September 20, 2019
An Analysis of Gladstone Land: A U.S. Farmland REIT
This blog post is part of my ongoing search for an easily accessible farmland investment. The focus this time is solidly in America rather than an emerging market as in the last farmland related post. The company to be reviewed is called Gladstone Land, a listed REIT traded on the NASDAQ exchange (symbol: LAND). When thinking about US farmland, the first thing most of us will picture are the vast fields of grain in the Midwest. Typically, corn, wheat and soybeans, which are commonly referred to as "row crops". Gladstone invests in these but tacks sharply from the norm by including a significant number of farms producing vegetables, fruits, nuts and even some vineyards. Gladstone Land is still relatively small. They started with only about $93M in farmland assets when they became a public security in 2013. Since then, they have pursued an aggressive growth strategy. As of the end of second quarter of 2019, total assets had grown to over $629M, up from $565M at the end of 2018. Gladstone Land follows a simple approach of buying and leasing farmland they believe will increase in value over time while being able to generate a reasonable net cash flow each year they funnel back to investors through dividends. They do use substantial leverage to pursue this plan through bank loans and more recently, preferred stock. To preview the conclusion, Gladstone Land presents a straightforward way to invest in a diversified and growing portfolio of farmland in the U.S., but there are a number of issues one must be comfortable with before making an investment, including its small size, reliance on leverage, some drought risk and limited lifespan.
Company History
The company was co-founded by David Gladstone whose career was primarily focused on private equity and small business lending before getting into farmland. Gladstone Land joined a suite of three other listed Gladstone branded companies, two in the business development field (symbols GLAD and GAIN) which focus on raising private financing for small companies and the other is a commercial real estate REIT (symbol GOOD). The idea and beginnings of LAND were personally tied to Mr. Gladstone. As part of his many business activities, he was the chairman of a large strawberry farm in California called the Coastal Berry Company. At some point, Mr. Gladstone decided he would rather lease his farm and be relinquished from the responsibilities of farm operations. When the lessee ended up to be Dole Foods, he realized there was commercial demand for certain types of farms for lease. He ran with this idea by first establishing some larger, more secure, credit lines and then forming Gladstone Land Corporation in 2003 to begin buying and leasing farms. Ten years later, in 2013, the company was large enough to be listed as a public company. A very simple business model that has served them well. The key factors that determine their success are (1) being able to borrow money at rates below leasing rates, (2) the ability to buy good farms at the fair prices, and (3) be able to consistently lease the farms.
Company Today
Gladstone Land Corporation currently owns a diversified portfolio of farms across the country in the states of Arizona, California, Colorado, Florida, Michigan, Nebraska, North Carolina, Oregon, Texas and Washington. The various geographies create natural diversification by covering a variety of “distinct growing regions” which enable over 39 different crops to be raised. The map below was taken from their website. Gold colored states are where Gladstone owns farms and green are earmarked for future purchases.
Fruits and Vegetables
What makes this REIT especially interesting is the diversity of crops other than corn, wheat and soybeans. Most of the available farmland funds (which are generally private) are focused on one particular area and a very limited number of crops. Gladstone's strategy of targeting a variety of locations and crops is very attractive. So far, they have acquired quite a variety of different types of farms, including those that produce fresh produce farms such as strawberries, raspberries, tomatoes, lettuce, and bell peppers and other fruits and vegetables. More recently, they have begun to add permanent crops to the portfolio. These are orchards and vineyards producing nuts and fruits such as pistachios, blueberries, and grapes. Here is how they breakdown their portfolio on the company’s 2018 annual report.
Note, traditional row crops make up 55% of the total acres farmed but only contribute 13.8% of the rental income. Instead, 52.4% comes from fresh produce and 27.5% from perennials (permanent) crops. This is in line with the Gladstone's core strategy of limiting row crops and diversifying into many types of specialty crops. Specialty farms are generally much more expensive than row crop land but they in turn generate much higher yields per acre. Since most of these specialty crops are consumed in the United States, they also offer some insulation from the volatility in global grain prices and more risks from tariff wars. Specialty crops should actually be less affected by recessions. Budget-cutting of households during slower economic will tend to spare core food products - everyone still has to eat. (Though not all, some items like pistachios and strawberries might see less demand).
Water
The annual report states they have wells or secure water rights for all their farms. They do not own any "rain based" land. One potential issue though is their concentration in California which has begun to experience serious shortages of water during droughts. Here is a breakdown for the portfolio by state as of Q2 of 2019, note California makes up just 15% of the total acres but contributes nearly 50% of the leasing revenue:
The company's records show most of the farms in California are located in the San Joaquin Valley region which has had serious water issues during recent droughts. Farmers there have dug more and deeper wells to compensate but this has led to the underground water table becoming depleted. There have been limits set by the government (and nature) on how much water can be drawn during droughts. Nut tree orchards, in particular, require a lot of water and appear to be particularly vulnerable. There is a possibility that the mix of California farms in the portfolio have unique access to water that most of the valley does not, but one should be aware that a severe, lasting, drought could have a significant impact on the earnings and the future market value of a significant piece of the portfolio.
Funding
Gladstone's portfolio of farmland assets has grown substantially since their public listing in 2013. The company has funded this growth through borrowing and issuing common and preferred stock. As of the end of 2018, about 2/3 of the land portfolio's listed value was leveraged through bank loans, bonds, and notes. The interest rates are mostly fixed in the mid-4% range, but a sizable portion of the funding converts to variable in a few years. While interest rates are low now and probably will stay low, a sharp rise could have a big impact on expenses. The being said, if rates did increase meaningfully, the culprit would probably be higher inflation and farmland is expected to be a hedge against inflation (this is probably the main reason many consider investing in farmland). Farm values and rents should move higher in a rising inflationary environment.
The company appears to have ambitions of becoming a much larger operation. They have been steadily increasing their available capital from all sources and promptly using it to purchase new farms. The company's reports state they have plenty of attractive acquisition candidates in the pipeline. The recent preferred stock issue was not especially large but carried an interest rate of 6%. Each issuance of additional common stock does not dilute the ownership in the same way as normal company since the cash from each new issuance is not spent on operations but remains as an asset of equal value once it is spent on new farms.
Management has stuck with their plans to continue to add specialty farms over row crops. The most recent additions have been nut orchards. In 2018, two almond orchards were purchased in central California. These farms are expensive. The market for almond farms has been hot for a number of years now. According to a group called Western Ag Professionals, almond land increased 400% in the last decade. What is driving this trend? People have become more health conscious and almonds are now viewed as a "super-food" of sorts. The field of "alternative" milk has grown substantially in recent years which includes almond milk. Other countries around the globe are getting wealthier and health conscious too, so exports in almonds have been picking up. Gladstone makes the case these trends will continue, which is plausible. If there was a recession though, maybe nuts might move from the healthy snack part of the family budget to a luxury food item. Nevertheless, the overall diversification of the portfolio into many different types of crops is appealing since it should reduce overall risk.
Leasing Model
Another reason Gladstone is interesting is they make the business of owning farmland for lease available in a publicly traded stock (rather than doing it yourself or investing in a private fund). They have so far been able to keep their land basically 100% leased. They make a very important point that all their properties are rented to outside operators. The majority of their farms are leased on a triple-net lease basis which means the tenant maintains the property, pays the property taxes, and insurance costs. This is attractive since it eliminates the cost of upgrading and maintaining the land. The rest are partial-net meaning Gladstone has some expense in maintaining the properties.
About half the current lease contracts mature by 2023 which coincides with the timing of the switch to floating rate interest rates on a good bit of their debt. Here is how the loan maturities look over time:
At the end of 2018, Gladstone owned 85 farms comprising 73,205 total acres, of which, 57,744 is being farmed. Here is a breakdown by state.
According to their appraised value, they were up 14% over cost.
They use a couple of methods for establishing a current value for the farms. Initially, the purchase price is used. In the years thereafter, they then rotate between independent and internal appraisals. If they start to overpay for new farms, this should show up in the data once the independent appraisals begin. The three stage approach to appraisals is a good compromise between keeping costs down and maintaining accurate information.
Profits
The net earnings for Gladstone Land are not stellar when taken at face value. In fact, they posted a net loss in 3 of the 6 years of their publicly traded existence. The company prefers investors to view their performance using a measure of earnings that is called “adjusted funds from operations” or AFFO for short. This calculation removes depreciation, amortization and one-time expenses. Depreciation, save a few minor buildings involved, is not really a factor anyway. They are not responsible for upgrading most of the land since they leave this up to the renter under a triple net leases, so there are not many capital expenditures. This approach seems fair (this is not another WeWork). In fact, this rejigging of the earnings calculations is not uncommon in the world of REIT’s due to the nature of the operations. For more on this subject, here are a few links:
Cash flow for the company is entirely made up of rent payments from leases. These are generally paid once or twice a year. Since financial statements and earnings are required to be produced quarterly, they smooth these payments out over 12 months in their financial statements. This seems logical to get a clear picture. Using AFFO, the earnings naturally look much better. LAND has produced a steadily increasing profits over their six-year existence using these accounting modifications, climbing from 16 cents to 56 cents in 2017. In 2018 the adjusted earnings fell to 51 cents, probably due mostly to the issuance of more stock.
Stock Price
The trading price for LAND, the symbol Gladstone trades under on the NASDAQ exchange, has averaged a 60% premium over a simplified calculation for NAV. Outside a large drop during the market correction of 2015, the price has held relatively steady.
Dividends are paid monthly, which is nice for investors. Since the rent only hits the books once or twice a year, depending on the lease, it takes some corporate cash management skills to produce the smooth payout. The net payout per share has been comfortably above 4% except for 2018 when more common stock was issued. This payout is appealing in the current environment of low interest rates and overall in line with typical rents for farmland.
Management
Gladstone is a small company. They have 65 full-time employees, 12 of which are deemed to be executive management. They pay themselves by charging management fees that are more akin to a hedge fund. (I suppose with the founder experienced in private equity, this is not surprising.) There is an annual base management fee set at 2% of the adjusted stockholders’ equity and an incentive fee of 20% based on any increase in the adjusted stockholders’ equity over a hurdle rate of 7%. They also are able to take 15% of any realized capital gains, which would presumably come into play when farms are sold for a profit someday. This added fee seems excessive since the stockholders' equity should already reflect the growing value of the land. Since no land has been sold yet, this fee has not been charged yet. All administration costs, including salaries, are paid by the company before fees are calculated. Overall, management's compensation seems generous, but since nearly all the other options for similar farmland investments are packaged as private funds with similar fees, it may not be a deal-breaker.
Conclusion
In a world with few options to passively invest in farmland, this one is worth a second look - especially because it is publically traded rather than a private limited partnership. The diversification of crop types and locations of the farms is a big positive. Their commitment to growth is also a positive. The use of significant leverage and floating interest rates is something to watch. Some of the specialty farmland they are buying is also getting rather expensive. The loss of water supplies in the San Joaquin Valley during an extended drought could have serious impact on rental income and the ultimate value of their holdings in California. Overall though, Gladstone Land Company is worth a closer look for investors who want to include farmland in their portfolio.