The S&P/ASX 300 Index (ASX: XKO) share Rural Funds Group (ASX: RFF) has suffered a fall of close to 40% since its peak during COVID-19.
I was recently contacted and asked why I am positive about the farmland real estate investment trust (REIT) despite the falling share price.
There are a number of reasons why I'm just as positive, if not more positive, at this lower level.
It's understandable why the market has punished the share price considering the higher interest rate. In theory, asset values such as farms do fall with higher interest rates.
How much could farm values fall? It's hard to say. But, the higher interest rate situation does put pressure on Rural Funds' finance costs, which can typically be the single biggest expense for a business like a REIT.
But, here are some reasons why I'm still very positive on the ASX 300 share.
Distribution income yield
While the Rural Funds share price has been falling, the passive income yield that it offers has been increasing.
Rural Funds has been growing its distribution by at least 4% each year since it listed and I think the business will be able to keep growing the distribution in future years because of a few reasons I'll outline below.
But, the current total payout of 12.2 cents per unit for FY23 represents a total yield of 6.25%.
Assuming the business grows the distribution by another 4% in FY24, it would be a distribution yield of 6.5%. I think that's a very attractive yield for a relatively defensive asset class of farmland.
Debt hedging
Rural Funds has entered into an increased level of interest rate hedges which will hopefully shield it from a lot of the higher interest rate costs.
In its FY23 half-year result, it said that it had entered into $175 million of additional hedges since 1 July 2022. Hedging will increase from $190 million in FY23 to $402 million in FY24. Its term debt drawn at 31 December 2022 was $504.4 million, so a large proportion of the debt is hedged.
The $402.2 million that is hedged for FY24 is at a weighted average hedge rate of 3.27%, so the interest rate increases may not impact the finance costs significantly.
Rental income continues to grow
In the HY23 result, Rural Funds pointed out that its property revenue grew by 7% primarily due to increased rent, rent on capital expenditure and new leases.
Almost half of its revenue is linked to CPI inflation, so the higher inflation is pushing this portion of the rent higher at a strong rate. This can offset some of the impacts of the higher interest rates, and help support the farm values.
Another third of the revenue has a fixed increase each year, which also boosts the ASX 300 share's revenue.
Rural Funds has a weighted average lease expiry (WALE) of 12.3 years, so there's a lot of rental revenue locked in for the coming years.
The tenants are large operators, so I think they're as safe as they could be for Rural Funds.
Farm values could hold up
As any property investor might agree, we can only truly know what a property's value is when it goes up for sale.
In the FY23 half-year result, Rural Funds said that its adjusted net asset value (NAV) increased by 3% to $2.78 which it put down to revaluations. Don't forget, water entitlements make up close to a fifth of total adjusted assets, which can behave differently to farm values.
I believe the fall in the Rural Funds share price has more than made up for the potential fall of asset prices.
A few months ago, the ASX 300 share released its latest newsletter which outlined why there has been a positive correlation between inflation, commodity prices and farmland values since 1900, suggesting that farmland values can keep rising over time.
Productivity improvements
The business is expecting to benefit in future years from its development pipeline, which can boost rental returns and isn't currently being reflected in the annual rental profits.
First, there is a 3,000 hectare macadamia development, which is forecast to be completed by FY25. Second, there is the development of an additional 2,000 hectares, which is forecast to commence in FY25 – Rural Funds will look for a tenant, or tenants, closer to the development commencement.
Third, there are 475 hectares of mature orchards going through improvements before seeking a long-term tenant.
Finally, productivity improvements are occurring on five cattle and cropping properties before seeking a tenant.
I think each of these will help boost the capital value and rental potential of Rural Funds.
Foolish takeaway
I'm still optimistic about the ASX 300 share, particularly at this lower level. I'm not expecting it to get back to a $3 share price any time soon, but it could get a boost when interest rates start dropping back towards 3%.
