Global farmland, a differentiated offering in real assets

Written By: Sherilee Mace Institutional Business Development Director Insight Investment

& Tom McKeon Portfolio Oversight Director, Farmland Team Insight Investment

Sherilee Mace and Tom McKeon of Insight Investment discuss how a global farmland portfolio that follows a responsible investment approach can help LGPS funds manage their cash flows and fulfil their obligations to investors

New regulations are leading many LGPS funds to seek out ways to further diversify their portfolios and demonstrate that they are taking environmental, social and governance (ESG) factors into account when investing. Global farmland investment could offer a way to achieve both objectives – along with the potential for income and real returns – which can help LGPS investors to manage their cash flows and realise long-term stability in contribution rates.

LGPS (Management and Investment of Funds) Regulations 2016 came into force in November 2016 for funds in England and Wales. They included the requirement to demonstrate investment across a wide range of assets, alongside guidance on responsible investing, which placed a stronger emphasis on the extent to which ESG considerations are taken into account in the selection, retention and realisation of investments. The creation of central asset pools is also likely to sharpen the focus on this area as funds set out best practice around any ESG policies to be handled by the pools.

Against this backdrop, an investment in farmland could be considered as an option for some LGPS funds.

Farmland: the investment opportunity
A farmland portfolio will typically invest in agricultural businesses, aiming to generate investment returns from a combination of income as a result of selling produce, and capital gains from developing the business and land over time for eventual resale.

The long-term case for investing in farmland is based on the expectation that demand will increase while supply growth remains constrained. The demand for agricultural commodities will grow as world population continues to expand, but supply growth is expected to struggle to keep pace, due to a combination of short-term limits to growth, less availability of high quality land as climate patterns shift, and resources such as water become scarcer. We expect these dynamics to place a premium on quality land in regions with a comparative production advantage. We believe investors in those regions, holding the right assets, will be rewarded.

Aside from the overall value proposition, investing in farmland could also offer other appealing characteristics, including:

• A well-diversified portfolio can potentially generate attractive annual income through leasing out the property to operators or by direct management of the assets.
• Farmland can also offer the potential for inflation protection. The asset class has historically had a positive link to the level of inflation through long-term adjustments in land prices and short-term sensitivity to commodity prices. While the link to inflation is less precise than that offered by inflation-linked bonds, the cost of the inflation linkage acquired through a farmland investment is typically less expensive as a result.
• Farmland investments are less correlated to economic growth than other real assets, such as property. As a result, they can help to diversify a portfolio.

Why responsible investment matters to farmland investors
A responsible investment approach lies at the core of effective farmland investment. There are multiple challenges that agricultural producers face, including:

• Insecurity over title rights (land and water)
• Labour rights issues
• Health and safety issues
• Deforestation
• Soil degradation and erosion
• Animal welfare concerns
• Water scarcity and quality

A responsible approach which addresses challenges such as these offers the potential for adding value to a farmland investment.

It is no coincidence that the most efficient and productive agricultural producers today make use of a responsible investment approach. They employ the latest technologies and techniques to maximise the output of their farms and their profitability. At the same time, they try to achieve best-in-class sustainability, which enhances the long-term value of their operations.

How responsible investment in farmland could add value
Investing responsibly in farmland is a multi-faceted process. Before constructing a portfolio, it is important to consider one’s ability to farm sustainably in a particular geography or product segment. For example, one might consider whether further sustainable farming practices could be introduced when considering a particular opportunity.

As a starting point, the investment process might consider each potential holding against a variety of indicators, including its fit with the broader investment strategy, financial and operating performance of the investment, the quality of assets and infrastructure, the potential for productivity enhancement and/or development, industry viability, customers and markets/supply chains, operational and commercial risks, and environmental considerations.

Once an investment has been made, following a responsible approach means adapting the approaches to the specifics of each investment. Taking into account the various challenges that agricultural producers face (listed to the left) these can include a wide variety of different practices. For example, businesses may adopt different approaches to soil conservation such as conservation tillage or the practice of cover cropping; or in the case of managing livestock, investors may seek to improve the health and welfare of cattle in order to have a significant impact on how a business performs.

With regard to soil conservation, one approach that businesses might employ is conservation tillage, a practice designed to conserve soil, water, energy, and protect water quality. It is a method of soil cultivation that leaves the previous year’s crop residue (such as corn stalks or wheat stubble) on fields before and after planting the next crop, to reduce soil erosion and water run-off. Other benefits include carbon sequestration and enhancement of soil biology. Conservation tillage systems can be an important part of a sustainable agricultural system in that they can help to decrease soil erosion losses ordinarily associated with traditional agricultural practices. Also, a decrease in erosion can also decrease the need for additional fertiliser and water, given that topsoil generally contains the most organic matter.

Cover cropping is a farming practice where crops are planted primarily to manage soil erosion, soil fertility, soil quality, water, weeds, pests, diseases, biodiversity and wildlife in an agroecosystem. A cover crop is simply a high number of plants which improve the soil structure through root penetration, soil aeration and breaking compaction. When the cover crop is tilled into the soil it is referred to as a green manure crop, as it acts to serve as a mulch and soil amendment, improving the organic content of the soil. Legume cover crops may also be used to fix nitrogen in the soil, reducing the need for applied non-organic nitrogen fertilisers.

With regard to livestock, pasture-based grazing strategies and other herd management techniques can help to provide environmentally sound and economical milk production over a sustained period of time. A well-planned approach to grazing is essential to make the most of any pasture as the rest period between feeding times determines the health of the pasture, the number of plant species in the sward impacts the health of the stock and soil, while diverse pastures may help dairy farms to reduce their environmental footprint.

In combination, robust practices such as these can contribute materially to the sustainability of farming businesses and, in turn, impact the long-term profitability for investors. We believe a holistic approach to sustainable farming will combine the best of traditional methods with beneficial modern technologies and global best practice to achieve high productivity and minimal environmental impact to ultimately drive value creation for investors.

A different approach to generating returns
We believe a farmland portfolio that follows a responsible investment approach will be best placed to exploit the characteristics offered by the asset class. A well-managed farmland portfolio can therefore help LGPS funds to manage their cash flows and stabilise contributions, while also fulfilling their obligations to consider a wider range of investors and to demonstrate they are taking ESG factors into account across their portfolio.