May 1, 2019
Farmland Investing Series
This is the first in a series of posts dedicated to finding a liquid, investable farmland vehicle. We will not limit search to the U.S. but will include the entire globe. Since we want some liquidity, this limits the options to listed entities and some private funds. This post looks towards Eastern Europe which has an abundant amount of underdeveloped "black earth" farmland.
An Emerging Market Farmland Investment
The United States is fortunate to have an abundance of fertile farmland, but there are of course other locations around the world. One region of the world with very fertile land but not expensive is Eastern Europe near the Black Sea. This region was nicknamed the breadbasket of Europe early last century because of its tremendous grain production. Now that Communism has receded into European history, activity is returning again to its eastern agriculture regions.
The land around the Black Sea stretching from Bulgaria northward through Romania, Ukraine, Russia and then further eastward into Kazakhstan is some of the richest in the world. The dark red and brown colors on the soil map below indicate where "black earth" is located. In preview, this blog post will explain the pros and cons of a pure farmland REIT that operates in the area circled below which is in Bulgaria.
The Company
The name of the farmland REIT is Advance Terrafund. They focus specifically on farmland in Bulgaria. The real estate trust package is structured in much the same way as REIT’s are in the U.S., in that nearly all the net income must be paid out annually as dividends to avoid taxes. Advance Terrafund, as of August 2018, owned 223,923 decares (55,332 acres) of farmland throughout Bulgaria. Income is generated by renting the farmland to local farmers and capital gains are occasionally realized by selling parcels that have appreciated in value. They do not operate farms or any other businesses. It is a simple, buy and lease operation.
The map below was taken from their website showing as of Q2, 2018, showing the areas of Bulgaria where the fund owns farmland and how much of the portfolio is dedicated to each.
Bulgaria
This country is not going to be familiar to most investors (unless you listened to my farmland fund pitch a few years ago). I have some expertise after spending the last decade or so managing direct investments in the region in both real estate and farmland. Even though Bulgaria is part of the European Union (they were the last admitted in 2007), I would still very much consider it an emerging market with all the associated risks and opportunities that go along with that. That being said, the country does have a tremendous amount of potential. The population is well-educated, there are plenty of underutilized natural resources, and most people have an honest desire to be part of a fully modern, developed European country. The main issue holding them back is entrenched corruption. I have seen the place close up since 2001. I would have expected by now the Communist officials who carried-over as leaders would have faded away. Unfortunately, the children of the old generation have somehow been able to retain power and rather than bringing the country forward, they prefer to operate in the corrupt ways of their parents. This is one reasons why Bulgaria and its immediate neighbors for that matter, have have taken so long to emerge from the financial crisis a decade ago.
Nevertheless, it is all not negative, there has been a lot of progress. The last ten years have seen substantial improvements. Roads and infrastructure are much better. Tax collection has improved. An influx of Greek money and businesses has been a positive (Bulgaria had none of the excessive debt issues that inflicted the Mediterranean EU countries). Membership to the European Union has been a positive and big force for change. For that reason, the Bulgarian people generally view the E.U. very positively. After a long history of shifting political alliances, they are also very practical; so they are comfortable balancing relations with Russia and the rest of Europe. Bulgaria is still the poorest country in the E.U., but growth has been picking up in the last couple of years. Anyway, emerging markets never look all rosy, one needs to see through the fog and balance the risks with the chance for rewards. There is a lot to consider with an investment in a Bulgarian company or real estate, but farmland is a bit more straightforward.
Business Strategy
Advance Terrafund pursues a basic business strategy, they purchase and hold a portfolio of farmland and lease it to local farmers. In Eastern Europe, one of the quirks that resulted after the collective ownership of property was dismantled was the breakup of large farmland fields into a patchwork of small, privately owned plots that were returned to the many descendants of the pre-Communist farming families. This created extreme fragmentation of ownership and has greatly slowed modernization and productivity. It also created a sort of arbitrage opportunity. Big plots are naturally worth more than small ones, so doing the work to merge small ones into big ones can be profitable. As one would imagine, this is an arduous task and takes time, but Advance Terrafund has been able to pursue this task successfully. Both small and large plot prices have steadily marched higher in price every year since democracy was reinstated in 1991. Most of the company’s portfolio of land was originally purchased in the early years of the company's history leaving it with a substantial unrealized gain on the books.
Advanced Terra REIT began its operation in 2001. They focused most of their early land buying near the Black Sea where the very best soil is located. Prices appreciated there faster than other parts of the country, so the company's management has shifted its focus to different regions of the country offering more value. This meant selling higher priced land near the sea and using the proceeds to purchase cheaper land elsewhere. Considering the recent pattern of development and price trends, this is a sound strategy.
Company Overview
The company's management personnel appear to have good reputations and are dedicated to their job in overseeing the company’s operations (which is an important consideration in a country where most people doing financially well are assumed to be corrupt). The founders have maintained ownership of about 18% of the shares outstanding since the early years of the company’s existence. They have kept the expenses of the company modest and the financial statements do not appear to be hiding any surprises. The prices of the past land transactions and the valuations used on the statements also look to be in line with market prices. There is always a chance that inflated transaction prices and self-dealing could have happened in the past, but I found no evidence of that.
Advanced Terra REIT is listed on the Bulgarian Stock Exchange. It trades only about 30,000 shares a day, even so, the company is one of the more active stocks in field of 160 listed stocks and bonds.
Earnings per share have been volatile, here are the last 5 years numbers:
They have maintained a regular dividend, here are the per share numbers:
Overall, the company has been regularly profitable and returning money to shareholders. They do not have any significant debt and therefore no interest expense. There are a few peculiarities beneath these numbers though. One thing that caught my attention was the relative size of the management fees. The founders and still managers of Advance Terrafund charge a percentage of land portfolio’s cost basis each year for their time in addition to their annual salaries as directors. They also take a cut of any profitable land sales above a certain threshold. Adding all these income streams together, it about matches the total cash flow generated from renting the farmland each year. In recent years, the total management fees and cash flow have both averaged about 3.6% of the total asset value.
With all the cash flow going to management, the question arises as to how the firm can still show a net profit and pay a dividend each year. From what I can see, they do this by selling off a little bit of the land portfolio each year. Because most of the farmland was purchased at much lower prices, each sale realizes a substantial profit. With that information in mind, the distributions seem more like a return of capital that include some capital gains. Whether this is a bad thing depends on your point of view as an investor. If you are used to hedge funds and private equity, there is nothing new here. One difference in that comparison though is leverage. Advanced Terrafund does not employ any borrowed money to enhance potential profit or their fees (which is the norm for hedge funds and private equity). Even in the world of REIT’s, using no leverage is unusual. For this type business, the difficult part is sourcing the land, securing ownership and finding reliable renters. After that, their work is basically done. The cost of management's expertise does seem to be overvalued. Nevertheless, the operation is located in a faraway emerging market that takes some real local expertise to navigate, so some extra leeway is probably in order. Taking a step back, investors wanting to add farmland to their portfolio are probably looking for one or more of the following attributes: (1) a hard asset inflation hedge, (2) an investment that should benefit from escalating world food demand, (3) and a place to hide out if the questionable monetary experiments of the world’s central banks blow-up someday. An investment in Advanced Terra REIT will not really generate any net cash flow from rent, but it does offer potential upside in the value of the underlying portfolio of farmland with an emerging market feature.
European Farmland
Looking at the data from the European Union’s statistical agency (Eurostat), farmland in Europe has been trending higher overall. Cropland in Eastern Europe still is much cheaper than that in the western countries. Land in the more developed western part of Europe increased by 16% over the last five years compared to 111% in the emerging East (weighting each country equally). All the following tables are denominated in Euros per hectare (one hectare equals about 2.47 acres and an exchange rate of 1.14 USD per Euro was used here).
Interestingly, even after this big move up, farmland in the East is still going for less than one-fifth the price in the west.
Further breaking down the data and looking at Bulgaria in particular, it is about average in price for those in the East and less than half the most expensive country, Poland (which is higher most likely due to its proximity to Western Europe and growing commercial integration with the Germany). Lease rates in Eastern Europe have increased on average 6.9% per year over the last 5 years compared with just 1.4% in the western countries. Rent as a percentage of land prices is also much cheaper in the East.
Earnings & Valuation
Just looking at the numbers, it seems reasonable to expect emerging market farmland prices in the East to continue to appreciate as they come closer to converging with the much higher levels of the West. As an investor, the question is whether the stock price of Advance Terrafund can be expected to accurately reflect any increase in farmland prices. Since the company does not have any other assets or any real liabilities, the book value is essentially the value of the farmland portfolio marked to market. The price of the stock had been trading near book till 2015. More recently it has been priced at a discount of about 20%. The data presented on the company’s website calculates the disparity as of the middle of 2018 at 28%. They list the book value as of June 30th of 2018 at 2.84 and a closing market price on September 17th of 2.05.
(Note the price data that was used in these calculations is sometimes not the exact last day of the year but a couple of days before or after. This is what was available from investing.com.)
There are few farmland REIT’s worldwide so there is not much historical data for comparison. Considering REIT's of all types, the chart below shows the premium or discount to asset values for U.S. based REIT's. Some have averaged substantial discounts over time.
The event in 2015 that most likely caused Terrafund to be start being priced below book was the Bulgarian parliament's enactment of a new law restricting farmland ownership to only persons and entities domiciled within the European Union. The legislature first moved to restrict ownership to only residents of the Bulgaria, but pressure from the European Union forced them to include their fellow Union members. Since a publicly traded REIT cannot know or restrict who buys their stock on a public exchange, publicly traded REIT's were given an exception to the new rule. This exception was granted primarily because of lobbying by Terrafund's management (in this case, I would say management earned their generous pay packages). A change of the rules midstream should cause investors to pause, but one has to keep in mind that farmland is sensitive topic for most countries. Who owns the local food supply is a touchy subject. Many countries, including some major farm states in the U.S. and provinces in Canada, actually have similar restrictions. In the case of Advance Terrafund and Bulgaria, there was a period of uncertainty as to whether the government would grant an exception for REIT's. This is most likely what depressed the stock price for which it has not recovered. I have heard rumors that the law will be eventually retracted, allowing those outside the E.U. to buy land directly again. If this turns out to be the case, the discount might be a buying opportunity.
Emerging markets, of course, have their own set of risks. Here are a few specific to this investment for consideration:
As with most foreign investments, investors basing their results in a currency other than the Euro need to accept (or hedge) fluctuations in exchange rates.
The European currency and even the Union itself have been judged by some to be unsustainable. Any chance of a big change is probably a long way out, but worth keeping in mind.
Bulgaria itself uses their own currency (Lev) which is pegged to the Euro. Many large transactions are done in Euros anyway though. The government has stated recently they would like to officially join the Euro currency as soon as it is practical.
More unchecked Russian adventurism beyond Ukraine is always possible, though probably less likely in a NATO and E.U. country that is home to 4 joint U.S. military bases.
Management self-dealing or other corrupt practices have not been an issue so far (from what I can see) but things can always change.
Conclusion
In a universe where there are not many farmland investment opportunities packaged as publicly listed securities, Advance Terrafund deserves consideration. It is unfortunate that in this case there appears not be any true net profits from leasing. Therefore, the real reason to own this REIT would be solely based on expectations for higher farmland values; either from inflation, increasing demand versus supply for food producing land or further convergence of land prices with those in Western Europe. Advanced Terra only trades on Bulgarian Stock Exchange. I have not been able to find any U.S. online brokers that access this exchange but there are a few Bulgarian ones to choose from. This blog, Investment Frontier, provides some information that might be useful in that regard. If anyone has specific questions on investing or doing business in Bulgaria - I will try to help, just email me through the website.