Tuesday, April 1, 2014

Real farm: The speculative opportunity of land values

By Paul Kanitra

Increasing numbers of institutional investors are seeking access to an asset class that lacks a liquid alternative. Meanwhile, farmers have long realized the importance of land values with respect to their bottom line. While futures and options are available for crop risk, no such risk reduction tools are at hand for declining land values. A futures contract based on a legitimate crop land value index would provide a hedging tool for farmers and speculative opportunity for traders.

Although no futures contract on land values currently exists, that doesn’t mean it isn’t viable. Here, we examine the makeup of the Peak Soil Iowa Cropland Value Index and discuss how a farmland futures contract linked to it can be hedged with a basket of existing commodities. This opens the prospect for locals and institutional investors to furnish liquidity support with the ability to hedge their exposures.

Down on the farm

Farmland has long been recognized for its attractive diversification features. Yet despite growing demand for the investment, concerns about pricing sustainability are becoming increasingly prevalent. While excess leverage has not fueled today’s land valuations, it’s clear the 1980s farmland bubble remains lodged in the minds of property owners. The complexities of physical ownership and the lack of effective hedging tools act as further hindrances.

A functioning farmland futures contract would address most marketplace concerns and needs. The Peak Soil Iowa Cropland Value Index is designed using “corn suitability ratings” from recorded property sales data rather than surveys. (A survey is vulnerable when a party providing data can economically benefit from that contribution—a lesson that might have served  purveyors of Libor well.)

Yet, a well-designed index does not necessarily result in a viable futures contract. The respected Case-Shiller Home Price Index never took hold as a futures market. In all cases, liquidity is king. Participants will wait on the sidelines until they know they can get their price, buying into or selling out of the market. Still, history shows that with the right circumstances, vested parties will back a contract in its infancy.

Marketplace noise

A farmland futures contract does not have a related instrument with a robust daily correlation. Nonetheless, farmland prices are influenced by many common marketplace factors. Farmland, though, maintains a longer-term economic focus and tends to ignore low-frequency marketplace noise. The resulting lower volatility makes replication modeling difficult and limits short-term usefulness.

Corn (NYBOT:JCK14) futures can react to an export or crop-related announcement. Interest rate futures answer to more mundane economic releases. But the long-term nature of farmland is not tuned to respond the same. It overlooks most short-term marketplace influences, focusing instead on events that bring about fundamental change. Interest rates can fluctuate up and down on their own, but a Fed policy change is pivotal and will influence both interest rates and farmland.

With identification of the major risk contributing factors embedded in farmland’s pricing, it is possible to determine the core drivers. These impact variables can be observed in the price action of other commodity future contracts. We can then replicate farmland values with an economically equivalent basket of specified futures.

There is documented evidence of long-term relationships between farmland prices and crops, particularly in states with a predominant crop. Kastens and Dhuyvetter (2011) evaluated Kansas farmland values vs. U.S. wheat prices from 1880 to 2010. They found a correlation coefficient between the two of 0.90. The discovery is not surprising, considering Kansas is such a wheat-dominant state.

Having identified such stout long-term land/crop correlations, replication of a farmland futures contract is feasible. While a model based on current futures contracts may be of limited value for daily trading, there is strong reason to suspect trading opportunities for much shorter periods than previously thought.

Value determinants

Current farmland values can simplistically be viewed from an Income Capitalization Model. Because farmland is a capital asset, its present value can be defined in a manner that exposes interest rates as a contributory factor to property values. Interest rates affect everything from loan payments to discounting future income streams. Low interest rates generally support higher land prices. The future income is less discounted while in the currency markets a weakening dollar encourages agricultural exports. Higher interest rates yield opposite effects.

But farmland pricing is often irrational, can temporarily disregard fundamentals and overreacts both on the upside and downside. Featherstone and Baker (1987) point out that “part of the explanation of change in farm asset values may lie in the time paths of adjustments to the fundamental variables, returns and interest rates.” Past studies have suggested other contributing factors in farmland pricing, including a linkage to returns, asset ratios, expected inflation and cash rents.

Moss, Schonkwiler and Reynolds (1989) attribute the 1980s price tumble to income, asset ratios and interest rate increases. Feldstein (1980) describes “a fundamental link between general price inflation and the relative price of land that deserves particular attention.” Moss (1997) found that inflation contributed the most to Florida land prices from 1960 to 1994.

Expected inflation must clearly be accounted for in a reproduction attempt. Historically, gold futures have provided a good proxy for inflation expectations. Recent inflation worries from the Fed’s quantitative easing were blatantly expressed in gold’s pricing.

Correlation analysis is subject to the period being viewed. Intervals can be found where almost any two items can misleadingly imply a strong correlation. However, specific commodities inherently share common data in their pricing. An economic synthesis of farmland values must use commodity futures that capture commonality. The recommended index has a strong economic connection with corn, soybeans (NYBOT:JSK14), gold (COMEX:GCJ14) and interest rate futures. These commodities can reasonably be used for replication purposes. Interest rate risk can be captured with either five- or 10-year Treasury note futures.

Data for the Peak Soil Iowa Cropland Value Index begins in 2005; correlation and regression analysis is limited to January 2005 to June 2013. With the understanding that a longer-term analysis might suggest otherwise, this observed 8.5-year period reveals an index that would present intriguing hedging possibilities as a futures contract.

Crop prices, expected inflation and interest rates have a commanding economic bearing on property values and are considered in the analysis. The analysis uses the month ending, spot futures contract price. The five-year T-note is used for interest rate risk, corn and soybeans for commodity exposure and gold for expected inflation. A wheat analysis was reviewed to examine the correlation to a crop not generally produced in Iowa.

Quarterly analysis used actual index levels while monthly analysis extrapolated prices from the previous and following quarter. A quarterly basis provides 34 observations while the monthly analysis offers 100 data points.

Correlation comparisons

Individual correlation coefficients for the components from January 2005 until June 2013 show the following:

High correlations exist for the state’s principal crops, corn and soybeans. The index has a 0.86 correlation to corn and 0.83 to soybeans. Those tight correlations occur despite an approximate $6 and $12 range per bushel price for the two commodities.

The significance of the income-producing crop is apparent when viewing the much lower correlation with wheat. Wheat is a non-productive agricultural factor for Iowa and as suspected, displayed a low correlation. Similarly, high correlations are witnessed for U.S. T-note and gold futures. The strong interest rate results are indicative of the prolonged downward rate cycle experienced in the viewed period. Inflation expectations seem truly to have been captured in gold’s price action. 

Multivariate regression analysis, using gold, corn, soybean and five-year T-note futures to estimate the Peak Soil Iowa Cropland Value Index, can be seen in “Comparing markets” (below). The monthly coefficient of determination between the actual index value and the predicted value of the commodity basket, known as the R-squared, is 0.85. The predicted value is replicated with optimal weightings as determined by the regression analysis.

The discovered R-squared implies that 85% of the variation in the index can be explained by the replication model, while the remaining 15% can be attributed to unknown variability. This demonstrates that farmland values in crop-dominant states can synthetically be reproduced with a basket of existing futures contracts. The analysis specifically indicates that the farmland index can be hedged with a replication for much shorter time periods than formerly thought. 

Farmland is an essential natural resource that has thus far been ignored as a commodity. This is surprising considering that farmland has greater long-term strategic value than oil and natural gas.

Acceptance of replications practicality opens the door to democratize the asset class. Investing in farmland will not be as daunting or restrictive and limited to long-only strategies. With farmland as a tradable commodity, new opportunities open for the financial and agricultural communities. Product development will accelerate into other geographic regions with investment and risk-management tools becoming more readily available. With hedging capabilities in place and the market opened to the institutional investor, farmland will become a more efficient, liquid and transparent commodity. 

The 1970s witnessed the beginning of the financial futures revolution. Currency, gold, crude oil (NYMEX:CLJ14) and interest rate futures were all presented as innovative new concepts. The introduction of cash settlement with the Chicago Mercantile Exchange Eurodollar contact paved the way for hedging equity exposure. Contracts mimicking stock indexes, not possible with a physical delivery, could now simply cash settle. 

A cash-settled farmland futures contract can be derived from a market-accepted index, such as the Peak Soil Iowa Cropland Value Index. From there, indexes can be designed to meet the needs of farmers and investors in other locations and with differing land characteristics. The possibilities are vast, with cropland, range land and even timberland indexes possible. 

In “Exchanges and Regulators let traders down in 2013,” Futures, February 2014, Steve Zwick points out how difficult current times are for the futures industry. But in that same issue, Hilary Till notes that transforming innovation has occurred in stressful times, in “Futures Industry: A story of crisis and opportunity.” It’s time for the reappearance of prudent innovation in the marketplace.

See the original article >>

No comments:

Post a Comment

Follow Us