The answer lies in the soil
As the world wakes up to the scarcity of land and turns its attention to food production needs, perhaps agricultural land makes serious investment sense. David White reports.
For pension funds wary of traditional real estate investment, Mark Twain's advice to "buy land, they don't make it any more" might be modified to "buy farmland, they're not making enough of it".
One of the main reasons why institutional investors should consider investing in agricultural commodities is the shortage of land, says Stephan Wrobel, chief executive of Diapason Commodities Management.
Diapason is a commodity asset management firm based in Lausanne which claims to have the largest allocation to agriculture of any fund manager globally.
Wrobel points out that most quality farmland is already in production, and that 30% will be unusable by 2020, largely as a result of the use of chemical fertilisers to improve yields.
The other reason for the scarcity of farmland is the growth of towns and cities and the accompanying increase in living standards, he says. "This year, for the first time in history, the world will have more urban than rural residents."
The process of urbanisation will continue. Between 2000 and 2030 the world's population is predicted to grow at an average annual rate of 1.8% to reach 4bn in 2017. "Almost all this growth will be absorbed in the urban areas of less developed regions," he says.
Meanwhile farmers have been leaving the land, or switching to the more profitable production of bio-fuels. As a result, the inventories of agricultural producers in the US, which act as a buffer to protect against price volatility as the supply and demand fluctuates, are at historically low levels. This will increase the pricing power of farmers, says Wrobel.
"Until now there's been massive under-investment in agriculture. But every 20 to 25 years farmers must be given pricing power to replace fixed assets and attract new workers into the industry
"These periods of higher prices tend to be sustained over a decade to complete this process." This point in the agricultural business cycle represents an investment opportunity for pension funds, he suggests.
If the time is right to invest in agricultural commodities, it may also be time to invest directly in agricultural farmland. Primary Investment Management, a new firm based in the Hague, focuses on agricultural real estate as an asset class. It is currently fundraising for Ceres 1 a global agricultural real estate fund with a target size of €500m.
Stefan Baecke, a founding partner of Primary, says the fund is based on the simple principle of a shortage of good quality farmland. "There's only so much land available. So if the world population is growing they will not only need more food in the future, they will need more space, and the wealthier they get the more space and food they will need.
"What you tend to see is that cities are traditionally built in locations where there is good quality land. So the first land that is being sacrificed to growing cities is good agricultural land."
The growing interest in bio industry and bio energy is also leading to a diversification in the use of farmland, he says. "The agricultural sector is developing from a traditional food-processing sector to a dynamic, bio-based economy.
"There's a lot of attention being given to bio fuels, but I think it's probably passed its peak. It's not really an efficient way of using natural resources because it's using quality products like grain and maize that would otherwise be food for humans or animals.
"Most of the research investments are now going towards second or third generation developments within the bio-fuel sector, where energy is obtained from waste products. There is also the ‘cradle to cradle' concept where products are put back into the production chain or put into the ground as fertiliser."
The rise of the bio industry, and its competition for farmland, is an opportunity rather than a threat, Baecke suggests. "While the space available for farming is reduced, there is also a rising demand for natural products. Almost everything that is now made from oil products, maybe can or will be replaced by natural products in the future.
"This is a long term trend, along with population growth, not some hype that will last only one or two years. This makes agricultural real estate a very promising sector and it aligns nicely with long term and sustainable produces that pension funds are also looking for.
Baecke says the fund will sit in either the real estate portfolio or an alternatives portfolio of a pension fund. "Some Dutch pension funds have set up a ‘portfolio of ideas' which gives them the flexibility to invest in new products and those funds are considering this fund for that part of their portfolio. Other funds may use it to diversify the risk in their real estate portfolio."
The Ceres I fund has been designed as a core fund, so risk is spread over different continents and regions, as well as both hemispheres to take advantage of different harvest periods.
It will invest mainly in developed countries that operate farming subsidies, says Baecke. Food and now energy from food are strategic assets to countries and therefore there will always be some sort of protection of the sector. "For our portfolio this means that there will be less downside because the subsidy is always there. There is also probably less upside, which is why we are adding a bit of risk by buying farmland in the more free market farming economies."
The scale of transactions will be large enough to make it worth the fund's while. "The minimum size of transaction is 200 hectares or €2m per transaction - otherwise operationally it will be a nightmare to manage."
The target regional allocations of the fund are Europe and Middle East (45%), North America and Canada (30%), South America (15%), Africa (5%) and Australia and New Zealand (5%). Investment is focused on 10 main agricultural countries in these regions - France, Germany, Romania, and Poland; the US and Canada; Brazil and Argentina; South Africa and Australia.
The fund's selection of suitable farmland is carried out at two levels - global and local. Primary IM uses a Dutch engineering firm to check out each potential acquisition to ensure that it is buying the right land. "They will look at the actual land and make a risk analysis of the micro-environment round that land. They will tell us, for example, whether there is a risk of flooding, or whether a river providing water to the land is likely to dry up in the next 10 years."
At a local level, Primary has built networks of local partnerships that alert the fund to acquisition possibilities and establishes channels of communication with local and regional planning authorities.
"Because land is of strategic importance to countries, we always try to talk to central or local government to explain our intentions," says Baecke. "We want to explain that we are not buying land to speculate on development changes. Our focus is on agricultural land and the exploitation of this land by local farmers and try to optimise this as much as possible.
"One of our big advantages is we have a pure agricultural focus, so our local partners know that we want to invest in agriculture and not try to speculate on any future trends. It's one of the key factors to be successful in this segment because, if you are perceived as someone who is seen to be trying to make a fast buck, you will probably end up buying the wrong land at the wrong price.
"The whole concept is based on supporting the primary sector to make money for the farmer and the investor because, in the long run, that will make the most money for both parties. We'll make sure that the noses are pointing in the same direction."
The target life of the fund is ideally 30 years. "This fund does not make sense to invest in if you have a horizon of only five years, because you will only incur costs and not the benefits of the underlying returns because it takes a while to build a good portfolio," says Baecke.
"In the short term, this fund gives investors indexed direct returns from a yearly yield that we will pay to them out of the leases that we have with the farmers - 2.5% in the medium term scenario, with the goal to index link to inflation.
"In the long term, the fund gives them exposure to an asset class that has great upside potential. For example, there has been an acceleration in agricultural land prices in the US over the last three years.
"There's still a lot of catching up to do with classical real estate - bricks and mortar - but I wouldn't want to see a big spike in the coming years. I'm expecting a nice gradual increase in the value of land that gives investors a stable rather than volatile returns," he says.