Dwight Aakre, farm management specialist, NDSU Agribusiness and Applied Economics Department, Published October 29 2012
Spotlight on Economics: Flexible land rental contractsA flexible land rental contract is an agreement between a landowner and a renter that includes a provision for adjusting the actual rent paid based on the results of the current crop year. The rapidly changing land rental market has fueled interest in flexible agreements, although they still are a minor percentage of all rental contracts.
Farm commodity prices, yields and operating expenses often are uncertain.
Therefore, operators and landowners may hesitate to commit to a fixed cash rent, especially for more than one year. Operators fear a fixed cash rent agreement could pose a real hardship if commodity prices decline, if poor growing conditions reduce yields or if input costs increase substantially.
Landowners believe they should share in the benefits from a sharp rise in crop prices or higher than expected yields. At the same time, neither party may desire a crop-share leasing arrangement. Therefore, the operator and landowner may turn to the use of a flexible cash rent of one kind or another.
Cash rents are flexed primarily by:
* Flexing for changes in crop price only
* Flexing for changes in crop yields only
* Flexing for crop price changes and yield variations
Be very cautious if considering using either crop price only or crop yield only as the factor to calculate the flexible portion of the rent. Both are simple to understand but significantly increase the risk to the tenant.
It is common for yield and price to move in opposite directions. The interest in flexible rents by landowners often is a result of a large rise in commodity prices, which has occurred this year. However, yield is the other half of the revenue calculation. If ignored, it can result in disastrous consequences for the tenant.
While we have experienced good yields in our area, one only has to look to our south to see the impact. Despite a big increase in crop prices, yields for many producers in states such as Iowa, Illinois and Missouri have been reduced enough to mean revenues actually will be below average, resulting in less ability to pay rent. Thus, it is highly recommended that flexible rent should be determined based on the total revenue. Total revenue should include the crop sold, value of the crop stored and crop insurance indemnity payments.
A simple way to accomplish this is to set the total rent due equal to some
percentage of the total revenue. This would be nearly identical to a crop-share lease, except the landowner never takes ownership of any grain.
The appropriate percentage should be different for various crops to reflect the large variability in the direct costs for each crop. This arrangement means the total rental payment is flexible. That much variability in the amount of rent paid often is not acceptable to landowners or tenants.
The majority of flexible agreements have a base amount of rent, with provisions to determine the flexible portion of the rent. If a flexible cash rent contract is to reduce risk for the tenant, it must either allow for both an increase in rent when revenue is above the target or a decrease in rent when revenues fall below the target. If it only provides for an increase when revenues are above the target, then the base rent should be less than the rent would be on a cash rent contract without a flexible provision.
Rental agreements that provide for a downward adjustment to the base rent are not very common for obvious reasons. The current land rental market is a seller's market, with the landowners being the sellers. There is tremendous competition for rental land, so the landowners do not have to accept the risk of a lower rental payment when conditions would warrant it.
An example flexible rental agreement can be a base rent of "X" dollars, plus an addition to the rent if the total revenue is above some predetermined level. While this is a relatively simple example, it leaves a lot of latitude in determining the level at which additional rent kicks in and how to determine what that amount should be. A suggested starting point for negotiation could be a base rent 10 percent below the typical cash rent, with a bonus (flex rent) coming into play when total revenue exceeds an amount equal to the average yield on that farm multiplied by the spring price used for multiperil crop insurance. The average yield could be the insurance average production history (APH) yield on that unit. The bonus or flex rent could be one-third of the total revenue
above this amount.
The above example makes no reference to the cost of production, which is
obviously important in profitability. With current prices, the spring insurance price likely is high enough to ensure the operator covers all expenses before a bonus rental payment applies. However, crop insurance prices follow the futures market price up and down. Therefore, it likely is that, in some years, the value calculated by multiplying the APH times the spring insurance price may not cover all costs. This can be dealt with by placing a minimum income threshold to be met if the example above is not high enough to cover costs.
A flexible rental contract can be a useful risk management tool for producers if careful thought goes into designing it. The bottom line is that it transfers some of the risk to the landowner in return for the potential to receive some of the profit in good years.
A good source for information on rental agreements for agricultural assets is the website developed by the North Central Farm Management Extension Committee at http://aglease101.org/. The committee consists of Extension farm management specialists from the 13 north-central states.
The NDSU Extension Service will be offering several workshops this fall and
winter covering land leasing in detail. These will be offered throughout North Dakota. If interested, contact your county Extension office to find a meeting near you.