contraction of credit across the industry. Logically, as land values declined, the cycle worsened. The situation began stabilizing with rising commodity prices in 1987 due to reduced global production that year, and since the early 1990s, farmland values have consistently risen on an aggregate basis.
Conclusion
Farmland value cycles are definitively different from other real estate classes for several reasons. High interest rates, which negatively affect residential and commercial real estate values, generally occur in times of high inflation, and farmland tends to perform relatively well in inflationary environments, because consumers rarely, if ever, significantly cut their food budgets. Also, agricultural commodities are priced in a global market, which means low correlation to domestic economic mishaps. The long-term nature of farmland, which is not subject to physical depreciation nor to technological obsolescence also reduces short-term market volatility.
At Glengarry, we have strong conviction in the value of farmland as collateral for our loans. We see its relatively low volatility as having excellent defensive characteristics in challenging economic environments, and while we do not expect that it will always enjoy the sort of value appreciation that we have seen in the last few years, we do believe that over the medium and long term, farmland will continue to appreciate. If we are sensible in the way we underwrite other aspects of the credit risk in our portfolio, we believe that we can count on the stability of farm values to help us produce excellent risk adjusted returns on our lending book.