Stoel Rives | Deeply Rooted Podcast S1E4: The Financialization of Agriculture with David Muth from Alternative Equity Advisors

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In the latest installment of the Stoel Rives | Deeply Rooted Podcast, titled The Financialization of Agriculture, hear from David Muth, PhD, managing partner of Alternative Equity Advisors. In a wide ranging conversation with Todd Friedman, Dave shares his perspective on issues including:

• The thesis for investment in agriculture
• The pandemic’s effect on operations and valuation
• Current state of operations and deal flow dynamics
• Impact of potential tax code changes
• The effect of sustainability trends on transaction volume and pricing

Episode Transcript:

(We use an audio transcription service and please disregard any errors below)

Todd Friedman 00:06
Welcome to the inaugural season of the Stoel Rives | Deeply Rooted podcast. I’m your host Todd Friedman, Co-lead of Stoel’s agribusiness, food, beverage, and timber industry group. This season, we are interviewing respected industry leaders and discussing how they, and their companies, are embracing innovation and capitalizing on new opportunities to move their industries forward in an ever-changing world.

Hello everyone, I'm pleased to present our guest today, David Muth Jr. David has a PhD in Mechanical Engineering from Iowa State University, and is the Managing Partner with Alternative Equity Advisors, which is the asset management arm of People's Company. People's company is a full-service farmland transaction company that runs a multi-state platform and brokerage for agricultural land. Dave knows everything that's going on in the world of farmland acquisitions and dispositions. Dave, welcome to the podcast.

David Muth 01:09
Thank you very much for the invite. Looking forward to talking through some of the fun issues that we have in farmland.

Todd Friedman 01:15
Great. Well, let's get started. As you know, it's been kind of a crazy year or 15 months, we’re coming out of the, hopefully, out of the Coronavirus pandemic. And early on in the pandemic, there were a number of dislocations in the agricultural supply chain that created an interesting environment for, at least from my perspective, for farmland transactions. What do you see out there in the farmland transaction space these days?

David Muth 01:42
It's been a really, really interesting year and a half here. Certainly, we've seen a swing of the pendulum in terms of the understanding of how farm operations, profitability, was going to come out, it was looking like is going to be a really tough year for farmers, a lot of federal programs, and then subsequently a commodity price run, it turned 2020 into one of the most profitable if not the most profitable on record. And then on top of that, what we've seen is the capital interest in farmland is the highest we've ever seen before. So, there is an immense amount of capital that would like to get into our $3 trillion asset class in terms of U.S. farmland, and they're really struggling with finding deal flow. And right now, particularly over depending on region, somewhere in the range of the last four to six months, we've seen an incredible price run that's driven by that interest, and the low supply. And so for investors that are investing on a specific thesis relative to their returns of the asset, getting into the asset class is very tough right now. But the interest is incredibly high.

Todd Friedman 02:55
So Dave, just to stop you there and ask a question. Clearly some of the programs that made 2020 a success for agriculture are not sustainable long term and are not going to exist long term. So, what's driving that interest in the investment in ag land?

David Muth 03:12
You bet. The primary strengths of U.S. farmland from an investment standpoint, is kind of that stability, and that consistency and return along with being uncorrelated with general economic trends and a lot of other equities. In that kind of chaotic environment that we're in right now. Certainly, markets are doing pretty well, overall. There's a lot of great metrics, but there's also this sort of hint of uncertainty that a lot of folks are feeling. And that's really driving that interest in farmland. We also will see some very specific kind of pointed theses from investors where they want to attack some consumer trends or some pretty specific verticals within the farmland asset class that they identify as having a nice runway.

Todd Friedman 04:07
Would that be things like organic production? For instance?

David Muth 04:10
You bet you bet. Certainly one of the key drivers that we're seeing right now in consumer trends are really, really clear. Consumers want to have more information and transparency about where their food comes from, that manifests itself in a number of different kinds of pathways. Organic is one that has an explicit sort of certification behind it, where the rules and regulations are well defined. And that serves the purpose quite well for a lot of consumers. There's other kinds of natural regenerative, a more social and environmental sustainability aspects that will fit into that. Also, organic is certainly right there at the forefront. And the key is consumers are willing to pay more

Todd Friedman 04:56
which implies that the assets then would be worth more In the context of a sale, and so what kind of premiums Do you see either organic or some other regenerative or other kind of specialized asset able to receive?

David Muth 05:13
Yeah, that's, that's really an interesting dynamic and identifying a premium around organic assets is not just a clear process. One of the real challenges is that the organic certification actually goes with the operator, not the land, the land itself has to meet certain characteristics in order for that crop on that land in a given year to be certified organic, but it is not inherently characteristic with the land. And the other challenge is that it's not necessarily going to be there next year. Right if an accident happens relative to perhaps an overspray by a neighbor, or perhaps some sort of spill, etc, it is a year to year proposition that organic certification happens. And so from a land value standpoint, there are regions within the country, the Pacific Northwest is an example where you can identify baseline premium, that's not really substantial, but a baseline premium, maybe five to 10%. For organic land in other parts of the country. Midwest is an example there actually isn't a clear premium on organic land. And we actually have seen sales were organically certified land or land that facilitates that organic certification will trade for less than market values. That's,

Todd Friedman 06:56
that's interesting. And maybe that's a good transition, thinking about the difficulty of capturing that premium to what I've heard you call the financialization of the ag sector. Why don't you talk a little bit about what that term means and what it implies for the future.

David Muth 07:15
It's been a pretty inefficiently capitalized asset class to date. And right now, on that $3 trillion asset class, we're only about 14% leveraged, it's really an incredible statistic. There's a lot of reasons for that. One is the nature of farmland within families, and how a lot of it transitions even off market. And right now, generally speaking, we're still seeing 60, 70%, again, depending on region, are being bought by owner of farmland for sale is being bought by owner operators, right. What we see going on in it, we also have these incredible demographic trends. So about 82% of the US farmland right now is owned by somebody 55 or older, and about half of that is owned by somebody 75 or older, when we put these characteristics together, there's going to be a really significant turnover of farmland as we looked at on a 10 to 20 year basis.

We're also going to see a lot more efficient capitalization of that farmland that inherently will be tied to more investor capital, in a lot of cases, institutional money coming into the asset class, which will stabilize some of the value proposition some of the price points and actually add a little bit more of a notion of a true investment, great asset class in terms of pricing, as opposed to you know, the old adage I hear from my father all the time, I'm from a farm in Iowa, is the farm across the fence comes for sale once in your lifetime. And you've got to be willing to pay for it. Right. And that creates a little bit of an interesting skew, and kind of an incredible dynamic as we look across the asset class now.

Todd Friedman 08:59
So does that, in your mind imply increased valuation for farmland as that comes to market and it can be capitalized more efficiently, whether with debt or with institutional equity capital?

David Muth 09:14
Yeah, potentially. We also definitely see where there's a lot of regions and even sub regions, little pockets within large agricultural regions like the Midwest where prices are skewed upwards because of that competition between local operators. In those cases, you probably see a little bit more of a stabilization in terms of pricing the assets in order to hit the common return thresholds that are part of the investment theses. But certainly, we see interesting dynamics you could take Iowa and Illinois as an example Iowa has corporate farming laws that are somewhat restrictive for institutional capital to come in and own farmland. It doesn't fully exclude they're certainly ways for these kinds of investors to get engaged Illinois does not. Subsequently what you see is there is more variability and a more dynamic price trajectory on farmland in Iowa as opposed to Illinois, it's more stabilized. So probably more so than just added value to the assets. I think stability certainly,

Todd Friedman 10:24
let's toggle a bit. I know that when I talk to clients who are interested in purchasing agricultural land, one of the things that they're there they're concerned about these days is risk management and risk mitigation. Specifically, the three I often am asked to think about, are climate change, water rights, water availability, and wildfires. And so how did those kinds of things factor into, you know, the space, you know, an institutional investor, considering the value of an investment or how it should be priced?

David Muth 11:08
You bet. So if we just think about stepping back up to the asset class as a whole, the primary challenges for capital get engaged are identifying deal flow, right, there's, you really have to have a lot of regional and local knowledge to make sure that you can be engaged in that deal flow and then understand all of the dynamics of production, whether you're talking about working with operators, whether you're talking about an investor direct operating themselves, and then you know that capacity and skill set to understand water dynamics, where it's relevant, and then ultimately execute in that is the kind of infrastructure that firms like ours is trying to help bring to investors, certainly, people's company with the National footprint, and regional offices and all that major agricultural regions helps identify and work through that deal flow side. And then as we move down through underwriting and diligence, and being engaged with the right folks to understand water dynamics, to understand some of those underwriting risks that you highlighted, on the operational side, this is a really important thing that

I like to call out to folks that United States farmland is pretty unique, from our perspective, relative to other investment grade asset classes, in that we have a minimum annual revenue floor set by the Federal Crop Insurance Program. That's not a catch. All right, it's a crop. It's an insurance program where performance dictates future indemnity potential. But that minimum revenue floor actually creates a really powerful tool for stabilizing some of the issues that you highlighted. Climate change, certainly one of them. And we've got lots of effects that we see right now, with some major droughts, certainly out west, in some of our assets out there are suffering a little bit from some incredible temperatures. Over the next few days, even with readily available water, being able to keep enough water on the crops in order to get them to perform and meet their yield potential is going to be quite a challenge in we've got a floor through our federal crop insurance program to help us with that revenue level. And that fits with whether you're working on a direct operations kind of concept where the investors actually operating the farm and owning the crops, or working with a farmer operator, where through a lease program where their revenue can make sure that that lease can be paid in a down year on the crop side.

Todd Friedman 13:49
So is it then overly simplistic to say from an institutional investors perspective, that the notion of investing in agricultural land or an agricultural operation by itself creates some diversification, especially with potentially some crop insurance, buffer there, that that's really the solution or a solution in an investor's mind, potentially, to these kinds of risks, that the risks are unique to the asset class, but the asset class is just a part of a broader strategy is that?

David Muth 14:27
Yeah, yeah, absolutely. I agree with that. And we what we see, typically in putting a portfolio together for an investor is there's going to be a mix of some pretty flat lease kinds of assets that have that annual coupon so to speak, that you clip when you get that lease check in that clicks into the annual return for that asset and then some exposure into the commodity space with some programs that are either direct operations or something Sort of hybrid, where the there's some investment in the crop. And then certainly the fold direct operations, which can be taking advantage of specific verticals in that supply chain and have some upside return potential. And that kind of diversification is really enabled, because we do have that revenue floor.

Todd Friedman 15:22
Interesting. And you see, I assume, then your investors interested in, in those various tiers of, of essentially risk bearing right in the in the agricultural space.

David Muth 15:35
Yeah, that's very common in you know, it does sort of parse itself a little bit on crop type and production system, you see more institutional engagement in direct operations with permanent crops, say tree fruit, we are doing more and more of it on even the row crops side. Now, in typically, there's going to be a sort of primary vertical thesis associated with that think organic, and even specific organic crops into cornered markets that create a little bit of extra value as an example.

Todd Friedman 16:11
Great. One of the things that we've heard a lot of talk about is changes to the tax code. And I'm wondering what your thoughts are on how changes in the tax code might impact the climate for investing in agricultural operations?

David Muth 16:30
Yeah, you know, candidly, we wish we knew exactly how this was going to play out, we've been trying to pay attention, certainly to the conversations in the news and figure out how to play it just a little bit. But there's still a lot of uncertainty. So there's, there's a few primarily primary high impact issues at play, it feels very likely that capital gains rates are going to increase where that number lands, it's not exactly clear. But that will certainly impact people's decisions to buy and sell to transact. When we start looking at some conversations around eliminating 1031 exchanges. That section of the tax code for deferring capital gains through a like asset, that could be a high impact kind of outcome. Also, it's much less clear that that's going to actually come to fruition versus what feels more likely from a capital gains increase standpoint. And then a third one that we've heard at least a little bit of chatter around is eliminating stepped up basis associated with moving farmland assets to errors. And you could create a hypothetical scenario where if stepped up basis was removed. Right now, certainly in a lot of parts of the country in Dynamics, most people want to die with their farmland in order to give their heirs, the option for stepped up basis to eliminate a very, very substantial capital gains burden that would most likely cause them to have to sell the asset, right? If you eliminated 1031 exchanges, and you saw a increase significant increase in capital gains tax, and these were all to happen and then be in effect in 2022. It would be really hard to fathom the amount of farmland that may look at hitting the market yet this year, given the demographics that we talked about earlier.

Todd Friedman 18:34
In fact, I would say I already sense in my world that there are some folks out there who are prepositioning, of course, not knowing what's going to come but at the margins, right, someone who may be interested in selling in the next few years saying, Hey, I better get this done in 2021, like we saw at the end of 2020, with a lot of people doing estate planning thinking that the state tax exemption was going to was going to change? Absolutely. Do you see the same thing?

David Muth 19:02
Yeah, absolutely. And we're having conversations, probably, I'd say on about a weekly basis with assets under management and investors that we're working with around do they need to look at potentially making some moves, adjusting some portfolios, shedding some assets and trying to recalibrate to the world as we see it right now within their portfolios. And there are definitely several that are close to making moves.

Todd Friedman 19:29
And in a world where that ended up occurring where there were tax changes over the rise, and that drove a lot of properties into the market. Do you see that as an acceleration is causing an acceleration of this financialization of the of the sector? I mean, would those properties be then more likely to be acquired by institutional investors than under normal circumstances in the past?

David Muth 19:56
Yeah, this this will be a little bit of a fuzzy answer to the question, but it's certainly seems possible, particularly in certain regions. The only reason that I hedged that is the fact that we're coming off of such a profitable year for farmer operators in 2020. With a lot of those, as you noted earlier, unsustainable programs that helped buffer that profitability, and we're still in a bit of a commodity upswing. There's a lot of farmers that are ready to buy also. But generally speaking, I would say yes, that's a that's a very real possibility, that we'll start to see that ball rolling and accelerate a little bit.

Todd Friedman 20:37
Interesting. Well, that's, that's, it'll be fascinating to see what ends up happening, both coming out of Washington, and then how that affects these markets.

David Muth 20:46
Yeah, absolutely. And we haven't come up with any brilliant deductions on exactly how to position all of our folks, within all of this right now, a little bit's going to have to wait and see what actually comes out?

Todd Friedman 21:00
Well, if you do come up with any letters, absolutely. podcast, I'd like to just circle back to one item that we touched on earlier a bit, which is sustainability. And, you know, we talked about sustainability in the context of a potential influence it might have on an asset price. But I'd like I'd like you to comment more generally on sustainability in agriculture, and what you see from a trend perspective. And in terms of what's going on out there, what people are talking about,

David Muth 21:33
yeah, this is really exciting time on the sustainability front, we're seeing a lot of different threads really coming together right now to create some momentum. Certainly, the consumer pressures moving through the consumer packaged goods. A lot of corporate sustainability reports that were put together over the past, let's call it 10 years on sustainable sourcing are starting to put real goals in place. And they're looking for farmers and production systems that meet certain metrics and guidelines. We're seeing a really swift movement on the carbon front over the past few years, which has a great potential to add some additional revenue to the land. And then we're seeing the market respond with some frameworks by which people can more clearly and transparently, actually get sustainability certifications. And that kind of a process behind showing sustainability.

We're engaged with a group called leading harvest. It's a really interesting sustainability certification, we like it quite a bit because it was developed for landowners, right? A lot of these efforts have focused really exclusively on the operators in the farmer side, and, you know, built along this mechanism of we need farmers to get to do X, Y, or Z, and we need to motivate them to do that. Well, we still have about 60% of the land in the US that's leased, and it's often on short leases. That creates a really challenging economic environment for farmers to adopt certain practices that have longer term payback periods, whereas the land owner is heavily motivated to be able to see and achieve the value of implementing a lot of these practices that are being driven to through these certifications and standards. So leading harvest is an initiative that we've gotten engaged in. We're also working with a company called CBOE to bring some carbon credits to market we're not anticipating a substantial payment, there's a lot of work to do around registries and finding that criteria and meeting the criteria needed to get those carbon credits to exchange from farmland. additionality and permanence, major keywords that are a little bit of a struggle for farmland, carbon credits, but if we are moving, we are seeing actual transactions take place and getting engaged on that front. So a lot of movement and a lot of exciting things around being able to position the assets under management in our portfolio. For added value going forward

Todd Friedman 24:12
It feels like it's early days, in some respects with regard to things like carbon credits in ag land, but it will certainly be an interesting place to watch over the next five or 10 years.

David Muth 24:23
Yeah, that's absolutely right. And you know, one of the things that that is our view of sustainability primarily within the large-scale commodities, we're not sure that that's going to play out to bring extra value to the operation and the land, so much does as it's going to become a barrier to entry for those commodities to actually make the supply chain. So we think there's an inherent value proposition associated with the land, and it may not be an added value proposition. It may be that hey, we have To meet these thresholds to ultimately engage the supply chain to buy our products without a discount. Interesting.

Todd Friedman 25:07
Yeah, it will be interesting to see. See how that plays out? Well, Dave, unfortunately, that's all the time that we have for today. That was a quick 25 or so minutes. But this has been a great discussion. I really appreciate you coming on the podcast and sharing your thoughts with us. I do want to mention that people's company your umbrella organization, runs the land investment Expo, which is an annual conference that brings together major players in the land business. It's in if I, if I haven't correctly, it's in Des Moines every year, is that right? That's correct.

David Muth 25:39
Des Moines and the dates are set for next year. I believe it's toward the end of January, I actually need to check myself

Todd Friedman 25:46
and you always seem to have amazing speakers there. So do you know who the speakers are going to be for 2022?

David Muth 25:51
there is several really excellent folks that are in process of getting booked. Now. I would encourage people just to watch the website, land investment Expo calm and keep an eye on who gets confirmed. But there's some really great folks going to be coming around through the through the event next year also.

Todd Friedman 26:12
Great. Well, we're all looking forward to it. We'll watch that, that that space and see who's on the docket. Excellent. Thanks again, Dave. I really appreciate your time. I appreciate you being on the podcast. And it's been it's been a great interesting conversation with you over the last 25 minutes or so.

David Muth 26:29
Very much appreciate the invite and appreciate everything you guys do. Take care. Thank you.

Todd Friedman 26:35
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