Farmland Is The Next Big Thing in REITs

6/30/2014
Farmland Is The Next Big Thing In REITs - Farmland Partners Inc (NYSEMKT:FPI) | Seeking Alpha
Farmland Is The Next Big Thing In REITs

Jun. 28, 2014 8:43 PM ET
by: Dane Bowler
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Summary
Farmland Partners has become cheap on exaggerated fears of conflicted interest.
An accretive acquisition pipeline along with internal rental rate growth should catalyze returns.
Farmland Partners should trade at a high resting FFO multiple due to the characteristics of its underlying
assets.
The Buy Thesis

Farmland Partners Inc (FPI) is a very new and very small farmland REIT which is largely misunderstood and mispriced
by the market. This creates an opportunity to buy in at a price substantially below fundamental value and capture
superior returns as it normalizes. 5 catalysts are positioned to enhance returns:
1.
2.
3.
4.
5.
Accretive growth pipeline in an untapped market

Dissipation of the perceived conflicts of interest
Multiple expansion as diversification places FPI among the safest equity investments
Secular trends favoring farmland
Substantial upside potential of land for Higher-Better-Use {HBU} or selling of mineral rights
Each of these will be explained in greater detail, but let us first introduce FPI as this company is likely new to most,
given its small size.
Farmland Partners
Farmland Partners Inc is a farmland REIT which buys tillable land from farm operators and rents it back to them. The
advantage of this platform to farmers is that it allows expansion of operations without upfront capital cost. Thus, farmers
gain scale and FPI receives reliable rental revenues.
FPI came public on April 10th, 2014 at a price of $14/share. It has since dropped to $12.50 which we believe to be an
opportunistic entry point.
(click to enlarge)
http://seekingalpha.com/article/2291113-farmland-is-the-next-big-thing-in-reits
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A likely reason for the drop is a lack of clarity in its structure. In addition to the roughly 4mm shares of public common
stock, FPI has 1.945mm OP units outstanding. These are largely owned by Pittman and Hough who received them in
exchange for the initial property portfolio. We will not go into extensive detail on the initial properties as they have
already been sufficiently covered in an article by Chris Katje with an excerpt quoted below.
"The current portfolio has 38 farms. Here is a look at the five largest and the total acreage and rental income for the
company:
Acreage Annual Rental Income
Pella Bins and Tracks (Illinois) 490
$229,497
Kaufman (Illinois)
427
$170,800
Cleer (Illinois)
298
$155,895
Matulka (Nebraska)
242
$144,300
Big Pivot
342
$136,608
Total
7,323
$2.64 million
"
Annual rent of $360/acre is fairly high for row crop farmland, but there is a reason for it. Much of the land is well irrigated
and it comes with supporting grain storage facilities.
While the initial portfolio is strong, the greater opportunity comes from the platform's unique access to an untapped
market.
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Total Return Catalyst #1: Growth

FPI has identified an approximately $150mm pipeline of potential acquisitions. Given its market cap of only $75mm, this
will undoubtedly move the needle. Despite only being public for 2 months, FPI has already negotiated numerous
accretive purchases. The acquisition dates in the table are links to the press releases.
Acquisition date Location Price
Acres $/Acre Cap Rate
4/21/2014
Colorado $8.75mm 3,696 $2,367 4.63%
5/29/2014
Colorado $24.5mm 12,500 $1,960 5%
6/4/2014
Nebraska $1.0mm
640
6/23/2014
Arkansas $4.6mm
1,250 $3,680 5%
Total
n/a
$1,562 6.25%
$38.85mm 18,086 $2,148 4.95%
While 4.95% may not seem like an impressive cap rate relative to other REIT sectors which can get 6%-9% even in
today's compressed cap rate environment, we must consider the difference in asset type.
Farmland has virtually no capex, has a tendency to increase in value over time, carries nearly 100% occupancy, and is
not susceptible to economic cycles. Assets of such a defensive caliber would typically garner cap rates closer to
3%-3.5%. How then is FPI able to source such a large pipeline at a weighted average cap rate of 4.95%?
Well, it is because it has a near monopoly in the space. There is only 1 other publicly traded farmland REIT, Gladstone
Land (LAND), and it focuses on different kinds of assets in different geographies. LAND tends to acquire fruit and
produce bearing land in warmer climates, while FPI focuses on row crop farmland in central US. Thus, the two
companies are unlikely to be rival bidders for a farmland acquisition. Farmland Partners will be one of few choices for a
Midwestern farmer looking to capitalize row crop farmland in a tax advantaged way. While there may be competing
private equity bidders, FPI has the ability to issue OP units which allow the seller to defer taxation. In many cases, the
book value of a farmer's land is deeply below market value so the tax event would be substantial and many bidders
would be inclined to choose FPI's OP unit purchase over cash from a private equity bidder even if FPI is offering a lower
bid; hence the outsized risk adjusted cap rate FPI is able to get.
The net effect of these and future acquisitions is substantial FFO/share growth. The already negotiated deals take pro
forma FFO/share up to ~$0.43 from only $0.11 in 2013. We believe that FPI's pipeline could lead to $0.60 FFO/share by
2016.
Capital to Support the Growth

In its April IPO, FPI raised $61.2mm. 6 days later, it took out a loan for $30.8mm. While a portion of this went toward
paying down some encumbrances on the initial portfolio, a large chunk remains for future acquisitions. We estimate
about $35mm available before further capital raises are required.
Total Return Catalyst #2: Dissipation of Perceived Risks

FPI intended to price its IPO in a range from $14.0 to $16.0. It came in at the low end at $14.0. Since that time, it has
dropped a further ~10%. We believe that much of this discounting is related to conflicts of interest inherent in the
structure.
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Since much of the initial portfolio consists of farms that were owned by Pittman, who now runs FPI as CEO, the rental
contracts are rather unusual. Pittman's company is renting some of its initial farmland portfolio to Pittman's farms. Thus
far, it seems Kosher as the weighted average rental rate of $360/acre is roughly in-line with market rates for land of that
quality/location. The concern lies in what happens when those contracts expire and renewals need to be negotiated.
How will Pittman fairly negotiate with himself?
From FPI's 10Q, we can see that this lease expiry is a near-term concern.
We believe that the market is overestimating the risk associated with the conflict of interest on these leases. While
Pittman may be an honorable man who upholds fiduciary duty to shareholders, the argument that the conflicts of
interest won't hurt shareholders does not even require that. Even in the unlikely event that Pittman is corrupt, it would be
exceptionally difficult for Pittman to give himself unfairly cheap rent for the following reasons.
1. Transparency: Rental rates to each individual farm have been disclosed, so roll-downs would be easy to spot.
Market rates are also fairly easy to uncover.
2. Tenant changeover is fairly simple for farmland. As 100% of rent is usually paid before the spring planting
season, when the ground is unplanted, renting the land to a different tenant would simply be a matter of a couple
contracts. There would be no tenant-specific improvements to change over as there would be in retail or office
(signage, partitions, et cetera).
Consequently, we believe that Pittman's farms will most likely renew at the fair market rate or FPI can find a new tenant.
Additionally, the concentration of rental revenue with related parties will substantially fade as FPI grows.
(click to enlarge)
The percentage of acres leased to related parties has already dropped materially just 2 months since IPO and we
expect it to become somewhat negligible as Farmland Partners matures.
To summarize this point, the actual risk is less likely to occur than the market pricing suggests and the magnitude of
the risk is diminishing with each diversifying acquisition. As this plays out, the associated discount will approach 0, thus
giving shareholders extra returns in the restoration of normalized pricing.
Total Return Catalyst #3: High Stabilized Trading Multiple

FPI is presently trading at about 30X the FactSet 2015 FFO/share consensus. As FPI is so new and so small it has a
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tremendous growth rate.
Data from SNL Financial

Thus, the reason its multiple is high now is because the growth is priced in. A 30X multiple while rapidly growing implies
a substantially lower stabilized multiple. In other words, the market is anticipating multiple compression as FPI matures.
However, there is a fundamental case that suggests Farmland Partner's STABILIZED multiple should be around 25X
FFO.
Justification for 25X Stabilized Multiple

Among REITs there is a stratification of normalized trading multiple based on characteristics of the underlying assets.
(click to enlarge)
Data from SNL Financial. Farmland multiple is our projection

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Innumerable factors influence normalized multiples, but some of the most important ones are:
Asset Life/Residual Value
Maintenance
Volatility
Hotels tend to trade at the lowest multiples as they require large amounts of maintenance capex and have extremely
volatile revenues. Self Storage REITs trade at the highest multiple among the primary REIT asset classes as their
assets require almost no maintenance, have long lives and can change tenants easily.
Farmland REITs should arguably trade at the highest multiple given certain superiorities of their assets. Not only is
maintenance extremely low, but land appreciates over time. As food is a necessity, farmland is nearly immune to
recession. Data from NCREIF shows farmland to have performed well every year since 2003, including the years of the
Financial Crisis.
(click to enlarge)
The immaculate historical performance and fundamentally low risk profile of land suggests a 25X multiple would be
appropriate.
Total Return Catalyst #4: Secular Farmland Tailwinds

As global land becomes more urbanized, less land is available for farming as a percentage of the population.
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Presumably, food demand would increase linearly with population, so the demand per acre of farmland is poised to
increase meaningfully. However, this is not the whole story. We must take into consideration the productivity of
farmland. If each acre can produce more food, less farmland would be needed.
To obtain a view on the whole picture, we would need to look at world food production, which includes both acres and
productivity. The data below is provided by the OECD-FAO agricultural outlook.
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Coarse grains provide a decent proxy for the staple crops typically grown on FPI's land. From now until 2022, supply is
forecast to increase by 12%. In contrast, demand for coarse grains is expected to increase by 17% over the same
period.
This suggests that staple commodity prices will increase at a rate in excess of inflation. Assuming a constant ratio of
farmland revenues to farmland rent, FPI's rental income should also rise at a rate above inflation on a same property
basis.
The global agricultural outlook lends FPI intrinsic growth which will sum with their external acquisition growth for sizable
overall gains to FFO/share.
Total Return Catalyst #5: Upside Potential from Land Value

One of the benefits of owning vast amounts of land is that it can appreciate unexpectedly. Land near developed areas
can gain new use, termed Higher-Better-Use, as cities expand. The value of the land for development may greatly
exceed its value for farming such that it can be sold at a premium to its former value. Of course, much of FPI's land is
rural in nature so this avenue is somewhat unlikely. However, rural land has potential to contain various natural
resources for which extraction rights can be sold.
In my opinion, this is a primary factor that separates FPI from LAND. Since LAND focuses on more specialized farms
that sell at drastically higher $/acre, it will not have as much acreage in the long run. Thus far, FPI has been purchasing
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land comparatively cheaply at around $2,150/acre such that it will amass a vast expanse of land. Superior acreage
greatly increases the chance of HBU or mineral related upside.
Summary of Buy Thesis

Farmland Partners has exceptional growth potential both internally through rent roll-ups and externally through a large
and accretive pipeline. Much of this upside is not yet priced into the market as fears of conflicted interest are on the
forefront of investor's minds. As these concerns fade and FPI gains diversification, we anticipate capital gains.
Magnitude of Opportunity
Earlier in this article we suggested a normalized trading price of 25X forward FFO. Based on the already consummated
acquisitions along with the pipeline and our tenant renewal expectations, we estimate 2017 FFO/share of $0.65. This
translates to a 2 year price target of $16.25. With 2 years of dividends ($0.84) we anticipate total returns of ~35% using
the current price of $12.60.
35% returns over 2 years may not seem that spectacular, but we must consider the asset class. Assets of this
resilience can rarely be expected to generate such returns. Thus, on a risk-adjusted basis, 35% total return over 2 years
represents a disproportionately strong return.
While we have spoken very highly of the safety of farmland, no investment is without risk, so we must give the downside
due respect.
Risks and Concerns

Diversification: While FPI will diversify over time through acquisition, concentration is a concern in the near term,
particularly in Illinois.
(click to enlarge)
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If a multi-year drought or other environmental hazard hit Illinois, FPI could suffer rent roll-downs or even default on current
contracts.
Lack of track record: While Farmland Partner's management team is experienced in both farmland and in business; it
has virtually no track-record at managing a REIT. It remains plausible that FPI could fail to capitalize on opportunities
that more experienced REITs would see.
Technology: Various technological advancements could reduce the overall global demand for farmland through increased
yields/acre. Historically, yields have increased rapidly but are expected to slow. Unexpected improvements in farming
techniques, plant genetics, or hydroponics could reaccelerate yield gains, thus lowering demand for farmland.
The Bottom Line

Farmland Partners is temporarily trading below normalized pricing due to temporary concerns. The underlying business
is fundamentally strong and this strength will be reflected in the market price as the near-term concerns fade.
Disclosure: 2nd Market Capital and its affiliated accounts are long FPI and LAND. I am personally long FPI. This article
is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the
writer.
Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market
cap. Please be aware of the risks associated with these stocks.
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The Buy Thesis

Accretive growth pipeline in an untapped market

Total Return Catalyst #1: Growth

Acres $/Acre Cap Rate

Colorado $8.75mm 3,696 $2,367 4.63%

Colorado $24.5mm 12,500 $1,960 5%

$38.85mm 18,086 $2,148 4.95%

Capital to Support the Growth

Total Return Catalyst #2: Dissipation of Perceived Risks

Total Return Catalyst #3: High Stabilized Trading Multiple

tremendous growth rate.

Data from SNL Financial

Justification for 25X Stabilized Multiple

Data from SNL Financial. Farmland multiple is our projection

Total Return Catalyst #4: Secular Farmland Tailwinds

Total Return Catalyst #5: Upside Potential from Land Value

Summary of Buy Thesis

Risks and Concerns

The Bottom Line

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