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Reaching fair rents for farmland

There are at least eight ways to negotiate land rental rates. But is there a right way?

A successful land lease is more than simply a negotiated rental price.

Back-to-back years of ugly weather mean many farmers will be re-thinking rents this December, especially farmers who still have crop out in the field or who have experienced yield or quality losses, or who’ve been hit with increased harvest and drying costs. If a land lease is up for renewal next year, they’ll be asking themselves, what is a fair rent? Should I even be renting that parcel?

Unfortunately, there are no easy answers. Many factors come into play, including the quality of the land, proximity to your existing land base, and the availability of capital, labour, and equipment needed by the farm business for all owned and rented lands.

The landlord’s desire for a financial return on their asset is fair too, to a degree.

After the last few years, more tenants will probably be looking for rental rates that transfer some (or more) risk to the landowner. However, if you expect the landowner to accept additional production and pricing risks, won’t they expect to be rewarded if the stars align and revenues exceed projections?

Perhaps most important, we cannot ignore the interpersonal relationship between a landowner and the farmer tenant. A successful land lease is more than simply a negotiated rental price.

Rent negotiation methods

In the 1970s, it was much easier to determine a “fair” rent, that is, a rent which rewarded and satisfied both the landowner and tenant. Most landowners had farmed themselves or were only a generation removed from the farm and lived in the immediate area if not still on the farm. They had some idea of the value of their land and its productivity, and they had some awareness of crop prices too. Plus, they would likely be renting to a neighbour they knew, and they were aware of his or her farming practices and management ability.

There was already an element of trust between the parties or the land would not even be offered to a potential lessee, and it was highly likely that the rent would be based on the traditional 1/3 to 2/3 crop share, or a cash rental equivalent tied to that ratio.

With time, however, landowners have become more removed from the business of farming. They have less understanding of the productive value of land and are more focused on the capital value of land.

And farmers have changed too. Periods of high crop prices prompted active solicitation of rental land by farmers looking for more acres, often to justify purchases of ever larger equipment. This has resulted in rental bids often exceeding the traditional rental ratios, and as word of these rents circulated through the community, other landlords looked for gains too.

Setting rents on the basis of what others are paying, or are rumored to be paying, may be the most unfair way to determine rent. It reflects none of the criteria that I noted at the beginning of this column.

Second, bids that exceed actual productive rent values inflate land values. Land prices have been driven up over the past decade by relatively high commodity prices and low interest rates which enabled farmers to bid up rents, thereby creating interest by non-farmers in investing in farmland for the rental returns on that investment, as well as the potential for further capital appreciation of the land. It becomes a vicious circle.

These inflated land values and fluctuating interest rates are the reasons most farmers shy away from determining rental rates based on a percentage of the market value of the land even though this is often what landowners without farm experience seek.

To try to bring some sanity back to the land rental market, farm advisors have urged farmers to first calculate, then negotiate. In their eyes, it is impossible to determine a fair rent unless you know your cost of production and have projected the potential returns.

One easy approach is to determine a crop share equivalent. Advisors suggest using actual crop insurance yields and insurable prices, if available, as a way to determine a fair rental. Simply multiply the expected price by expected yield to get projected revenue. Next discount this calculated projected revenue by 25 per cent to account for yield and price risk to come up with a risk-adjusted revenue estimate.

Historically, crop share rentals have been 75/25 split if the landlord is not supplying any inputs other that paying the taxes, so advisors suggest a crop share equivalent rental rate would amount to 25 per cent of the estimated risk-adjusted revenue amount. It is important to make this calculation for all crops you intend to grow in the rotation on the rented land over the period of the lease and then average cash revenue equivalent for the various crops to come up with an annual rental rate.

A modification of this calculation has led to the introduction of flexible cash rental rates. Instead of discounting average yields and insurable prices, a calculation is made of insurable revenue which the lessee is eligible to receive. So the landlord would receive 25 per cent of the lessee’s insurable yield multiplied by the insurable price as a base rental. But since the landlord is now accepting some price and yield risk, they are rewarded by receiving a predetermined percentage of revenues which exceed the insured revenue value.

While basing rental rate calculation on historical production records or crop insurance data is a much better option than basing rents on coffee shop talk, flexible cash rents and crop share equivalents tend to be nothing more than calculated refinements of traditional splits between landlord and tenant.

Instead, a much fairer rental rate can be determined by focusing on the actual costs of production. List all costs which will be incurred farming the land in question, including all inputs, labour, equipment, management fees and property taxes, and also include a return to the landlord for their land investment. Determine who will be paying each of these costs or how they will be split and this will provide you with the contribution made by each party. A fair rental is one where the split of revenues received from the production on the rented land is equivalent to the contribution made by the landlord and tenant.

Unfortunately, such calculations are time-consuming and can be more a point of friction than a help in negotiating a fair rent if the landlord has no comprehension of modern farming practices.

So today, we are now seeing more and more landowners turn to public tendering or auctions when renting land. They simply do not have the knowledge of the business of farming to negotiate a rental rate or even know who may be interested in renting their land.

Auctions are among the oldest methods of determining price, and most people are familiar with how auctions work. If price is the primary driver, then there is likely no better way for a landowner to maximize the return to the land than through a tender or auction.

Lyndon Lisitza of Regina, Sask. has even created the online land rental auction site Renterra Inc. where landowners seeking tenants can post their land holdings and farmers can place bids to rent land. Lisitza describes his land rental service as “the fairest way to determine land rental rates.”

“Renterra provides better price discovery for the landowner and opens up the market to many more potential renters,” Lisitza says, adding that farmers can also benefit by finding land for rent which may not be in their immediate area, but which may be attractive if the parcel is big enough to justify the travel. Lisitza notes he once auctioned the rent for a 13,000-acre parcel.

Most important question

It all means there are many ways to determine land rents. But there’s another question farmers really need to be asking, and which is more important than any of these ways of determining rent. What can I afford to pay in rent?

Sadly, this is the question many farmers ignore in the quest for more land.

To determine the residual available operating costs, all inputs including fuel, repairs, crop storage, insurance, interest, labour, etc., are subtracted from the estimated revenues.

Then the portion of the farmer’s fixed costs including equipment depreciation, housing, management, and a return on investment must be assigned to the rented land. It may be argued that these costs would be incurred regardless of whether the land is rented or not, but over time they are real costs that must be covered by the farm business so it is best they be shared across all acres of the farm including rented acres.

After subtracting these fixed costs, the (any) remaining amount is what is available for rental of that land.

Is this a fair amount in the eyes of the landowner? Likely not, but it is the amount the farmer is able to offer without the rented land becoming a drain on the rest of the farm business. And isn’t that the reason for renting in the first place — to become more profitable, not less?

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