Could the American “cash with bonus” system be the best way to rent land when commodity markets are so volatile?
A new type of American land rental agreement is gaining ground across the Midwest and may soon cross the border into Canada because it appears to offer advantages both to farmers and landowners, especially with 2012’s economic forecast.
Called “cash rent with bonus,” the lease is being praised for helping farmers reduce risks in volatile markets.
University of Illinois economist Gary Schnitkey agrees with the overall industry consensus that the increasing volatility in commodity prices makes it extra difficult for landowners and tenants to negotiate a rent that is fair to both parties.
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“Commodity prices can go up or down a dollar very quickly,” Schnitkey says. “We just don’t know what prices will be a year from now, and that impacts the amount of rent that a farmer can afford to pay.”
Landowners, meanwhile, are worried that traditional rental agreements will freeze them out of any windfalls if commodity prices explode, as they’ve shown in the last three years they can certainly do.
The variability in rent is clearly shown in the November 15, 2011, Farmdoc Daily news release which looked at farmland rental rates in Illinois in 2010. Rental rates in this mega-yield corn- and soybean-growing region of the U.S. are much higher than in most parts of Canada, but if you look at the amount of variability rather than the dollar-per-acre average, it’s thought there is a lot of similarity here.
For example, the average Illinois cash rent in McLean County was US$233 per acre in 2010. Yet only 35 per cent of rents fell within $20 of that average. In all, 26 per cent were between $20 and $60 lower than the average, with another 10 per cent more than $60 lower. Meanwhile, 19 per cent of rents were $20 to $60 higher than the average, and 10 per cent were higher by more than $60 per acre.
Some of these rate differences can be explained by differences in land productivity. Even so, Schnitkey believes much more of the disparity is due to the goals of the owner and farmer and the relationship that has been built between them.
Regardless, Schnitkey says, setting the cash rental based on an area average just doesn’t work well any more.
In part, that’s because traditional cash rental agreements do a lousy job of allocating risk and reward. They put all the downside price and production risk on the farmers, and almost all of the upside risk on landowners, who say they can’t afford to keep sitting on the sidelines when markets are so volatile and when corn and soy genetics have shown the power to explode when weather conditions are right.
Typical crop-share agreements divide price and production risk more equitably between the landowner and tenant. However, disputes can arise over the timing of the sale of the crop and also over how payouts from programs and subsidies are shared.
The flexible cash lease attempts to attack these concerns by varying the rent according to a formula that adjusts for yield and price variations, but this type of lease is often considered too complicated by landowners and tenants alike.
In response, Schnitkey developed the cash rent with bonus leasing arrangement. It provides a base rent that is paid regardless of yield or price, and then pays the landlord a bonus if crop revenues exceed a pre-set revenue target.
That means it offers both parties the advantages of the cash lease by having a known minimum fixed cash payment. Yet it also allows the landlord to receive some benefit from high prices and yields without the complexity of the flexible cash lease, and it protects the tenant if prices fall dramatically or if yields are poor.
“We tried to make this lease as simple as possible,” says Schnitkey.
For this lease to work, the tenant and owner must agree on a number of parameters. The first is the minimum cash rent that will be paid regardless of grain prices, production levels, and crop revenues. Schnitkey says it’s important for both parties to recognize that the lower the minimum rent is set, the higher the level of risk will be for the landlord, which then means that any revenue split to the landlord must be correspondingly higher too.
In part, this is why determining the minimum cash rent is the most difficult part of this lease. One method Schnitkey has used is to discount the average cash rent in the area by $50 to $75 per acre. He adds however that this is based on Illinois rents that average around $200 per acre. In areas such as Canada’s West where land rents are lower, Schnitkey suggests setting the minimum base rate at roughly 25 to 40 per cent below the average cash rent in your area.
An alternate method for setting the minimum cash rental rate would be to look at an amount equivalent to the returns the owner would get from a guaranteed deposit certificate for an investment equal to the current land value. In other words, if land is worth $1,000 per acre and a GIC (for the same term as the proposed lease) is currently two per cent, then the minimum cash rent would be $20 per acre, with this cash amount paid prior to seeding.
The second parameter the parties may want to agree on is the maximum rent to be paid, although Schnitkey says this is an optional step.
Third, the revenue trigger must be calculated. This is the amount at which the bonus kicks in. Schnitkey recommends that the trigger level be the sum of all production costs plus the base cash rent. By using this formula, it ensures that all the costs (before profit) of the tenant are covered before sharing of revenues of the crop occur.
Crucially, that makes the cash-with-bonus approach a lot different from a standard crop share or flex lease where crop revenues are shared regardless of tenant’s costs and profitability.
Fourth, the landlord and tenant must decide on the division of crop revenue above the trigger. As with setting the minimum cash rental rate, there are no hard rules to follow. It is strictly a negotiated rate. However, the lower the minimum cash rental is set, the higher the revenue share going to the owner should be, Schnitkey says. In the online example from the Illinois website, the landlord’s share above the trigger was set at 40 per cent for corn and 45 per cent for soybeans.
Finally agreements must be made on how yields will be measured, how the commodity price is set, and when the bonus is to be paid. Crop insurance harvest reports may be the criteria used to indicate yields. Expected prices could also be gathered either from crop insurance, from futures markets, or by daily averaging during the growing season.
A Canadian example
Let’s say a farmer named Smith wants to rent a half section from a landowner named Jones on a three-year cash rent with bonus agreement. Land in the area is selling for $1,333 per acre and three-year GICs are 1.5 per cent. Therefore they agree the minimum base rent payable April 1 each year is $1,333 times 1.5 per cent, or $20 acre.
The two parties then agree that the maximum total rent will be $100 acre.
Smith has good financial records which show his cost of production (no land costs included) last year was $150 per acre of wheat and $200 for canola. Thus, the revenue trigger is set for wheat at $150 plus $20, or $170 for wheat, while for canola it is set at $220.
Smith and Jones then agree that any crop revenue exceeding the trigger will be split 40 per cent for Jones (owner) and 60 per cent to Smith (tenant) for both crops. The bonus (if any) is payable by Dec. 31.
Finally, the farmer and landlord agree yields will be determined by bin measurement and allowances will be made for grade and dockage based on grading analysis done at the nearby inland terminal. Price of wheat will be based on the Oct. CWB PRO less the freight adjustment for the nearby terminal. Canola prices will be based on the January futures price less local basis on Oct. 1.
Come fall, yields and prices are both good. Smith harvests 150 acres of 50 bushels per acre of wheat that is valued at $7 per bushel, and he bins 35 bushels of canola over 155 acres, priced at $11.50 per bushel.
That means crop revenues are $350 per acre for wheat and $402.50 for canola.
With both crops exceeding the trigger, the bonus must be calculated. Here, it is derived by subtracting the trigger amount from the total crop revenue, and then multiplying by the share percentage. The wheat bonus therefore is $350 per acre minus $170, with the resulting $180 multiplied by 0.4, so the landlord gets an additional $72 per acre of wheat. The canola bonus is $402.50 minus $220, with this $182.50 multiplied by 0.4 to show a payment of $73 per acre.
Thus the total rent for the wheat is $92 per acre and for the canola it is $93 per acre. Total rent payable would be $92 times 150 acres of wheat plus $93 times 155 acres of canola, which works out to $28,215. The landowner would have received $6,100 in the spring, prior to the crop being seeded and a bonus rent based on yield and price of $22,115 which would be paid at the end of the calendar year.
While this rent may seem high to many farmers in our example area, it is very much in line with the rental which would have been payable through a typical flex lease or under a crop-share arrangement given these yields and prices. Had crop revenues been lower, the rental payable would have also been lower.
Where this arrangement is different is that no sharing of revenue occurs until after the tenants have their production costs covered. Furthermore the landlords are guaranteed an upfront minimum cash rental payment that is equivalent to what they would have received through a guaranteed investment. So both parties have minimized risk.
The Illinois corn and soybean example can be viewed at www.farmdocdaily.illinois.edu/004347print.html. The same website has links to blank worksheets which you can print if you want to pencil in your own numbers to see how this lease arrangement would work on your farm. CG
