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November 2013 Archives

Searching for a Fair Rent for 2014

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After the recent years of high crop prices and low interest rates, land prices and rents have risen to new heights. But now, with the recent drop in crop prices and the stickiness of land rents not falling as quickly as crop prices, many farmers are feeling the squeeze once again between revenue, costs, and rent. This is painting an unhappy, perhaps tense picture for both tenants and landowners as rents are discussed and negotiated for 2014.

As a first step in rent negotiation, let's look at what each side sees from their viewpoint.

As a base, we'll start with the projected returns and costs for growing corn in 2014 in west central Minnesota (Table 1). This projection is based on the 2012 production records for west central Minnesota, recent NASS data on prices paid by farmers for inputs, and CBOT futures prices. (Details are in the footnote for the table.)

Based on this projection, an owner-operator is projected to face a loss of $180 per acre. This may be a "paper" loss. The owner-operator does not necessarily face financial trouble immediately, but they would not receive their desired returns for labor, management, and equity in land.

To understand what a tenant and a landowner face individually, we split the owner-operator revenue and costs into two columns: one for the tenant and one for the owner.

In a traditional cash rent lease, tenants receive all the revenue and pay for all direct expenses of growing the crop, their overhead costs, and rent to the landowner - plus they have an expectation of receiving some income for unpaid labor and management ($70 per acre in this example). In the tenant's column for cash rent, the tenant's share of revenue and expenses is projected to provide a net return of $108 per acre before any land rent is paid. Thus, these cost and revenue projections indicate the maximum cash rent the tenant can pay (and still pay all other expenses plus their expectation for labor and management) is $108 per acre.

The astute reader who knows the current land rent market can already see a problem coming.

Landowners do not receive any revenue from production in a traditional cash lease and do not pay for any production costs. Landowners do have overhead expenses such as real estate taxes and insurance plus they have an expectation of a return to the value of the land from production ($240 per acre in this example). In the owner's column for cash rent, the landowner is projected to have expenses of $288 per acre before receiving any rent revenue. Thus, these projections indicate the minimum cash rent the landowner wants is $288 per acre in order to pay all expenses plus their expectation of a return to their land.

There is a large difference between the tenant's negotiating position and the landowner's negotiating position in this projection. The tenant has a maximum of $108 per acre for land rent, and the landowner wants at least $288 per acre for land rent. This does not create an easy negotiation situation--perhaps a mild statement.

Current land rents are much closer to what the landowner wants and not near what the tenant is projected to be able to pay. Even if the tenant was willing to receive no income for his or her labor and management (instead of $70), the tenant's maximum cash rent would be $178. So what do the tenant and landowner do?

One quick answer is for this landowner to look for a tenant willing to pay $288 or more. Given the financial position of many farms, some tenants may be willing to pay a rent this high or higher in 2014. I hear some have. This projection says they will be losing money in 2014 on this rented land. But this loss may not create financial devastation for the farm if they have sufficient cash reserves. Perhaps their long run view says this loss is necessary in 2014 in order to increase the farm size for future years. Perhaps these farms have already priced their crops at prices higher than current future prices indicate.

But crop price projections do not indicate a foreseeable return to levels to the levels of recent years. So, how long can (or should) a tenant continue to pay a cash rent higher than the tenant is able to sustain into the future?

The current tenant may not want to lose acreage so signs the owner's lease agreement for the high rent even though they know they are losing money ($180 per acre in this projection). Again, how long can this be sustained? When should the tenant decide to pursue other income alternatives because the expected returns to labor, management, and equity are greater in those alternatives?

Another answer (for 2014 or a subsequent year) is for the tenant and landowner to accept that crop price levels have changed and both the land market and land rental market are likely to change or have changed. Then the two parties can negotiate over what their expectations are.

The tenant will have to change their expectation for returns to labor and management to less than $70. The landowner will have to adjust their estimated land value and expected rate of return to less than $240 per acre. These are the residual returns after other expenses are paid. The amount of adjustment each party has to make will depend on the competitiveness of the rental market and which party has more bargaining power.

The negotiation centers on these two expectations because they are the "softer" numbers in the budget compared to the "harder" estimates of what the cost of the fertilizer will be, for example. The tenant and landowner will likely not talk openly between them about these expectations, but they are what they will be adjusting as they negotiate.

We could say the tenant should adjust production practices (and thus costs) or increase yield to be more economical. But farmers know their land and are choosing cropping practices that are economically optimal or close to that. Some lax management may have crept in during the recent years of high prices, but it's not the $180 difference in this projection. I don't know any farmers who do recreational tillage or recreational fertilizer applications.

Another answer to this current situation may be to change the form of lease.

Instead of a cash lease, the landowner and tenant could choose to sign a share lease or some form of flexible cash lease. In a share lease, if the production and the direct production costs (including drying) were shared 50-50, the tenant paid all machinery costs, and both parties paid their overhead costs, the projection in shows the tenant paying 48% of the total costs and the landowner paying 52%. So, a 50-50 share lease is probably fair given the uncertainty of prices and yields.

However, if these projections became the actual numbers in 2014, both parties would have losses under a share lease. The tenant would not receive any return to labor and management and lose another $6. The landowner would not obtain the desired return to the value of land.

Moving to a share lease or other form of flexible lease may be needed to provide both parties the ability to survive this period of adjustment to new market conditions.
