February 2008 VOL. 2

Grape Expectations
Institutional investors seek vineyards and wineries

Although most people look at a glass of wine and see a tasty libation, many commercial real estate investors have started to see dollar signs when they look at those same glasses of wine. These investors, who have traditionally invested in core real estate properties like office buildings, industrial warehouses, shopping centers and apartments, are now plowing their capital into vineyards and wineries.

"Big institutions, along with high net-worth investors, are adding vineyards and wineries to their investment portfolios, often as part of the commercial real estate holdings," says Richard Wollack, co-chairman and co-CEO of Premier Pacific Vineyards, a Napa, Calif.-based company that that has partnered with CalPERS to develop 33 vineyards along the West Coast. "The two main reasons are attractive returns and a compelling story of supply and demand."

Vineyards and wineries have many characteristics of a classic, desirable commercial real estate investment - specifically, they offer both operating profits and capital appreciation. Like office buildings or apartment communities, vineyards and wineries are generating cash flow on a regular basis, usually by producing grapes and/or wine. Additionally, investors benefit from the increasing value of the real estate - in this case, the actual land used to grow the grapes and house the wineries.

"The wine industry is just now showing up on the commercial investor radar screen even though it has been growing steadily throughout good times and bad," says Vic Motto, chairman and CEO of Global Wine Partners, a St. Helena, Calif.-based investment bank that specializes in the wine business, along with managing a vineyard REIT in partnership with Kansas City-based Entertainment Properties Trust and an international wine investment fund. "There's a lot of opportunity for investors, but they have to be smart about it because grape growing and wine making requires expertise."

Investment strategies
Wine drinking in the U.S. isn't a new phenomenon but Americans are drinking more of it than ever, particularly Baby Boomers and their children. Boomer children, also known as Generation X, are guzzling wine at twice the rate of previous generations. By 2010, the U.S. will be drinking 3.8 billion bottles of wine annually, making it the biggest wine consumer in the world, according to Silicon Valley Bank.

Commercial real estate investors want a taste of the action and have entered the wine industry in three different ways - the development of vineyards, redevelopment of existing vineyards, and the sale-leaseback of wineries and vineyards.

Premier Pacific Vineyards, for example, has chosen to develop vineyards instead of trying to seek out existing vineyards and wineries. "We view this as a real estate development strategy," Wollack says. "We find the finest parcels of raw land - they could be an alfalfa field in Washington State, a cherry orchard in Oregon or a cattle ranch in Sonoma County - and develop them into vineyards."

Last summer, Premier Pacific completed its second joint venture with CalPERS and has invested a total of $200 million in equity with the institution. It has since raised $50 million through a partnership with a large university endowment to develop six more vineyards. Additionally, Premier Pacific is raising a $100 million to $200 million fund that will also invest in vineyard development.

The fund, which will kick off its development program this month, has received investment from several pension plans and endowments, Wollack says, explaining that institutions are attracted to wine-related investments because they add diversity to their portfolios. "The research is clear that vineyards, although they are a real estate asset, don't correlate with traditional real estate, which evens out the performance of the portfolio," he notes.

Premier Pacific is only interested in developing vineyards that produce high quality wine, Wollack says, adding that 51 wineries buy grapes from the company including such high profile brands as Cakebread and Beaux Freres.

The company has an entire team dedicated to selecting those areas that will produce the very best grapes, and once those locations are under its control, Premier Pacific puts together the development plan, chooses the different grape varietals and works through the art and science of creating the vineyard. It takes five years to bring the vineyard to full fruition, and then the company looks to sell the vineyard or lease portions of each vineyard to wineries. For the properties that it doesn't sell off, Premier Pacific's ultimate exit strategy is to aggregate several vineyards and to create a real estate investment trust (REIT).

"We could probably invest $200 million in equity every year for the next five years," Wollack says. "We can't put the money out any faster than that because there's only so much land you can acquire at any given time. It's scarce."

Silverado Wine Growers, also headquartered in Napa Valley, has a different strategy - raising money from institutions and then buying existing vineyards that have been underutilized. The company often replants the vineyards, lines up new winery contracts and sells grapes at a higher price - generating yields from both operations and real estate appreciation.

In contrast, Vintage Wine Trust and Kansas City-based Entertainment Properties Trust, both of which are REITs, have employed a sale-leaseback strategy, buying a vineyard or winery property from an operator and then leasing it back.

Motto, who helps to manage EPT's wine investments, contends that investing in vineyards and wineries can be just like investing in an office building. "Like any other sale-leaseback, we've made vineyards and wineries passive investments where the operator takes on all the risk," he explains.

But, the sale-leaseback model has been challenging to implement, according to industry experts. For example, many vineyard and winery operations are family owned, and the owners are disinclined to sell off the "family silver". However, the ownership of many of these properties is being transferred to younger generations, who lack the desire, financial strength, and/or skills to continue with the family business. As a result, many of these properties will come to the market, providing new opportunities for investors with an acquisition strategy.

And, there are plenty of investors out there, according to John Compagno, a partner with Holland & Knight's West Coast Land Use and Environmental Law Team. "For a lot of investors, the creative aspect of this type of investment - the idea that you're making something unique every time you grow a grape or cork a bottle a wine - adds value beyond the financial return."

Many grape returns
Demand for vineyards and winery operations is strong and prices are high. Napa Valley vineyards have set the high-mark for valuations, says Tony Correia, president of Correia-Xavier, a Fresno, Calif.-based company that does vineyard appraisals and valuations. It's not usual for land to trade at $275,000 to $300,000 per acre - a hefty price equates to more than $6 per square foot of land and about $250 per vine.

As land prices have increased, cap rates for these properties have compressed. "Cap rates are four to five percent in the premier areas," Wollack says.

Admittedly, the return on most wine properties is somewhat lower than most commercial real estate investors are used to. However, these investors are attracted to wine properties' continued real estate appreciation, which ultimately provides a good return.

"The long-term expectation is that investors will see some really strong returns five to 10 years down the road as grape prices continue to increase," says Gordon Axton, principal of the Axton Wine Group, a Napa, Calif.-based appraisal company. "If you look historically at the overall yield rate, folks that have invested in the last 15 years have made very strong yields of more than 12 percent and as much as 20 percent in Napa." He says that he's seeing more trades of vineyard properties than in the past, with an average transaction amount of $20 million.

In general, vineyard real estate has appreciated at a compound annual growth rate of 12 percent over the last 30 years, and from 1996 to 2006, Napa County real estate appreciated at five times the Dow Jones Industrial Average.

While the Napa Valley remains the sexiest region, and clearly, the most expensive, the outlying valleys of Napa County can provide higher rates of return, as grapes can command relatively strong prices due to the Napa Valley. The new darling of the professional investors, Oregon's Willamette Valley offers relatively low cost land with the potential to produce quality Pinot Noir and Chardonnay.

Made in the U.S.A.
More often than not, Americans are drinking American-made wine: foreign wines accounted for less than one-third of the wine sold in the U.S. last year despite the competitive price points. Australia, Spain, France and Chile are big players in the U.S. wine industry, although production in these countries has decreased significantly compared to the past several years.

At the same time, Americans' wine palate has become more sophisticated. In the past, most of the wine consumed in the U.S. has been commodity wine - wine that sells for under $10 per bottle. Today, however, there's greater demand for premium wines - those that cost $25 per bottle or more -- and sales of wine in this segment have increased more than 30 percent over the past three years, according to Silicon World Bank.

"Wine is one of the few organic growth industries in the United States," Motto points out. "In most industries you're just competing to take a piece of the pie, but with wine we're actually expanding the pie."

But as demand for wine grows, the U.S. is facing a shortage of grapes. Although the industry suffered through a glut of grapes over the past several years - 2005 was the biggest grape crush in history with 3.2 million pounds of grapes crushed for wine - vineyard operators did not plant many vines during that period. In fact, industry players expect a grape shortage in 2008 for all grape varietals except for Merlot.

"The general belief is that we'll have a shortage of grapes both this year and 2009," Correia says. "If that happens, growers can increase grape prices and wineries can increase wine prices, which causes dramatic increases in land values and greater operating profits."

The grape shortage will be especially acute for premium grapes, Correia notes, adding that about two-thirds of the vineyards in the U.S. produce grapes that make commodity wine, while the remaining 30 percent provide grapes for the premium wine sector. Although there are vineyards and wineries in every state (North Dakota was the last state to get a winery), these premium-wine making grapes can only be grown in specific locales. Specifically, Northern California's Napa and Sonoma Counties and select parts of Oregon's Willamette Valley produce the best grapes and the best tasting wine, experts contend.

"There is a limited amount of land suitable for growing premium grapes," Motto explains, pointing out that vineyard investors are protected from competition, similar to the benefits traditional commercial real estate owners enjoy in high barriers-to-entry markets.