Food, Forests, Fuel, And Real Estate

Farmland

In order to sustain a global population of almost 10 billion people by 2050, the Food and Agriculture Organization of the UN (FAO) estimates world agricultural production would have to increase by roughly 50% compared to 2012. Meanwhile, overall consumption by the emerging market middle class is on the rise, bolstered by favorable demographics in Asia, rising per capita incomes, a growing labor force, higher levels of educational attainment, and expanding urbanization. Rising affluence in the emerging markets has resulted in wealthier middle class consumers shifting towards more advanced and diverse diets. Additionally, constraints on the supply side should push up farmland values over the long term as world arable land per capita continues its steady decline amid rapid industrialization, urbanization and climate change. Given the combined pressures of arable land scarcity and rising populations, U.S. exports have been an important factor in combatting food shortages among the least developed nations.

Timberland

We expect timberland values to be supported by similar supply and demand dynamics. U.S. exports of forestry products to emerging markets have been rising as an expanding middle class spends more on manufactured goods and housing. In the U.S., over one million new households are formed each year; this, along with America’s expanding population, paints a favorable picture for the U.S. housing market and timber demand. Long-term supply constraints include urban development, deforestation, government regulations and natural causes, all supportive of higher land values.

Energy

A growing global middle class and economic upswing are also positive signs for global energy demand. The International Energy Agency forecasts world energy demand will rise by 30% between now and 2040, with the largest contribution to demand growth coming from India. Renewable energy adoption is another theme to watch over the long term, given the rapidly declining cost of renewables and increased government and businesses focus on mitigating climate change. Conventional energy—coal, oil, and natural gas—will remain the dominant energy source over the intermediate term, even as renewable sources gain some ground.

Commercial Real Estate

General economic conditions are good for commercial real estate going into 2018, yet material divergence in performance by property sectors should be watched closely. While our outlook is neutral for the asset class in the short term, given valuations in the current phase of the economic cycle, long-term factors such as favorable demographics, rising disposable incomes, urbanization, and the proliferation of data storage centers and big box warehousing centers should drive demand. Rising wealth in the emerging markets should also support demand for this asset class.

Farmland

Weather has always had a profound impact on agriculture. When a farmland owner surveys their field, or the farmer walks the uneven ground, their eye is often drawn to the horizon—watching the weather where the crops and clouds meet. With commodities descending to historically low levels, farmers have faced some challenging storms over the past couple of years. Cash rents to landowners have also come under significant pressure. But we believe 2018 may well be the year when the squalls start to calm and the storm clouds begin to clear. So for the long-term investor, looking beyond the apparent horizon, we believe global trends in population, consumption and climate will drive farmland to a highly sought after place on the world stage. Given the current cycle of farmland income and land price levels, 2018 could prove to be a favorable, opportunistic entry point for farmland investors to take advantage of the intersection of increased demand for food and the diminishing supply of land on which to grow it.

The upside of farmland ownership is buoyed by a growing worldwide population with a hunger—not just for food—but for food diversity and previously unaffordable proteins. That same new relative affluence has meant more residential homes on larger lots. That, along with expanded commercial development, has further depleted the world’s supply of arable land into the foreseeable future. These favorable supply and demand trends, along with macro fundamental drivers of appreciation, recurring income stream, and risk reducing diversification benefits, make a strong case for farmland ownership over the long term.

Leasing: Stability and Sustainability

In our view, landowners and farmers have, for the most part, adjusted to the decline in commodity prices and lease rates have settled back into sustainable levels for the current environment. In addition, the increased use of adaptive leasing strategies implemented over the last several years have helped to support revenue in this lower commodity price environment. These leasing strategies, such as a flex lease, are often able to optimize returns from each crop by capitalizing on the advanced improvements in agricultural technology and crop performance analytics.

Lease demand for investment-quality farmland remains strong as preparation for the 2018 crop year begins. Even though projected income levels remain in a cyclical low, farmers still seek to lease land as an alternative to ownership so that they can produce on more acreage without the burden of the capital outlay necessary to purchase land. Most importantly, farmland still produces recurring lease revenue on an annual basis, even though the current cycle has produced lower lease yields than in years past.

Crop Prices: Export Opportunities Produce Possibilities

It is likely that commodity prices will have minimal upside in 2018, but given macro demand, we believe there will be limited downward price pressure. Fortunately, export demand continues to provide support domestically and offers previously unforeseen market opportunities. Price upside in grain markets will be weather-dependent heading into the 2018 growing season in North America. Any significant weather event that leads to reduced global production could provide short-term price support for the grain markets. Over the long term, macro factors such as global population growth and demand for food commodities will facilitate continued need for crop producing acreage.

Land Prices: Supply Meets Optimism

The supply of investment quality farmland is projected to remain thin in 2018. However, the fourth quarter of 2017 experienced increased market activity. There is optimism that this activity will lead to additional opportunities throughout 2018. Land values are projected to remain steady to slightly lower in 2018 as limited supply and steady demand continues to sustain land markets. Additionally, if inflation begins to pick up in 2018 as anticipated, that should further support and improve land values over the long term.

The Bottom Line

Farmland is not an asset class to be viewed in short-term or year-over-year increments. The current cycle is not a new scenario for agriculture. Long-term farm ownership can help to mitigate volatility. Farmland investments offer unique diversification benefits due to low correlations with traditional asset classes. Additionally, given the basic fundamentals of farmland holdings, coupled with opportunities for income and appreciation, we remain steadfast in our long-term favorable outlook.

Timberland

Timberland is sometimes referred to as “dirt with trees on it.” This is truly the heart of timber ownership. Timberland markets are influenced by timber markets, as you would expect, but also have their own stimuli. The land itself may change highest and best use over time, and appreciate over the long term. Institutional investors continue to seek timberland investments as low risk/low volatility opportunities that are non-correlated with traditional investments. The same macro-trends in population growth, global middle-class emergence and increased demand for housing in urban areas impact both timber and timberland values.

Large acreage deals, preferred by institutional timberland managers, have been limited over the last year. Sellers have maintained high expectations for sale values that buyers have resisted, leading to limited closed deals. Sellers have likely been influenced by the prices they paid at the time of entry, which in the case of ten-year-old funds was a time of historic high prices for large timberland deals. Conversely, institutional buyers have lowered discount rates in order to rationalize higher purchase prices in order to close deals and place capital. This “efficiency premium” can be explained both as the price of timely capital placement, as well as the reality that many institutional investors can accept lower returns due to their long-term outlook.

Small acreage deals, largely ignored by institutional buyers, can be influenced by emotional or amenity values that are not supported by investment management. Large and small acreage properties often carry premiums for the reasons discussed. This creates potential opportunities in the “middle market,” which may consist of properties too large for the neighbor or local buyer, and too small for the institutional manager. Yet, even within the middle market, we observe regional differences in timberland opportunities. Over the past year, there have been fewer middle market deals in the Pacific Northwest and the Northeast, while the Southeast has had more active markets for land.

Timber Supply

Timber is, in essence, the logs and other wood fibers that grow on timberland. The value of timber is influenced by supply and demand factors consistent with any other commodity type.

For example, on the supply side we are seeing the oversupply of British Columbia (BC) salvage wood (from the mountain pine beetle epidemic) starting to wane, with reports of some BC mills closing due to lack of timber.

This has had a positive effect on timber prices in the Pacific Northwest. Countering this supply adjustment, the overhang of sawtimber inventory in the Southeast U.S. (from the curtailed harvests post housing crisis) has remained, keeping sawtimber prices low in the region. It has yet to be seen if rebuilding efforts after two major hurricanes will have the effect of absorbing more of the inventory surplus.

Timber Demand

Timberland enters 2018 bolstered by the same global influences that are converging for farmland, leading to optimism for both the land (timberland) and the trees (timber). Demand factors include an expanding middle class in emerging markets demanding and spending more on manufactured goods and housing. In addition, timberland investments have long been known to provide low volatility, a biologic inflation hedge, and risk diversification for portfolios.

There are three primary timber markets: building materials, pulp and paper products, and the growing bioenergy market. For building materials, the slow pace of housing start recovery has stagnated demand, though there has been progress which could prove beneficial in the future. New building technologies, such as wood cross-laminated building materials, and a drive toward renewable and sustainable materials in new construction, may exert positive pressure on saw log markets.

Pulp demand has largely remained stable with the need for packaging products being influenced by the “Amazon effect,” in which a significant boost in online purchasing has resulted in increased use of wood-based packaging. Additionally, the increased global demand for consumer goods and fluff pulp products provides attractive long-term opportunities for rising timber prices. Pulp demand from newsprint is expected to decline, but OSB (oriented strand board) and bioenergy sectors will continue to grow and play a bigger role in the pulpwood markets.

Lastly, the influence of wood pellet production for renewable and sustainable fuel continues to slowly grow market share. Continued development of pellet facilities in the Southeast and demand for “green” fuels in Europe offers a positive outlook.

There has been significant interest in the role that the burgeoning millennial generation will play in the housing market recovery and the subsequent demand for new home starts and timber. But recent studies show that millennials are not purchasing their first home until the average age of 32, while the average age of millennials themselves falls far short of that—23 in 2016.1 We expect it will take several more years before the large wave of millennials moves toward home ownership and influences from that wave will take place over a long horizon.

Energy

Global energy demand has continued to grow and it is expected to rise by nearly one-third between 2013 and 2040. Power will continue to account for the largest portion of the total, increasing from 43% in 2015 to 47% by 2035, followed by industry at.28% and transportation at 17%.²

In order to meet this increasing demand while addressing climate change concerns, the world is continuing to transition to alternative energy sources and improving energy efficiency. Despite the dramatic decline in fossil fuel prices since 2014, dedicated support from governments and strong commitment from private investors led to the largest yearly addition to global renewable power capacity in 2015.—.147 gigawatts.—.and the lowest-ever prices.²

Oil and Gas

Forecasts by the EIA (Energy Information Administration) predict an increase in the per barrel price of West Texas Intermediate crude oil of $2 in 2018 over 2017, as well as a production increase of 800,000 barrels per day, indicating a robust scenario which will partially offset OPEC’s initiative to reduce total worldwide crude oil production in order to raise prices.

The EIA also forecasts that domestic natural gas production in 2018 will be over 6 billion cubic feet per day higher than in 2017. Growth in natural gas exports, as well as domestic consumption in 2018 are expected to contribute to higher prices also. Recent and upcoming increases in LNG (liquefied natural gas) production, primarily in the U.S. and Australia, has created a convergence in global gas prices, with prices in lower-cost regions rising and prices in higher-cost regions decreasing. As the worldwide production capacity of LNG increases, we expect this pricing trend to continue.

Natural gas continues to replace coal for power generation due to being cheap, abundant and more environmentally responsible. For 2018, the EIA expects 32% of electricity generation from natural gas and 31% from coal. Coal production for 2018 is expected to drop about 2.5% due to lower exports and flat coal consumption.

The acceleration of shale drilling that has occurred in the U.S. in recent years is showing signs of leveling off. Rig count in the third quarter of 2017 grew at less than one third the rate of the four previous quarters. Contributing to this trend is a slowing of technological innovation and an increase in labor costs and field services.

Renewable Energy

Given macro-trends such as population growth and energy demand, tied closely to increased concerns regarding climate change and the environment, renewable energy is slowly pushing itself forward as an emerging theme to watch. Wind energy capacity is expected to grow by 9% and solar energy capacity by 11% in 2018. While these alternative energy sources still have issues with relative high costs and storage, those costs are declining and the strength of lower CO2 emissions drives desirability. In addition, the private sector is showing a stronger commitment, and ability to see relatively high sunk costs as a long-term investment.

Onshore wind power installations are predicted to double over the next five years. Economies of scale may ease problems with financing and infrastructure, yet challenges of storage and reliability for both wind and solar have yet to be overcome. After all, the wind doesn’t always blow, and the sun doesn’t always shine.

Commercial Real Estate

Performance of commercial real estate (CRE) has generally mirrored the performance of the domestic economy, while reflecting changes in the global economic landscape, such as rising disposable incomes, urbanization and the accumulation of wealth in emerging markets. Heading into 2018, this positive economic outlook and balanced market fundamentals serve as a backdrop for technological innovations and demographic shifts driving dynamic changes in demand for office, retail, industrial and multifamily properties.

Consistent with our previous commentary, we expect relatively fair valuations and positive performance for commercial real estate heading into 2018, driven largely by continued growth in U.S. GDP, a healthy job market and increasing consumer spending. Continuing low interest rates—albeit rising—and a deep flow of domestic and offshore capital emphasizing direct investment in U.S. real estate also help to support this view.

While not all U.S. property sectors and markets are synchronized at this point, there are continuing positive signs that the U.S. CRE markets are generally in balance with the exception of some specific property types and markets, including power centers and the bifurcated regional mall sector, and in some multifamily and central business district office markets.

Ultimately, the current cycle is in the mature phase and eventually will end, and investors need to play it forward in considering how long-term CRE investments will both bridge into the next cycle and perform in the evolving and dynamic economic landscape that is being shaped by innovations in technology and shifts in demographics.

Emphasis on Fundamentals

In light of our assessment of relatively fair market valuations and a maturing cycle, supply-side fundamentals for rentable space across the major property sectors and in most U.S. markets are­—with some exceptions—generally in good shape and can be expected to remain that way into 2018. The demand-side of the equation for rentable space also continues to be strong. Increasingly, rents and operating profits at the property level will be the main driver of real estate returns, as growth in value from cap rate compression has long since run its course. As always with commercial real estate, market fundamentals—occupancy, rents, supply and demand—and investment results will vary by property type, location and economic conditions, and emphasis should center on well-located properties in strong regions that exhibit attractive rent roll and durable cash flow characteristics. For core properties vacancy rates remain low, largely trending downward on a nationwide basis across the major groups of apartments, retail, industrial and office (NCREIF).

Fundamental drivers of CRE returns are cap rates and the supply and demand for space, especially as reflected in changing occupancy levels and rents. At the macro level, general economic growth as measured by GDP drives growth in jobs, which in turn drives demand for real estate and eventually is reflected in occupancy levels and rents. Broadly over the past couple of years, occupancy levels for real estate have been strengthening and rents have been growing, notwithstanding some soft spots in certain markets and property types. Assuming construction levels remain at or near current levels, CRE lending, which currently appears to be reasonably well-disciplined, does not get out of control and key macro drivers for CRE—growth in GDP and jobs—continue as expected along the current trajectory, we can expect continuing good health in the fundamentals of most property markets. On a composite basis, net operating income (NOI) growth for core properties over the past several years, especially since CRE began to emerge from the great financial crisis in 2010, has largely been steady and consistent at attractive levels, despite the general absence of inflation (NCREIF).

CRE pricing and CRE yields as reflected in cap rates are driven in large part by capital market considerations, specifically how much capital is being allocated to and flowing into CRE investments. Broadly, cap rates represent CRE yields and comprise risk-free, risk-premium and growth components. Going into 2018 with a 10-year Treasury yield of about 2.35%, today’s indicative cap rate spread is trending near long-term averages, suggesting generally fair market pricing for core real estate.

Measured increases in interest rates due to a growing economy are potentially positive for CRE. As a growing economy results in increased demand for rentable space while at the same time the Fed pushes short-term rates higher, the growth in the new development pipeline may slow due to an increase in the cost of capital for new CRE projects. Likewise, a resulting increase in long-term interest rates due to increasing inflationary expectations will likely be reflected positively in rents and will help to partially offset some of the eventual increase in cap rates.

Key Disruptors Drive Market Dynamics

Looking across the skyline of America’s cities and towns, dynamic changes driving commercial real estate center on demographics and digitization. Telecommuters are being pulled back into office space, in some cases with dramatic changes in floor plans to densify usage and accommodate new technologies. Tertiary market malls are converting vacant obsolete department stores into gyms, offices and other potential uses. Online meal-delivery services are gobbling up retail storefronts.

Retailers are acquiring online ecommerce capabilities and pure-play online retailers are establishing and acquiring physical stores, integrating digital with brick-and-mortar, both operating on the backbone of last-mile delivery warehousing and high-cube distribution centers. And infill shopping centers and Main Street retail, once nearly written off as malls dominated the retail landscape, are benefiting from secular trends of urbanization and gentrification, driven in large part by the collective economic gravity of millennials.

For investors, the critical factor to keep in mind is that while trends in demographics and digitization are altering the commercial real estate landscape in fundamental ways, the fundamentals of commercial real estate investing have not changed.

In Summary

These investment themes provide a broad context for investors to understand the current state of real asset investments. That said, there are many potential downside risks to this macro outlook: increased protectionism which disrupts global trade, inequality that stalls per capita incomes in emerging markets, or a global economic slowdown that comes sooner than expected.

However, we believe that volatility for direct investments in the above assets should be relatively low if held over a long-time horizon. This is one of the many advantages of holding specialty assets, in addition to investment diversification, inflation protection, favorable risk-adjusted returns, and the potential to generate cash flow.