The ever-changing landscape of farmland rentals

The risks are growing. So is the pressure to lease more land. What does a smart rental strategy look like as we head into 2020?

There’s a small panic in the air, the muted response you might expect from farmers who hold their cards close and practise a stoic realism that helps them navigate the risks they can’t control: weather, grain prices, the impact that a single Chinese tech executive might have on an important market. Most of these are temporary, navigable issues we can wait out, or refinance, or set policy for.

But today, a new kind of tension has emerged as the trajectory of land management changes. We’ve tended to focus on escalating land prices as farms attempt to consolidate acres. But perhaps more disconcerting is land scarcity, farmers left to jockey over the few acres actually offered for sale and increasingly turning to leasing from landlords who have expectations about the return on their investment.

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Leasing does work for many farmers in many ways. Young farmers in particular find many advantages in renting land. The authors of Saskatchewan Agriculture’s Land Rental Arrangements (2018) argue leasing is really a means of “financing” a land base. They also point out that when funds are limited, which is often the case with new and young farmers, it is more profitable to spend money on inputs and machinery. Investing scarce funds in land may restrict operating capital, thus lowering the efficiency of the farm. Renting allows farmers a gradual entry into the industry.

Based on 2016 Stats Canada numbers, farmers new and old are taking advantage. While the total number of acres farmed in the country decreased by just under two million, the percentage of rented acres increased from 23 to 25 per cent as a proportion of all acres, with the actual number of rented acres increasing by nine per cent over the period.

In Saskatchewan that number is even more significant, with leased land rising to 27 per cent of total farm acres. As Ken Evans reads it, larger farms in the province are picking up leased acres while smaller 1,500- to 2,000-acre farms are cash renting theirs out. “I’m surprised how many large-acre farms have significant leased acres,” says Evans, an agriculture program specialist with Saskatchewan Agriculture’s Weyburn office. “I often wonder how those acres are obtained, given that there is a lot of competition from similar sized nearby operators also seeking leased land.”

One way farmers are obtaining more land is to travel farther from home, but Evans isn’t sure how they’re penciling it out. “Some are going 40 or 50 miles to lease land and I’m not sure how efficient that can be. They need huge tracts of land to be worth it.”

There’s a lot of risk for those leasing a lot of land, and the potential for a huge setback if a farmer gears up with machinery for those extra acres and loses them.

“It’s hard to find 3,000 acres overnight and the producer will find themselves with excess capacity,” Evans says, although some of that risk can be mitigated with longer-term contracts. “Lots of operators taking on substantial land will negotiate a three- to five-year lease with the ability to renegotiate the annual lease rate but not the availability of the land.”

Sticky rental rates

Efficiency and security are parts of the land equation, but the hit to cash flow from escalating lease rates is another. “It’s counterintuitive,” Evans says. “There’s more land available for lease, but I think that is countered by a lack of available land for sale so rental rates are rising.”

J.P. Gervais, chief agricultural economist with Farm Credit Canada agrees. “Rental rates are notoriously sticky. Despite a couple of years of depressed (commodity) prices, the rental rates are only starting to shift now, and not everywhere, and not by much.”

In recent years owning land has been very profitable, and not just for investors. Retired producers who might have once sold and invested the capital are choosing to keep their land and rent it out.

“The FCC Farmland Values Report shows there are fewer (land) transactions generally,” Gervais says. “Demand has weakened a bit, but I think it’s more a question of supply because of the profitability of owning land relative to investing.”

While Canada does not have good stats on land rental rates, the U.S. does. There, the evidence shows that even after their major downturn in the farm sector, it took almost four years for any significant downward shift in land rental rates, says Gervais. He expects the same slow response in Canada.

It’s only been this past spring that Tim Hammond has seen resistance from farmers to the annual rental rate increases expected from the 50,000 acres he manages for investors at Tim Hammond Realty in Biggar, Sask.

“These are sophisticated investors with perhaps 15 different contracts. These investors are return specific (as opposed to location), and might eventually divest if they don’t get that four or five per cent they’re looking for. At $2,000 per acre, that means an $80 per acre rent. And they can’t necessarily get that anymore. Saskatchewan still has a better rate of return than anywhere in the world, let alone in Canada,” Hammond says. “A $3,700 investment in Saskatchewan generates $500. You can spend $11,000 in Ontario for that same return. Prices scare people in Saskatchewan but they’re still low.”

Hammond believes investors filled a gap in land ownership the past few years.

“Six or seven years ago investors were a higher percentage of our business. Farmers were suffering and slowly accumulating capital until they became more confident. Investors who bought 10 years ago expected a four per cent return with two per cent depreciation. They met their 20-year objective in five years and are selling and moving on… The guy buying the land is the farmer previously leasing it, so the investors filled a role there when the tenants couldn’t afford it. By investing they gave the farmers time to build capital (while renting) until in a position to buy.”

Since January, Hammond has seen more land hit the market with values holding. Leasing or buying, he understands the pressures on farmers; “You stare at that half section across the road every day and know it’s only going to go up for sale every 25 years. You’re going to do what you can to get it. That’s why in sales there’s a high end and a low end. Sometimes it’s worth more to one person than another and it would be the same with rental rates.”

Indeed. So, leasing land is working for landlords keen on investor return in an otherwise weak investment market, but just how do those farming it determine rental agreements that allow for business expansion and growth? It’s a question top of mind as competition for available land becomes fierce, and not always friendly, the days of renting almost exclusively from family and neighbours rapidly coming to an end.

Determining the rate

“On the face of it, the decision to rent should be based on margins,” says FCC’s Gervais. “Am I making a profit off this land. Obviously it is more complicated than that. It is not that static.”

The rental rate matters to cash flow, but the Catch-22 for producers is knowing those acres might never become available again. So despite a possible loss at a particular cash rent, a producer might decide to take on those acres to fulfill part of the farm’s strategic plan, to spread fixed costs over, or for succession purposes.

“Ultimately, the land contract has to allow the farmer to make a profit so it can’t be an emotional decision,” Gervais says. “It has to be part of a larger strategy and be made objectively.”

Farmers should have realistic expectations of yields and costs, he says. From a lender perspective, FCC would look at the debt service capacity and whether there is room for an unexpected shock, such as weather volatility, commodity prices or trade disputes, all of which we’re seeing at present. “If a farmer is signing (rental) contracts that would impede the ability to service debt, then FCC might say that’s not the best plan for us as a lender. We’re not in the business of setting up the strategy for the farmer, but we can help point out flaws.”

Landowners want to tie the value of the land to the rent regardless of the land’s productivity because they’re looking at a simple percentage return on investment. It’s up to the farmer to know the productivity of the land and determine if the rent is worth it.

While Ken Evans feels most operators are good at analyzing their costs, at some point they’ll go backward if they’re paying too much rent, and he shares a rough guide for calculating a start point for lease rates: take four per cent of the value of the land, add taxes, and divide by the number of acres.

“Most farmers would be willing to pay more for heavy clay than for sandy, light soil,” says Evans. “It only makes sense from a risk and business perspective. But it doesn’t always work that way. It comes down to making sure you’ve done your analysis so you know what you can afford and putting a risk management strategy in place.”

Is insurance the answer?

Escalating cash rents drive cost of production up, having an impact on the bottom line and necessitating new ways to mitigate risk on those acres.

“Land rent takes a lot of cash out of the operation. Cash flow is the number one driver behind how farms make risk management decisions,” says David Sullivan, chief marketing officer with Global Ag Risk Solutions. “If you’re a larger, growing farm, you’ll likely have thinner margins and so mitigate risk differently than an established low-debt farm with declining cash needs.”

Based in southern Saskatchewan, GARS is a quickly growing player on the farm insurance scene, offering private, revenue-based insurance. A multi-peril product, GARS insures input costs on fertilizer, seed and chemicals, plus a specific amount of revenue per acre. As input costs increase so does coverage, with no ceiling and no effect on premium, the idea being that farmers can then use best practices at optimum timing.

Sullivan says mitigating risk on rented acres depends on how the rent is structured. Cash rents mean higher COP on that land, both fixed and input costs. Producers then need higher insurance levels and separate insurance on those acres and that’s where private insurance like GARS fits, filling the gap between what is needed and what government programs can provide.

Crop-share arrangements are another beast entirely with a variety of structures such as percentage of crop or percentage of margin. “Lots of these structures are thought to be more flexible,” says Sullivan, formerly an accountant with MNP, but most end up more expensive for farmers than cash rents. “For eight or nine years the crop share is higher than cash would have been so when you have a bad (production) year you’ve been pre-paying on that. It’s a business decision, but the numbers indicate the farmer ends up paying more over the long run and foregoing a lot of profitability.”

Working capital, cash flow and equity all influence insurance needs. On rented land a backstop is more important than ever, Sullivan says. “You’re not paying grandma and grandpa anymore. They would wait a few months for the cheque.”

Renting comes with risk and farmers need to know the worst case scenario for their farm and clearly articulate a plan to deal with that scenario. That means knowing the farm’s working capital, refinancing and mortgaging options, and what risk mitigation programs are available. “Then if it happens, you simply execute the plan and it’s not a scramble because the banks and insurers and farmer all know what’s going to happen. The plan can kick in seamlessly and you avoid financial disaster,” Sullivan says.

From an insurance perspective, he believes it is often a combination of crop and hail insurance and GARS that works best, especially as cost of production rises, partly due to the rent on leased acres. While government insurance provides coverage on yields, GARS insures cash, which is generally what the banks want to see.

But lenders have yet to embrace insurance as security and that is another less obvious risk of leasing land.

One of the downsides of leasing is a lack of credit available to the tenant farmer who usually has a more difficult time obtaining intermediate and long-term credit than does the owner. Lenders require land as security; leased land does not build equity.

“Traditional bank securities don’t allow for expansion on new land,” Sullivan agrees. “In the future there will be more rented than owned land. Operating credit will be needed but without a lot of land (for farmers) to mortgage, the banks will need to figure that out and will need to recognize insurance as security.”

This is especially true for young farmers trying to enter a market with few options for land purchase. Sullivan points out that in the U.S., half of all land is leased, and in Europe many farms are 100 per cent rented. He sees Canada headed in the same direction, which means young farmers will need a new way to access credit, perhaps using insurance as security.

With land prices escalating, available land scarce, and land owners expecting a return on their investment, the competition for acres is real and growing. It’s time for a cool head, an eye on costs and keeping the tools of risk mitigation handy.

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