TelferYoung Limited
Rural Land Investment
2 September 2008
The good news in property markets is coming from the rural land sector, particularly where dairying is an appropriate use.
Introduction
It has often been said that "land is the basis of all wealth" and there is no doubt that the future of New Zealand is highly dependent upon the export receipts that flow from our agricultural, horticultural and forestry enterprises. One of the major economic lessons learnt from the early days of "Rogernomics" was that if the land based export sector is strangled by a combination of an over valued dollar, high interest rates and an inflating internal cost structure, then the rest of the community eventually suffers. It was no coincidence that the rural sectors restructuring problems in the mid 1980s were followed by the 1987 sharemarket crash and a subsequent slump in commercial property values as the NZ economy hit the wall.
Discussions about property investment in New Zealand tend to be focussed on residential property on the one hand and commercial or industrial on the other. At this point in time, the third quarter of 2008, these markets are going through some realignment ending a strong upwards surge that began early in the new millennium. Residential markets in most locations are currently showing the sharpest reduction in value. Commercial investments, although suffering some weakening in yields, are not expected to reduce in value to the same extent unless the country's economic fundamentals deteriorate markedly over the next six to twelve months.
Commodity Markets
Despite ongoing efforts to add value to our exports before these are shipped overseas, New Zealand remains heavily dependent upon world commodity markets. As a food producing nation, with a significant percentage of exports being milk products, beef, lamb and fruit, the New Zealand economy has struggled to compete with other western or industrialised nations and we have gradually lost ground in relation to Australia and other developed economies in the standard of living stakes. Increased agricultural efficiency world wide, with over production aided and abetted by a policy of subsidising farmers in the EC, Japan and USA, resulted in farmers in this country receiving less and less in relative terms as they produced more and more. Trade barriers also hampered access to lucrative markets.
That situation has now changed dramatically and for the first time in decades the production of food is being rewarded with higher world prices. Climate change, the energy crisis, and a move towards biofuels production plus the rapidly increasing affluence of Asian economies, lie behind this turnaround. The biofuels policies pursued by the likes of USA and Brazil mean that less and less land is available either for direct food production or to support livestock enterprises producing milk and beef. With demand increasing sharply as China modernises, there has been a classic supply/demand imbalance. The result is that food prices have moved to a new higher level and this would appear to be a permanent readjustment when compared with the previous three decades. As any Fonterra supplier will attest to, it is a good time to be a farmer or to be involved in rural land investment although some sections of the rural economy are still struggling, especially traditional hill country. The forestry sector has also been suffering and uncertainty over the emissions trading scheme has created a planting hiatus.
Characteristics of Rural Land
Rural land is diverse as to highest and best use, parcel size, location, and productivity. There are varying degrees of economic status from multi million dollar turnovers to low revenue part time operations where lifestyle elements assume high importance to those involved. Corporate farming or ownership by investment vehicles has not been the norm in New Zealand. Traditionally, most rural land purchases have involved families that actively farm the land owned. Exceptions include the New Zealand Rural Property Trust which owns farm properties throughout New Zealand. Some are operated directly by managers or sharemilkers, with most being leased out to experienced farmers, providing a secure passive income stream to the Trust. Traditionally the farming sector has been dominated by purchases for personal occupation and non-monetary factors often play a large part in the investment decisions. That is, the so-called "family farm" will often have personal and business motivations intertwined.
A more recent phenomenon has been the upsurge in equity partnerships. These were initially made up of largely farming families and close associates pooling their resources to purchase farm properties that were otherwise priced beyond their means. The boom in dairying and capital growth opportunities from escalating land values has now seen the rise of professional syndication pioneered initially by AgInvest. This company has put together a number of large syndications over the past 12 or 18 months under the MyFarm brand including a $32.5 million proposition in the King Country to graze dairy replacement stock. The investors here are in the main large scale dairy farmers in their own right, utilising their shareholding to support their own farms as "dairying platforms". This is a rational response to the current profitability of milk production. It is these profits that are now belatedly attracting some interest from the wider investment community in New Zealand as the shine comes off commercial property and the financial investment sector staggers from crisis to crisis.
Such interest is, not unexpectedly, confined largely to the dairy industry or in properties closely associated with that use. Traditional beef, sheep and wool operations will require a much reduced New Zealand dollar for these returns to be attractive. However, certain "trophy type" properties in this dry stock category will continue to be sought after by high net worth individuals or families particularly if situated close to a main centre, ski fields or the coastline and therefore suitable for periodic use as a "weekend retreat".
Economic Factors
Investors in the commercial property sector look carefully at the return being generated and yields or cap rates are likely to determine the value of the property. The rental flow establishes a market return that is quite separate from the commercial investors own circumstances. Those contemplating investing in rural land need to recognise major differences in the urban and rural markets. The largest influence in the rural market is purchasers who will carry on a farming business themselves or via sharemilking arrangements rather than receive a revenue stream by leasing to a third party. As mentioned previously, an owner operator farmer also pays much more attention to the personal occupation aspect and other non-monetary factors. The ability to live in the countryside and the way of life generally can be significant motivations for many. A hard headed investor ignoring the emotional and non-monetary factors is therefore competing with the farming community who do put weighting on non-commercial aspects. Many farming entities consistently buy on "affordable" rather than "investment" criteria. This partially explains the tendency for farmers to bid up the price of land and stock in response to anticipated better returns, often before such returns actually materialise. It is also a fact of life that farmers have very little control of costs outside the farm gate, while many costs on the farm are also subject to price escalation that is difficult to avoid. As certainly as night follows day, the cost structure for intensive dairying has risen along with the recently improved revenues. Modern farming systems also result in a much higher proportion of operating costs being fixed rather than variable. There is no doubt that the immediate prospects for dairying are positive, but revenue volatility is a fact of life. This can be caused by production variations (climate, disease, management) and product price fluctuations (international markets, trade barriers, exchange rates).
Rates of Return
Leaving aside expectation of capital growth, a rational response to the uncertainties outlined would be a rate of return on assets employed that at least equated the level available from a sound commercial property investment or a safe financial instrument. In reality, the value of farm land rises rapidly in buoyant times, being a function of fixed supply against increased demand. The current competition for dairying land has bid annual return rates down to below 3% in many cases. That is, the higher net incomes being earned from dairy farming are from an asset base with much greater value than was the case a year ago. With bank borrowing rates being about three times the level of operating return rates, the economic rationale of rural investors obviously extends further than mere income related returns. The answer lies in an overview of rural land value increases over the past few decades. Although there have been periods of falling values, the average increment in the long run has outperformed the urban property sector and the sharemarket. When these gains are factored into the investment decision the meagre returns on an annual net income basis increase to an overall return that approximates 10% per annum. Most of this is of course tax free capital gain and explains why many in the farming community view their farm as a superior form of superannuation funding.
The Two Business Philosophy
In essence, taking a typical owner operated dairy farm as an example, the proprietors are really involved in two separate businesses. The first is a dairy farming business where they own the stock and plant and utilise their land to generate sufficient net cash income to operate the business, service debt, and meet their own personal requirements including taxation. A 50/50 sharemilker operates exactly this type of business, the land owner receiving half of the dairy cheque in return for the use of the land. Secondly, in this typical owner operator example, the proprietors have a property owning business that under personal occupation develops no annual cash return and requires the farming operation to be of sufficient viability to meet capital holding costs. The land in fact becomes akin to a superannuation scheme and if purchased in say 2000 and then sold ten years later, the typical gain in value is more than sufficient to attract investor interest when annualised.
It is this reality that has underpinned the success of syndicated offerings in the dairying sector, managed by the likes of AgInvest or Farm Right, while the large numbers of equity partnerships that have been formed are, in general, also pursuing this investment model.
Future Trends
Whereas the catch word in rural investment used to be diversification, there is now no doubt astute investors need to identify the highest and best use of the land being considered for purchase and then concentrate on that core activity. The uniquely New Zealand system of sharemilking provides dairying with experienced and motivated persons capable of running large scale dairy units for non-resident investors, supported by the consultancy profession and a highly developed dairying infrastructure. Outside of dairy farming the managerial requirements can be more difficult to source and an investor should ensure that this aspect receives as much attention as does the land investment. The purchase of rural land for passive leasing to a tenant farmer is a further option but not one usually favoured unless there are personal reasons for that particular purchase. The Rural Property Trust provides an avenue for this category of investment, via the purchase of units, without the need to invest in farm land directly.
Despite the strengths of the sharemilking system, the availability of good farm labour is certain to remain a future issue for dairying. Property owners will need to invest in improved milking and infrastructural facilities as well as better housing than has been the case in the past. Resource management restrictions are also likely to impact adversely on the profitability of the dairy industry in the immediate future. Finally, while uncertainties remain around the Government's climate control policies, these may eventually result in an outcome that sees dairying carrying a large part of the Kyoto Protocol costs.
Conclusion
In conclusion, rural land investment is available in many different property categories but a ‘hands off' investor would be wise to tap into the strength and resilience of the dairy industry in New Zealand rather than take on additional risks inherent in the sheep and beef sector or in forestry. Providing the investor recognises that a buy/sell time span of ten years may be appropriate, and that equity levels should not fall below 60%-66%, then it is a matter of finding the appropriate property or investment vehicle. When weighing up the purchase of a dairy farm, the potential rural investor should seek answers to the following questions:
- What is the productivity of the property under normal management and how will any potential be achieved?
- What are the contingent capital costs within a three to five year period and what are the prospects for capital growth?
- Based on a longer term view of milk-solids returns and operating costs, what cash rate of return does the proposed purchase provide on assets employed?
- What is the debt servicing capability under the proposed ownership and/or management structure?
Having addressed these matters, independent valuation is essential prior to committing to a purchase.
Based on three and a half decades of experience with investment in rural land, the best advice that I can give is to obtain some advice. In other words "look before you leap". Rural investment is a complex field but if your personal and investment criteria are met then the purchase of a farm property or a share in an equity partnership can be both stimulating and rewarding. Businesses come and go but the land endures.
J P Larmer
This monthly paper reflects the views of the writer and may not represent the views of all TelferYoung staff.