Fiduciary Management of Agricultural Assets Part II

Transcription

1 Fiduciary Management of Agricultural Assets Part II PDS Services, Inc So. Bowen Rd, Suite 335; Arlington, TX This course qualifies for Continuing Education for the CTFA and CFP designations. See the last page of this handbook for a CE Credit Application The Institute of Certified Bankers (ICB), a subsidiary of the American Bankers Association, is dedicated to promoting the highest standards of performance and ethics within the financial services industry. This statement should not be viewed as an endorsement of this program or its provider.

2 Fiduciary Management of Agricultural Assets Part II Join Us for Our Upcoming Webinars The Brower Quadrant By Lee Brower Tuesday, October 14, :00 PM - 2:00 PM CST Notes/Mortgages and Liability Assets By Rick Knox, CPA Wednesday, October 29, :00 PM - 2:00 PM CST Generation Skipping Trusts By Randy Pople Thursday, November 13, :00 PM 2:00 PM CST Notes/Mortgages and Liability Assets Fiduciary Management By Rick Knox, CPA Wednesday, November 19, :00 PM - 2:00 PM CST Click on the following link for more information and to register for our upcoming webinars: questions to: info@pdscompanies.com PDS Companies Fiduciary Management of Agricultural Assets Part II Page 1 of 48

3 TABLE OF CONTENTS Table of Contents 2 Introduction 5 Agricultural Property Types 5 Farms 5 Ranches 5 Recreational Property 5 Orchards and Groves 5 Timberland 6 Vacant Land 6 Urban Fringe 6 Ownership types 6 Typical 6 Family Limited Partnerships 7 Life Estates 7 Specialized Ownership 7 Leases and Operation 8 General 8 Cash Leases 8 Cash Farm Leases 9 Cash Grazing Leases 10 Hunting Leases 11 Crop Share Leases 13 Multiple Use Integration 13 Direct Management 14 Non-Farm Revenue 15 Billboard/Tower Sites Leases 15 Wind Energy Leases 15 Pipeline and Power Line Easements 16 Negotiating Oil and Gas Transmission Lines 17 Negotiating Oil and Gas Gathering Lines 17 Power Line Easements 18 Condemnation 18 Oil and Gas Surface Damages 19 PDS Companies Fiduciary Management of Agricultural Assets Part II Page 2 of 46

4 Drill Sites 20 Lease Roads and Lease Pipelines 21 Production Sites 22 Ingress/Egress 23 Frac Pits 23 Water Sales 23 Caliche/Gravel Sales 23 Seismic Permits 23 Oil and Gas Related Contamination 24 Government Programs 25 USDA Farm Programs 25 USDA Conservation Programs 26 Conservation Easements 27 Risks of Agricultural Assets 28 Investment Return Risks 28 Cash Farm Leases 28 Cash Grazing Leases (Ranch) 28 Crop Share Leases 28 Asset Appreciation Investment Risk 29 Asset Concentration Risk 30 Asset Sales Risk 31 Agricultural Asset Environmental Risk 31 Fuel Storage Tanks 31 Chemical Storage 32 Dump Sites 32 Livestock Dipping Vats 33 Agricultural Asset Regulatory Risk 33 Changes in Governmental Policy 33 Water Rights 34 Endangered Species 34 Liability 35 Hunting Lease Liability 35 Attractive Nuisance 35 Workmen s Compensation 36 PDS Companies Fiduciary Management of Agricultural Assets Part II Page 3 of 46

5 Management Requirements 37 Tracking and Reporting Systems 37 Property Inspections 39 Pre-Acceptance Inspection 39 Periodic Inspections (Annual Inspections) 39 Special Inspections 42 Asset Valuation 42 Asset Review 43 Pre-Acceptance Review 43 Post Acceptance Review 43 Annual Review 44 Summary 46 PDS Companies Fiduciary Management of Agricultural Assets Part II Page 4 of 46

6 INTRODUCTION Agricultural assets can be an important part of fiduciary portfolios. In many cases the property can be an excellent investment offering an alternative to the financial markets. In other instances, the property is held for non-financial reasons such as in the case of the family farm or ranch. Specialized knowledge and appreciation of this asset class is essential for efficient management and minimization of fiduciary risk. While it is relatively straightforward to outline the management requirements of this type of asset, the difficulty comes in the application of the management techniques. In the case of rural assets the true art is in the implementation of the management scheme. Two main objectives should be foremost in every asset manager s mind; the property manager should always strive to do what is right for the property and for the client, and when the asset is distributed to the ultimate owners, it should be in better condition than it was when it was placed in the account. Unlike the management of urban real estate, farm and ranch asset management is the combination of science, economics and the art of negotiation. The fiduciary manager of agricultural assets must recognize that because these assets rely on biology (e.g. growing crops or grass), a strong knowledge of the science underlying the properties productive ability is a must. Agricultural economic principals are important as the marketing and value of the underlying commodity produced has a direct relationship on the profitability of the asset. Finally, while guidelines for leases and easements are easily outlined, it takes a skillful negotiator to maximize both the return and appreciation value of the activity for the client owning the farm or ranch. Note: This document is not intended to offer in depth guidance to all aspects of farm and ranch management. Rather, it is meant to be an introduction to the unique aspects of managing rural assets. AGRICULTURAL PROPERTY TYPES FARMS For the purposes of this document, farms will be considered as tracts that are mainly cultivated and produce annual crops such as wheat, corn or soybeans. In many areas of the country, the term farm includes the production of livestock. RANCHES A ranch is generally a large tract of land dedicated to the production of livestock and/or the marketing of wildlife through hunting. A ranch relies on forage production from either a rangeland resource or from improved pastures. RECREATIONAL PROPERTY Recreational property is any rural property that was purchased for recreational use. This includes assets purchased for hunting and other outdoor activities as well as those purchased strictly as a second home. Hobby farming, which is using an asset for agricultural purposes without the intent of making a profit, can also be considered as recreational. ORCHARDS AND GROVES Orchards and groves are primarily permanent plantings of trees that produce fruits and/or nuts. These require highly specialized management techniques and are normally operated in concert with an on-site manager or management company. While many of the operational requirements discussed apply, specific management schemes are beyond the scope of this introductory document. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 5 of 46

7 TIMBERLAND Timberland is a highly specialized use of rural property. As is the case with orchards and groves, timberland generally requires the engagement of a local timber management company. Additionally, there are valuation and tax requirements that are unique to timber assets. Timberland should be considered as an individual asset class as it has drastically different financial return characteristics and management requirements. While many of the operational aspects of timberland are the same as other rural assets, in-depth coverage of the timberland asset class will not be included as part of this introductory document. VACANT LAND Vacant rural land is land that is in an agricultural area that has little productive value and thus the use by a prospective tenant is limited. Often, these are tracts orphaned by a prior sale, tracts purchased at tax sales or tracts purchased as a bad investment. The land typically is low in productivity, un-fenced, lacks a source of water and commonly has no formal access. It is unfortunate that over time, many agricultural portfolios managed by fiduciaries have become burdened by large quantities of largely non-marketable rural vacant land. The operational requirements of fiduciary management of these tracts is the same as productive rural assets. The challenge of the fiduciary is applying the requirements in a way that is economically viable to the client. URBAN FRINGE Urban fringe is any agricultural asset that is located in the pathway of urban development. Because of the potential change of use, the appreciation potential for this type of asset is magnified. These are valuable assets that present different management challenges than are found in typical rural assets. For example, the importance of tax valuation accuracy is magnified. If development is planned in the near term, the abilities required may be beyond those skill of a typical farm and ranch manager and professional assistance should be retained. OWNERSHIP TYPES TYPICAL The ownership structure found with agricultural properties is similar to other real estate assets. Differences lie in the attitudes of the clients owning these assets when compared to urban real estate. A typical farming or ranching family views the asset as a source of wealth as well as a source of annual income. They have benefited from the revenue derived from the family farming or ranching operation. As a result, they will be very comfortable with the asset class. Often too, a family may appear to be land poor with high portfolio values of farm and ranch assets and very low levels of liquid assets or financial investments. This results in the addition of agricultural assets added to the family operation over time and as they became available. Farms or ranch properties may be considered to be a part of that family s heritage. There has likely been a concerted effort to keep the assets in the family over past generations. Many families have close ties to the land. For these reasons, some agricultural assets are often referred to as legacy-type assets. From the family s standpoint, the land was never really considered an investment since the ultimate objective was to operate the property and not to monetize the asset and move the proceeds to the financial marketplace. Legacy type properties and historical avoidance of other investment classes present unique challenges for a fiduciary. When managing agricultural assets, one should quickly determine the importance of the asset to the client as well as their ultimate objectives for the farm or ranch. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 6 of 46

8 FAMILY LIMITED PARTNERSHIPS Family limited partnerships are a very common type of ownership structure for agricultural assets. The partnership may have been created to easily transfer ownership of the asset from one generation to the next. Alternatively, the partnership may have been formed to streamline the operational decision making process for the family farming or ranching operation. LIFE ESTATES Life estates are somewhat common in agricultural assets. It is important for any fiduciary to quickly determine the type of ownership involved. If a life estate is found, a fiduciary needs to first determine if the account owns the life interest or the remainder interest. Accounting and tracking of these types of interests is essential. The existence of a life estate does not lessen the importance of pre-acceptance inspection and review or tax and insurance tracking. SPECIALIZED OWNERSHIP One type of specialized ownership unique to agricultural assets is mineral classified ownership. This is unique to the state of Texas. In this situation, the owner of the surface owns one half interest in the underlying minerals. The other half interest in the minerals is owned by the state of Texas. If the surface estate is sold, the mineral ownership is also sold as the mineral ownership cannot be severed from the surface ownership. Thus, when conveying rural lands, it is important to determine if the tract being sold is mineral classified. Another type of ownership found is checkerboarded ownership. This was utilized as a way to keep the lands owned by the family and is normally found with large contiguous tracts of land. Using his method, the owner of the ranch would, either through will or by conveyance, leave (for example) the odd numbered sections to one set of family members and the even numbered sections to a different set of family members. This essentially prevented a sale of the ranch without the agreement of all parties. The challenge in managing a checkerboarded ranch is allocating rents and other revenue between the owners equitably. For example, revenue from a pipeline easement should be allocated between the owners of the sections crossed. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 7 of 46

9 LEASES AND OPERATION Operating a ranch or farm typically requires more time, effort and expertise than is normally available at most financial institutions. Realistically, most fiduciary accounts cannot bear the risk nor the cash flow requirements of a direct operation. As a result, leasing the asset to a producer is the normal and recommended course of action. GENERAL Of all of the activities associated with farm and ranch assets, selection of a lessee is among the most important. The tenant should be well versed in the technical aspects of operating the property as well as financially capable of paying the rentals. Additionally, the tenant should have a reputation for honesty and integrity as they will be the landowner s representative on the place and will, for the most part, be allowed to operate the farm or ranch without the daily input from the owner. Sources for good qualified tenant referrals can be found in the local agricultural community. The local offices of the USDA such as the NRCS and the FSA can provide limited information regarding prospective tenants. Additionally, owners of the local Coop or feed store may also be a referral source. Neighbors near the property are clearly prospective lessees as well as a potential referral source. The worst method of finding a tenant, however, is to place an advertisement in the local paper. Weeding out the qualified applicants from the unqualified will be very difficult and time consuming. A tenant s technical ability can be gauged by touring their currently operated places. Ideally this should include those owned by the prospect as well as those that they lease from others. The tenant s current and past operations should reflect how you would like the owned tract to look over time. If the tenant s places are weedy and the fences are falling down, for example, they will likely apply the same standard of care to the tract you lease to them. Ensure that the prospect will have the expertise for the type of operation supported by the tract you have for lease. For example, try not to lease a rice farm to a farmer growing corn and soybeans. Take note of their equipment if a farm is to be leased, they must have the capacity to fully utilize the tract. Finally, note that although a college degree in agriculture can be valuable, there are often very well qualified candidates that have grown up in the family farming or ranching operations and who do not have a college degree in agriculture. Agricultural leases require a large capital investment by the lessee. For example, if you lease a 1,000 cow ranch to a rancher that is fully stocked, they will have to purchase cattle for the place. The purchase of 1,000 cows will require an investment of greater than one million dollars. To add to this, there will be an additional burden of the lease payment, maintenance, and labor expenses with the additional heads. Take the time to ask for financial references and then call those references to ensure that the tenant can handle the additional expense. CASH LEASES Cash leases are the most common agricultural lease. For the most part, a cash lease removes or lessens the production and commodity price risk found in share type leases. Prior to entering into a cash lease on an agricultural asset, a sound lease should be drafted by an attorney specializing in this asset class. Cash lease rates are dependent on the productivity of the property as well as the underlying price of the commodity produced. For example, a farm producing 220 bushels of corn/acre will support a higher per-acre PDS Companies Fiduciary Management of Agricultural Assets Part II Page 8 of 46

10 lease rate than a farm that produces 120 bushels of corn/acre. Similarly, if corn is currently selling for $6.50/bushel the current lease rate will be higher than if corn is selling for $4/bushel. For a lease to be successful, it is essential to remember that the tenant must make a profit while returning an acceptable rate of return to the landowner. An above the market lease will push the lessee towards undesirable management practices. For example, a high grazing lease may force the tenant to overstock or to be less responsive to drought. An exorbitantly high cash crop lease may tempt the tenant to abandon crop rotation. Sources for lease rates include the same entities as previously used for tenant referrals. Additionally, most land grant universities will summarize and report lease rates for different areas of their state. Managers of agricultural assets should be familiar with lease rates in the area and should monitor these rates, particularly as the end of the lease term approaches. While triple net leases and monthly payments are common in commercial real estate leasing, they are rare in agricultural leases. Typically lease payments for farming, grazing and hunting leases will be on an annual, semi-annual, or quarterly basis. A hybrid type of lease term is often found in hunting leases where a portion of the payment is received at the execution of the lease with the balance due prior to the beginning of hunting season. Keep in mind that with some real estate accounting systems, this payment schedule can be challenging to track. CASH FARM LEASES When an acceptable tenant has been found and a proposed lease has been drafted it is time to negotiate the cash rental with the lessee. This is where a good farm manager shows his benefit. A farm manager should listen carefully to the objections and concerns of the prospective tenant. It may well be that in evaluating the asset, an important aspect influencing operation may have been missed. Prior to agreeing to rental rate or terms, the manager should evaluate whether or not the concerns are merited and a rental adjustment is valid. It may be concluded that a different tenant should be considered. A typical farmer will want a lease term as long as possible. In an initial lease, it is preferable to use a one year term. The reasoning that is normally accepted by most farm tenants is that neither of the parties to the lease knows the other. A short initial lease term will give each party a chance to understand how, in the farm manager s case, the tenant operates the farm, and how the farm manager manages the asset and its tenants. From an economic standpoint, a one year term benefits the landowner in an environment where commodity prices are rising. The reverse is true in the case where commodity prices are falling and the tenant benefits. If the tenant has an acceptable track record established managing the farm, one may consider a longer term lease. Three year terms are very common and are particularly attractive if it is believed that the prices of the underlying commodities are going to decline. Additionally, a three year term may be utilized to attract an exceptional farm tenant that may not have other farms in the area. This will allow them to purchase additional equipment for the farm if necessary. One mistake commonly made with leased farms is to give the tenant a power of attorney to sign agreements relating to the USDA farm programs. While the paperwork burden is considerably less as a lessor of a cash lease rather than a share type lease, there are decisions and programs that potentially could enhance the value of the asset. These should be reviewed and executed by the fiduciary manager of the farm and not the tenant. It is important to impress upon the tenant, the landowners focus on the improvement and maintenance of the farm. One way to do this is to include clauses in the lease to require control of undesirable plants, maintenance of facilities and fences, participation or cooperation with participation in farm programs. If there is resistance from a prospective tenant to this type of clause, an alternative tenant should be selected. Including places a duty on the fiduciary to monitor the activities outlined. Every inspection should include an PDS Companies Fiduciary Management of Agricultural Assets Part II Page 9 of 46

11 evaluation of conservation related issues and if issues arise, the manager should work with the tenant to resolve the issue. CASH GRAZING LEASES A cash grazing lease is similar to a cash crop lease in that both are dependent on productivity as well as the price of the underlying commodity. When evaluating the utility for a grazing operation the carrying capacity of the tract as well as the property s facilities (i.e. fences, pens, water) need to be considered. In looking at these two aspects, it can be determined if the property is capable of running a herd of livestock of economic size on its own or if the property needs to be combined as a part of a larger operation. For example, a tract that will run 50 animal units but is fenced, has water and some facilities is capable of standing on its own. However, in an area where 250 animal unit operations are the norm, the tract will likely not attract the top tier of local operators but will be very attractive to smaller operators because it fits their definition of economic size. The result is a situation where there is a wider but less talented market of potential lessees and the manager is forced to accept a potentially less qualified tenant. At the other end of the production spectrum, a tract, regardless of size, with low carrying capacity that is not fenced and has little or no available water but is located in the middle of another rancher s pasture has utility only to the adjoining landowner. Determining the properties productivity requires knowledge of the biology behind forage production while determining the value of the property in the market requires knowledge of agricultural economics. Once the productivity and economic potential of the property have been determined, potential lessees can be found. Sources for potential grazing lessees are similar to those of any agricultural lease. As is similar to a cash crop lease, the lease of additional acreage by a potential lessee may require a large capital investment. Prior to leasing the financial capability of the prospective tenant with respect to any additional capital outlays as well as potential rentals needs to be determined. Similar to a cash crop lease, the prospective tenant needs the experience and technical knowledge to be able to effectively manage the property. To evaluate the prospects abilities, other operations run by the prospect can be inspected. During the inspection, discussions with the prospective tenant will indicate the overall philosophy of management. Once the manager is confident of the financial and technical ability of the prospective tenant, a lease can be drafted. While most grazing tenants will want long terms, it is prudent to keep the lease term as short as possible. If management of the tract is fairly simple and the prospective tenant is going to add the tract to an existing operation, a one year term is probably acceptable. This will give both lessor and lessee the opportunity to be comfortable with each other, the property and the lease terms. If a large capital outlay for livestock is necessary, a three year term is reasonable. A cautious and prudent approach is to ensure that no grazing lease terms are more than three years. If an initial inspection of the property has revealed the potential for improvement through conservation programs, these need to be discussed with the tenant when negotiating the lease. You can easily determine the prospective lessee s attitude towards the proposed improvement practices. If such practices are anticipated, the lease conditions should require cooperation with any conservation programs entered into by lessor. Some conservation programs require grazing deferment and if so, rental adjustments should be necessary and defined in the lease. Conversely, if the practices increase the carrying capacity of the property, the tenant should understand that there may be a corresponding increase in the lease rate upon renewal. Note that from a tax standpoint, it is not a recommended practice to allow the lessee to pay for conservation improvements in lieu of rent. Over grazing can damage a ranch for a number of years and cause additional problems such as the enhanced PDS Companies Fiduciary Management of Agricultural Assets Part II Page 10 of 46

12 establishment of undesirable species. Over grazing normally occurs when during a drought year if the operator does not reduce the stocking rate. Over grazing can also occur during market upswings where additional livestock is purchased to take advantage of the market. If you have carefully selected a grazing tenant you should have a feel for their drought management philosophy as well as their activity in response to market moves. Regardless of their ability to not over graze, the lease drafted should contain an over grazing condition. The over grazing clause in the lease should also address any possible rental rebates that may be necessary. Use of facilities on a ranch can be an issue. If there are residential improvements on the property, a decision needs to be made as to occupancy of those improvements. For insurance reasons, keeping residential improvements occupied may be necessary. If the tenant has no use for additional accommodations for his employees, removing these from the grazing lease may be considered. However, if the property is remote, it may be difficult to attract an acceptable residential tenant to generate additional revenue. As an alternative, residential improvements that do not fit a grazing tenant s operation may enhance a potential hunting lease if a hunting lease is a viable option. Once the decisions regarding use have been made and an acceptable tenant has been selected, a well-crafted grazing lease needs to be prepared. There are attorneys that specialize or at least have experience in drafting agricultural leases. A qualified attorney should be used and a lease should be prepared based on the property and proposed use. HUNTING LEASES A typical fiduciary is normally adverse to leasing hunting rights because of the perceived increase in liability. Done correctly, a hunting lease can provide additional revenue with minimal liability increase. More importantly, in areas where recreational demand is high, an effectively managed wildlife resource can add additional value to the asset. There are several methodologies available for leasing hunting rights: Leasing to a hunting club with many members and many different properties available for members PDS Companies Fiduciary Management of Agricultural Assets Part II Page 11 of 46

13 to hunt (not advisable) Day hunting through an outfitter (not advisable) Leasing to a group of hunters for the season or for the year (recommended) Sale of permits received from state wildlife agency (recommended) The problem with the first two methods above is one of control of the number of hunters and the complexities involved with maintaining a suitable wildlife conservation program. Technical expertise is extremely important when finding a qualified hunting tenant. Normally, the lease is with a hunting club consisting of a number of members. The lease is negotiated by a party chief who is the spokesman for the members. The club should have a strong set of lease rules that reflect the objectives of wildlife management on the ranch. The group should have a strong focus on wildlife management and camp safety. Because the lease contact on the hunters side is a single individual, seldom will the lessor know all of the members of the group. The party chief should have tight control over the activities of the group and there should be a methodology either in the camp rules or in the hunting lease for removal of hunters that are not acceptable to the group or to the landowner. As was the case in determining the use of a grazing property, a similar evaluation needs to be made regarding hunting potential. The value of a hunting lease depends on the quality of wildlife, property size, available facilities, past and future wildlife management programs and proximity to urban areas. A great deal of wildlife biology knowledge may be needed for evaluation of the habitat and wildlife potential and engagement of a qualified wildlife biologist may be necessary. The habitat quality and whether or not marketable populations or wildlife exist need to be determined. While wildlife habitat and population is the main driving force behind the value of a potential hunting lease, the size of a property too can limit the hunting potential of a tract. A small tract leased for hunting may not desirable from either an economic nor a liability standpoint. Conversely, a large tract may result in leasing to multiple groups, thus adding additional complexity to operation. The term of a hunting lease can be for the season only year-long with season only being preferable. As is the case with other cash leases, initial leases with unknown groups should be kept to terms of one year or one season. Once the acceptability of the hunting tenant has been tested, longer terms can be offered. Certain wildlife conservation/management programs can extend the hunting season making it more valuable. Because many of these programs require habitat improvements, a lease term for three years may be required. If this type of program is used, ensure that hunting parties will cooperate with the governing regulations of the program and both lessor and lessee must agree on the allocation of any additional costs to implement the program. Hunting leases should contain harvest limits in the lease. Generally, these are determined prior to each hunting season as a result of a wildlife census, or as a part of the long term objectives of a wildlife management plan. Consider using a wildlife biologist to conduct wildlife surveys and set limits. The lease should require hunting lessees to follow limits set on the number, age and size of the wildlife hunted. The hunting lease should then require lessees to keep an ire a logbook showing game harvested and any needed data on those game (i.e. age, weight, antler dimensions etc.). If current improvements are used or if hunting camps are to be constructed, the lease should put strict guidelines on the construction, operation and removal of any hunting camps. A particular issue that arises is PDS Companies Fiduciary Management of Agricultural Assets Part II Page 12 of 46

14 disposal of furniture and appliances taken to the hunting camp by hunters and then discarded when newer items are brought to the camp. The lease should place strict rules on the handling of unused furniture, appliances as well as unused deer feeders and blinds. If the property is leased for both hunting and grazing, every effort should be made to integrate both enterprises. For example, the lease may require that all deer feeders are fenced to exclude livestock. Similarly, it may be necessary to limit livestock feeding activity to avoid interference with peak hunting hours. These are only a few important issues that relate to hunting leases. The preparation of a good hunting lease will require the assistance of an attorney familiar with hunting leases. The attorney, if they have experience drafting hunting leases, will have additional clauses that need to be included. CROP SHARE LEASES Crop share leases are contracts where instead of cash rent, the lessor receives a percentage of the crop(s) grown. As a part of these leases, the lessor is also required to share in a percentage of the expenses in growing that crop. Generally, in good crop production years, the return from a crop share lease will easily exceed that of a cash crop lease. However, in bad crop years, the return from a crop share lease may be considerably less or negative. Crop share leases carry with them production risk as well as commodity price risk. Because of this risk profile, if a crop share lease is to be used, the client(s) must be knowledgeable with the risk incurred and must also have the ability to support the potential cash flow. For example, insurance, fertilizer, and other non-harvest expenses may be incurred months prior to the harvest and sale of the lessor s share of the crop. The percentage of the crop received varies by the commodity produced and what is common in the area. For example, a crop share lease may require one third of the grain crops produced but only one quarter of the cotton crop produced. In areas of the Midwest, crop share leases where the landlord percentage is 50% are common. The expenses borne by the lessor are normally at the same rate of income received. The type of expense shared is negotiated between lessor and lessee but is usually what is customary for the area. Expenses typically shared include herbicide, insecticide, fertilizer and harvest costs. The lessor does not normally share in the cost of seed, labor, equipment or custom work done. While not common in most crop share leases, these may come into play in higher rate (e.g. 50% share) leases in the Midwest and other areas of the U.S. MULTIPLE USE INTEGRATION One of the biggest challenges of managing a ranch with multiple uses is integration of the potential uses. For example, a ranch can be leased for grazing, hunting and have mineral production simultaneously. All users will be utilizing all or part of the property at the same time. This also occurs with farming tracts particularly where a farming tract also contains a quantity of grazing or hunting acreage. If the property has marketable populations of wildlife, a decision needs to be made regarding the management and leasing of the property for hunting. The grazing tenant will want to control the hunters and will want to include hunting rights with his grazing lease. If this is the case, then the same technical requirements imposed on a hunting lessee should be placed on the grazing lessee. If the grazing lessee has the technical ability to operate a hunting operation, then the rights can be given to the grazing lessee at an additional rental charge. The resulting rate should be reflective of the market rate for grazing leases plus the market rate for hunting leases. In this situation, it is advisable to write two separate leases as the stringent provisions necessary in a hunting lease are not typically found in a grazing lease. If the property will be leased PDS Companies Fiduciary Management of Agricultural Assets Part II Page 13 of 46

15 to a different lessee for hunting, ensure that the grazing tenant will cooperate fully with the lessor and the potential hunting lessees. There will be disputes between both tenants at some time during the lease terms. Both leases, grazing and hunting, should contain provisions outlining how disputes between the two parties are to be handled. Oil and gas exploration and production presents challenges similar to integration of grazing and hunting, the difference is that the landowner will not be able to renew or amend the existing mineral lease. The objective remains the preservation of the quality and value of the property. An additional objective is to efficiently identify any potential revenue from oil and gas surface damages. Because the typical grazing tenant is on the property on a daily or weekly basis, they become the best source of oil and gas activity and problems on the property. In many cases, damages are shared with the grazing lessee to encourage communication of oil and gas issues. If this method is used, the sharing arrangement must be defined in the lease and it is prudent to cap total payments made to the tenant at a percentage of the total annual grazing rent. In an active mineral area, it is easy for uncapped reimbursements made to the tenant to exceed the lease payments made. Finally, often a grazing property will also have some farmland. If the amount and income potential of the farmland portion exceeds that of the grazing portion, it may be more effectively leased as a farmland tract. If both classes, farming and grazing, are to be leased to the same operator the technical ability of the operator with respect to farming and ranching needs to be determined. The lease can be cash grazing and cash crop or it may be cash grazing and crop share. DIRECT MANAGEMENT Direct management is the least used method of operation for fiduciaries. This is where the owner of the farm or ranch is also the operator. The account will own the livestock and equipment and employ the workers necessary for the production of the targeted agricultural commodity. All production expenses are borne by the account and the account will receive all of the gross revenue. As an owner/operator, the fiduciary will experience the greatest amount of risk. Additionally, any fiduciary employing this type of management scheme must have expertise in the proposed agricultural venture. While this methodology is not recommended for fiduciaries, it is sometimes requested by principals of the account. The request normally is that the beneficiary/remainderman will operate the place and the fiduciary will bear all the expense and receive all or a portion of the revenue. A better approach is for the fiduciary to lease the property to the principal making the request provided that the requestor is able to qualify as any other tenant would (they are financially and technically capable). PDS Companies Fiduciary Management of Agricultural Assets Part II Page 14 of 46

16 NON-FARM REVENUE Depending on the location, there may be several income alternatives available to owners of agricultural assets. When available, a managing fiduciary should investigate these opportunities as they arise. The detail surrounding these alternatives is well beyond the scope of this introductory review. However, the following brief discussion will increase awareness of some of these possibilities: BILLBOARD/TOWER SITES LEASES Billboards are a good source of monthly revenue for agricultural assets located adjacent to roads. In many areas, because of regulations, new billboards may not be an available option. However, there may be existing billboards on the property that potentially could increase income to the owning accounts. If an inspection reveals the existence of these, research should be done to determine if the area surrounding the billboard was sold to the company or if there is a lease of the site. Billboard site lease rates are somewhat difficult to ascertain and determining an appropriate rate may take quite a deal of research. Note that if the initial lease was a long term lease, the lease may have been initiated prior to the imposition of construction limits. In this case, because of scarcity of available sites, the value of the lease may have increased dramatically. Cell tower site leases are also very common along major highways, particularly if the asset has hills along the highway. A cell tower site lease will typically include ingress and egress to the site. The owner of the asset may be able to improve the asset by requiring the construction of a road to serve both the leased site as well as areas of the farm or ranch. Communication companies, because of the size of the investment, will require longer term leases and lease options. Because of the complexity of these leases, an attorney should be used to review the communication company s proposed lease. WIND ENERGY LEASES Wind energy leases are by far the most complex leases found in the farm and ranch world. Wind farms became important as a result of the Energy Policy Act of 1992 which provided production tax credits for wind farm produced electricity. The act has been extended several times since 1992 and is currently under PDS Companies Fiduciary Management of Agricultural Assets Part II Page 15 of 46

17 consideration for renewal by congress as the last extension expired at the end of If the act is once again extended, there will be renewed interest in leasing additional property for wind based electricity production. One of the main components of a potential wind lease is whether or not there is enough wind on a consistent basis to merit the investment in a lease and construction of towers. High winds are not really as important as a consistent wind. Companies will first place monitoring stations in what they feel are potential sites. The stations will normally monitor the wind for a period of 3-5 years. At the end of the monitoring period, a typical wind lease will give the energy company the option to lease acreage and begin construction. Another aspect of a farm and ranch asset that may bring value to a wind lease is the proximity to an electricity transmission line. Clearly, the closer the property is to an existing line, the more likely it is that a wind energy company will want to lease. Terms contained in a wind energy lease are typically an initial payment for the installation of monitoring sites. Additionally, if sites are constructed, the lease will have a payment for each tower site as well as a royalty on the energy produced. Rates are difficult to determine because many wind energy companies impose confidentiality agreements as a part of the lease. The closest parallel for this type of lease is an oil and gas lease. However, an oil and gas lease implies use of the surface but a wind lease does not. Unless use of surface is included in the lease, surface use may be an issue. Additionally, unlike an oil and gas lease where the lease continues as long as there is production, the wind lease term is specified in the lease. These and other complexities in writing a wind lease and also because of the specialized nature of this type of lease, an attorney that has experience in wind leases should be used. PIPELINE AND POWER LINE EASEMENTS Pipelines can be characterized as one of three types: Transmission lines, gathering lines or lease/flow lines. Transmission lines are large diameter pipelines used to deliver product from a producing area to a processing area. Most of these lines are intended to transport products for a variety of production companies. As a result they qualify as common carriers and will probably have condemnation rights. Gathering lines are used by oil companies to move production from an oil and gas lease to a production facility that may be located off lease. From the production site, the product is either delivered to a transmission pipeline or picked up and delivered by truck or rail. If the owning account also owns the minerals and these are being drilled and produced, gathering lines are extremely important to get the production from the owners lease to market. As a result, a reduction in per foot or per rod rate can sometimes be justified and usually time to negotiate and execute the easement is short and critical. Flow lines are pipelines that move oil or gas from the well to an on lease storage facility or to a gathering line site. Often, an oil company is given the right to place flow lines without compensation by their oil and gas lease. It is not normal nor is it beneficial to have formal, recordable easements for on lease flow lines. The owner of the asset should work carefully with the oil and gas company to have the flowlines placed where they will cause the least amount of damage to the property. Normally, oil companies are reasonable if such a request is justified. For example, the shortest line may cut diagonally across a pasture near an existing water PDS Companies Fiduciary Management of Agricultural Assets Part II Page 16 of 46

18 feature. The company may be willing to move the line along an existing road to avoid potential problems and to enhance the ability to monitor the line for leaks. For transmission and gathering lines, the easement form presented by the requesting company is almost never satisfactory to both protect the client s property rights as well as to protect the property from damage. The following are suggested tips for negotiating both: NEGOTIATING OIL AND GAS TRANSMISSION LINES a. When a pipeline company has rights under Eminent Domain, most states have a notification requirement that must be given at first request. b. Unless, it is easily apparent that the company is a common carrier, you should verify that they in fact are. c. Be sure that you know your rights if condemnation is threatened i. Rights are in place to protect both the landowner and the pipeline company ii. Do not be intimidated by the condemnation process iii. Understand how your actions and what you negotiate in one phase of the process can affect your rights in a subsequent phase d. When negotiating, the requesting company can and often do, request rights beyond those afforded by statute i. They will request more than one line ii. They will request a width of easement greater than necessary iii. They will ask for ingress and egress through adjoining lands iv. They will ask for various appurtenances e. The final easement should require i. Limitation to a single pipeline ii. The diameter of the line should be defined iii. The width of the easement should match the width given with the company s condemnation authority. iv. The temporary construction easement should be defined v. Do not allow telecommunication lines to be laid with the pipeline vi. Do not allow the pipeline company to change the size of the line vii. Specify the products transported and specifically exclude those that are extremely hazardous (e.g. sour gas) viii. Include a reversion clause with additional damages to be paid upon removal ix. The easement should not be assignable x. Limit damage payment to present damages (installation) and nothing further xi. If possible make the easement non exclusive xii. Specify beginning and ending construction dates xiii. Require double ditching in most cases and specify depth xiv. Ingress/egress from ends of the easement only or via a defined road xv. Remediation requirements after construction re-seeding and erosion control NEGOTIATING OIL AND GAS GATHERING LINES a. The benefit may be different if the product is produced from owner s minerals i. A gathering line bringing gas from new wells is valuable to the mineral owner where a gathering line crossing the owners tract that is not tied to the owners mineral production is not PDS Companies Fiduciary Management of Agricultural Assets Part II Page 17 of 46

19 b. Lines can be moved to minimize disturbance to operations and thus the asset value i. Along fence lines/roads is preferable ii. 90 degree turns are often requested by owners but are difficult for pipeline companies to do c. Same requirements as above (e.g. one line only, specify size, etc.) POWER LINE EASEMENTS Electrical lines (distribution lines) for farm use from local coops are commonly requested. Electrical coops do not usually pay for easements. Further, the coop easement form is generally not subject to much negotiation and revision. As a landowner, you do not have to grant the easement but may need to promote good will to the neighbor needing the electric service. The site of the easement can often be moved to allow future benefit and decrease the detrimental effect to the property. When approached and the easement does not benefit the owned asset, you can attempt to have the owner requesting service to pay for the easement and surface damages. A caveat to granting coop easements is that most will come in the form of a blanket easement. One should attempt to at least have the easement defined as built with the center line being the actual poles and line constructed. Electrical transmission line easements are extremely regulated by most states. While there have been a few transmission lines that are not common carriers, most are and have condemnation powers. As a result, there will be notice well in advance of construction. Typically various routes will be under consideration and the landowners along those routes will be contacted. Often, the landowners along the routes will be given a chance to voice their objection in public meetings and it may be prudent for a fiduciary to attend these initial meetings to gather as much information about the proposed lines as possible. A few general guidelines apply: 1. While you can often negotiate the type of construction (i.e. monopoles vs steel towers), movement of the line to accommodate boundaries is rare. 2. The easement form should match the specifications defined commission granting the company the right to install the line 3. While modification of the easement terms may be initially unsuccessful, the negotiations may be beneficial in later stages of the condemnation process. 4. Remember that viewscapes are called community damages and are not compensable. Stick to the value of the land within the easement, the damage caused by the construction and the decrease in the value to the remainder of the farm or ranch after construction. The company s appraisal should break down the easement valuation into these three categories. 5. Appraisals are not required but you will be more successful if you have one. CONDEMNATION A thorough discussion of condemnation as it applies to pipeline and power line easements if beyond the scope of this presentation. As owners are usually uneasy with the process the following are some tips. 1. The condemnation process gives landowners rights as well as rights to the condemning authority. It is essential that you know your rights. 2. Know the process. For example, the process in Texas is composed of three steps a. Stage One: Negotiation with the landowner i. Ends with a final offer from the condemning authority b. Stage Two: The issue goes before a commissioners court where compensation request are argued by the company and the landowner PDS Companies Fiduciary Management of Agricultural Assets Part II Page 18 of 46

20 i. Award is made by the commissioner s court c. Stage Three: If the award is appealed by either the company or the landowner, the issue escalates up to county or district court. The cases are presented before a judge or jury if requested. 3. If the company s right of eminent domain is questionable, this needs to be voiced early in the process (stage one). 4. Understand that the condemning company does necessarily not have to offer market value. 5. Know that companies will ask for more rights than are allowed. 6. Always negotiate the terms of the easement prior to negotiation of compensation 7. Negotiate in writing 8. Have the pipeline/power line company break out compensation to: a. Sale of the easement b. Damages for temporary workspace and easement c. Reduction in value of the remainder d. Ask the company to provide copies of written appraisals used to determine the values. 9. The first phase of condemnation can be done without the assistance of an appraiser or an attorney if valuations are known. The second phase requires at least the assistance of an appraiser and often an attorney. The final phase requires both appraiser and attorney. 10. During phase one, the negotiations are usually done by contractors. Often, the most productive negotiations are accomplished after the final offer is made and prior to presentation to the commissioner s court. More information on this topic can be found at websites such as the Texas A&M Real Estate Center or via an internet search for the state where the property is located. Finally, while legal representation is not required until stage three of the process, it often is advisable to seek legal assistance prior to reaching that stage. OIL AND GAS SURFACE DAMAGES In Texas as in many other states, the rights of the mineral owner or mineral lessee are superior to those of the surface owner. The use of the surface estate by a mineral lessee in Texas and many other states is governed by the Accommodation Doctrine. The accommodation doctrine provides that the party possessing the mineral estate (the dominant estate) has the right to go onto the surface and extract the minerals, including incidental rights reasonably necessary for the extraction. Typically, compensation to the surface owners is at least customary when oil companies utilize surface area for oil and gas development. If the client has leased the minerals, prior to negotiating surface damages, you should review the oil and gas lease for surface use provisions and possibly compensation rates. If the lease is silent regarding surface use, the surface owner relies solely on the accommodation doctrine. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 19 of 46

21 The key to the successful integration of surface and mineral activities is a good working relationship between the landowner and the oil company land representative. The earlier this can be established, the more successful you will be in ensuring that oil and gas development will not adversely affect the surface estate. Generally, if you receive a high level of financial compensation you will have little control over the use of the land. If you want a great deal of control, then expect less compensation. The most prudent answer for most agricultural assets answer is somewhere between the two approaches. When meeting with company representatives, you need to impress upon them that it is your desire to take care of the land such that when development and production are finished, the impact on the value of the property will be lessened. If possible, see if a binding surface use agreement can be drafted. While you may be comfortable with the current oil and gas operator, if their lease is sold, it may be sold to a company that is less financially capable or that does not have the same emphasis on running a clean operation. When drafting a surface use agreement, it is tempting to assign rates for different types of activities. Understand that an oil and gas lease can continue as long as there is production and that what seems like equitable compensation today, may not be adequate in twenty years. Thus, if rates are specified, they should carry with them a term, beyond which the rates are re-negotiated. As an alternative, scheduled rates adjusted by a published index may be an alternative. What is often forgotten by both landowners as well as oil companies is that damage compensation is for more than just the value of the land. The surface owner will have to deal with additional vehicle traffic needed for the wells as long as they are producing. The probability that gates will be left open, livestock will be run over and wildlife will be hunted from service trucks increases with every well drilled or pipeline constructed. Types of oil and gas sources of compensation to the surface owner include the following: DRILL SITES A drill site, also known as a well location, is a large gravel/caliche pad constructed by the oil company prior to drilling the well. Drill sites can be an acre or less but a multi well pad where fracing will be done, the size of PDS Companies Fiduciary Management of Agricultural Assets Part II Page 20 of 46

22 the pad can easily be five to fifteen acres (depending on the number of wells drilled from the pad). Compensation can be based on the size of the pad or a rate per pad or well. If possible, require that after drilling, the company should reduce the size of the pad to a mutually agreeable size (e.g. to an area defined by the tie down points for a workover well). With the new drilling technology available, there is some latitude regarding the placement of the well. For example, if the proposed drill site interferes with the operation of a center pivot irrigation system, it may be possible to move the site to a dry corner of the farm. Rate information can sometimes be difficult to obtain. The current tenant on the farm or ranch may have drilling activity on lands they own and if so a conversation with that tenant is beneficial. Similarly, neighboring landowners will often share information regarding what they are charging as well. It should be remembered in this and in all negotiations that the first offer is never the best offer. In absence of any substantive information regarding drill site damages, often doubling the rate offered is a practical response. It must be remembered however that often the rate settled on the first well will become what is offered on subsequent wells so getting the rates right on initial drilling is important. When negotiating drill sites make sure that the company representative understands that the damages paid are current damages for the drill site and not for any roads, power lines, pipelines etc. These should be negotiated separately. Note too that damages should be only for the drilling and completion of the well. Any future damages caused by production should be negotiated when they occur. If the location is located in a tillable field the company is responsible for negotiating any crop loss damages caused by the construction of the drill site. Finally, one should include in the negotiations a notification requirement, so that the company is required to give advance notification prior to beginning any work. This allows proper notification of the tenant so that they can move livestock out of the way of the work. LEASE ROADS AND LEASE PIPELINES With lease roads, the placement, type and maintenance of the road is more important than the compensation the landowner will receive. The selling point given by most oil companies is that the landowner will be getting a new road. Unless the road is going to a place that benefits the overall operation, the new PDS Companies Fiduciary Management of Agricultural Assets Part II Page 21 of 46

23 road will have no value. If possible the landowner should work with the company representative to integrate the new roads into the existing operation. Depending on the type of well drilled, there may be a huge amount of traffic during drilling and fracing. If this is the case, you should consider routing the traffic as far away from occupied improvements as possible. If there is a caliche/gravel pit on the property and the quality of the material is suitable for the construction of roads, offering material to be used for construction of roads but at a reduced rate is often beneficial. This ensures that the company will use enough road material to construct a quality all weather road. If the company is going to use an existing ranch road, consider having them upgrade the width and quality of the road to support the additional traffic. The company should be required to maintain all of the roads that they utilize not only during drilling but during production as well. If roads are to be part of a surface use agreement, it is advisable to include specifications for the lease roads constructed. Also, consider including speed limit penalties and penalties for driving off road win the surface use agreement. To prevent gates being left open, attempt to require installation of cattle guards at all fence crossings As indicated previously, lease pipelines (a.k.a. flowlines) do not necessarily require an easement. Unless otherwise specified in the oil and gas lease, the company is allowed to lay flowlines for the movement of product from the well to a storage or delivery point as long as the lines are on the leased minerals. If the primary objective is to conserve the value of the surface estate, then the manager should work closely with the oil company to ensure that the placement of lines does not interfere with the operation of the surface estate. Compensation for flowlines can vary considerably. Most oil companies are more generous with respect to compensation if the landowner does not own any mineral rights. If the route of a line is re-located to accommodate the surface owner and the resulting line is considerably longer, the landowner should expect less monetary compensation. PRODUCTION SITES Production sites are normally allowed under the terms of most oil and gas leases. A production site contains storage tanks, separators valves and other equipment necessary to collect, store and sell what is produced on the oil and gas lease. Often, the storage tanks are placed on the drilling pad once the well is completed. It is common for companies to construct these sites separately and in close proximity to roads for easy tank truck access. As these sites can be quite large and often unsightly, careful thought must be made prior to agreeing to placement on the farm or ranch. Normally, the underlying oil and gas lease nor the rules governing oil and gas production, give the company the right to gather production from other leases or operators. If the request is made by the oil company, the landowner may give the company this right. Note that this may result in a drastic increase in the size of the production site. There are three ways to receive compensation for production sites. The first and most common is a onetime payment made prior to construction, similar to payment for a drill site. The second is to lease the site to the PDS Companies Fiduciary Management of Agricultural Assets Part II Page 22 of 46

24 company for a specified term and rate. The leasing opportunity is normally associated with a site gathering production from additional oil and gas leases. A production site lease is somewhat complicated and requires preparation by a qualified attorney. Finally, the landowner may consider a sale of the tract to the oil company. In the non-sale approaches, any agreement for the construction and operation of a production site should, at minimum, contain several items. There should be a strong environmental indemnification clause in the agreement together with a strong liability indemnification. The company should not be given the right to lay additional pipelines to the site without formal easements and compensation. The agreement should contain a reversion clause so that if the site is abandoned, the site reverts to the landowner. There should be a clause in the agreement regarding remediation of the site once production has ceased. INGRESS/EGRESS When an oil company has to cross a tract that they do not have leased, they will need some sort of ingress or egress across the unleased property. If this is the case and the unleased landowner is represented, an opportunity to generate additional revenue can be achieved through a road use agreement (basically a lease of a road). Road use agreements specify an annual, semi-annual or quarterly rental rate. They also should have provisions such as responsibility for maintenance, time of use, speed limits etc. In almost all cases, a road use agreement with an oil company is preferable to granting an easement. FRAC PITS A frac pit is a large water storage facility used to store water used to frac a well. Since these pits cannot be constructed on the watershed (i.e. blue line on a topo map) use as a stock pond after the oil company no longer needs them is not a good option. If there is another source of water for filling the pond other than runoff water, it is possible to utilize the pit as a water feature. Since there is little future utility for agricultural use, compensation for the pit to the landowner is per acre or per pit. When negotiating the placement and compensation for a frac pit, ensure that there are remediation provisions in place. WATER SALES Selling water to oil companies can be very lucrative. Oil companies need water for both drilling and for fracing wells. Drilling does not take much water while fracing takes an abundance of water. If a deep abundant source of water is available, selling water may be an option for the operation. If none is available, and the oil and gas lease does not permit underground water use, it may be possible to negotiate an agreement where the oil company drills a well, pays the landowner a per barrel rate after the investment is paid off and then assigns the well bore back to the landowner when the well is no longer needed. CALICHE/GRAVEL SALES Caliche is needed by oil companies for the construction of drilling pad sites and roads. If there is a source of acceptable material located on the ranch, you may wish to allow companies to collect and use the material. When this is done, compensation to the landowner is normally by the cubic yard used. The difficulty is ensuring that the landowners receive payment for all of the material removed from the site. If the tenant is willing to monitor the operation, compensation to the tenant can be a portion of the proceeds from caliche sales. SEISMIC PERMITS Seismic surveys are conducted by oil and gas companies prior to exploring for oil and gas. Among several methods available to oil companies, there are two main techniques used; 2D and 3D. Historically a seismic PDS Companies Fiduciary Management of Agricultural Assets Part II Page 23 of 46

25 shoot consisted of three cable lines; one main line and two receiver lines. This was typical for 2D seismic and damages were paid by the mile for each of the lines. 3D seismic is now more commonly used and utilizes receivers placed on the ground rather than cables. Seismic rent/damages for 3D is paid on a per acre basis rather than by the length of the line. The biggest difference is that in modern techniques, the seismic company no longer uses below ground detonation of dynamite to generate shock waves. The shock waves are generated by dropping a very large cement block. The primary guideline for granting seismic permits is to make sure that the company making the request has the minerals leased. Granting seismic surveys on unleased minerals offers an oil company a free look to see what they potentially will lease. This can adversely affect the negotiation of a mineral lease. While technology used for shooting seismic has improved, there is still potential for problems and a seismic permit should include: A date by which the work should be completed. A non-refundable payment paid upon execution of the seismic permit Indemnification language and insurance requirements The distance the company must stay from improvements, wells, surface water, etc. Delineation of access points and notification requirements for access If brush is to be cleared, specify the type of clearing that will be done (i.e. dozer vs hydro axe) Prohibition against hunting OIL AND GAS RELATED CONTAMINATION Oil and gas companies benefit from operating their leases in a clean manner with practices in place to prevent contamination of adjacent lands and water. However, if a spill occurs, note that laws are in place at both the state and federal level requiring remediation of the spill. If a spill occurs, as a landowner representative, it is more important that the company cleans and remediates the site than pays monetary damages. Certainly, if there is significant damage remaining after remediation, then monetary damages are appropriate. Again, the preservation of the land and its value is the key point in remediation. It is tempting to try to dictate remediation methodologies to the company. However, anything beyond specifying reseeding to establishment with specified species should be avoided. If potential contamination is feared, prior to activity beginning, baselines should be established. For example, if underground water contamination is probable from fracing operations, prior to drilling, water wells can be sampled for quality by environmental testing labs. This defines a base point showing the environmental quality of the water asset prior to the commencement of operations. The data can then be utilized as proof of contamination if problems arise. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 24 of 46

26 GOVERNMENT PROGRAMS The main governmental programs involving agricultural assets are administered by the Farm Service Agency (FSA) and the Natural Resources Conservation Service (NRCS). Both are agencies of the United States Department of Agriculture. While the FSA is responsible for crop programs and the NRCS is primarily responsible for conservation programs, most programs will require the involvement of both agencies. After becoming familiar with the potential opportunities offered by the USDA, a fiduciary should evaluate the potential benefits and constraints associated with the program and review the merits of participation to see the program fits the objectives of the account. In addition to programs offered by the USDA, the U.S. Fish and Wildlife Service as well as the Forest Service that offer programs that may benefit the management of the property. Moreover, state and some private agencies often can provide technical assistance in implementing programs with very specific objectives. USDA FARM PROGRAMS The United States Department of Agriculture runs farm programs through the Farm Service Agency (FSA). If the farm is cash leased, the lessor will not receive any compensation from the programs. However, if the farm is leased under a crop share agreement, the landowners may be qualified to participate in the programs. Note that each entity that has a direct or indirect ownership in the property must meet the limitations on adjusted gross income set. This means that if a fiduciary account receives a check from the USDA and then the proceeds of that check are included in distributions to ten beneficiaries, then each of the ten beneficiaries must meet the AGI limitations to participate in the program. The FSA will require each entity to complete a form, including the individual s social security number, and certification that their AGI is less than $900,000/year (2014 Farm Bill). The FSA then cross checks each AGI with the IRS to ensure compliance. This procedure can be unsettling to many beneficiaries of fiduciary accounts. From a fiduciary standpoint, it is important to stress the importance of accurate AGI reporting to the USDA. If irregularities occur, the account will be required to refund any payments made by the USDA to the account. This may occur long after the funds have been distributed to the beneficiaries. The newest farm bill was signed January 2014 after three years of negotiations. A summary of the new farm program can be found on the internet at: The crop subsidies found in earlier bills have been replaced by an insurance like system that provides a safety net for producers. The 2014 Farm Bill removes the direct and counter cyclical payments for program crops PDS Companies Fiduciary Management of Agricultural Assets Part II Page 25 of 46

27 that had been received under previous farm bills. This may decrease the overall profitability of a crop share lease over the long term. Under the new farm bill, the owner of the farm will need to make decisions regarding the base acres and the base yields for the farm. The base acres for all crops other than cotton may be re-allocated to any crop or crops planted on farm between 2009 and The base acres for cotton becomes what is now known as generic base acres. The decision, from the landowner's perspective, that will need to be made as a result of the new farm bill will be to choose between re-allocation of the base acres for each crop or to retain the existing base acre structure. Additionally, the new farm bill may give the landowner the option to update payment yields to 90% of the crop year averages. A recommended approach is to work with the any current tenant on the base acres and base yields adjustments to maximize those that will bring the most value to the farm. The farms base acres and yields potentially affect the use and thus the profitability of the farm. Because of this, they can have an effect on the future overall value of the farm. In order to make informed choices, the owner of the farm should obtain a copy of FSA form 156EZ and FSA578 forms for the prior three years. Note that signup for the 2014 farm bill will likely be delayed until late 2014 and possibly early The new farm bill also modified the minimum gross income levels required for participation. Rather than having different levels of AGI as before, entities earning less than $900,000 are now allowed to participate in the program. This will open the door for participation by a greater number of owners. As a part of this, while the FSA formerly spot checked AGI numbers for owning entities, under this bill, the AGI levels will be checked for all participants in the program. IRS Tax records for each owner will be checked by the FSA to ensure qualification. The new farm bill is still in its infancy and few know exactly how it will work. The initial signup will take some thought to preserve the value of the farm. USDA CONSERVATION PROGRAMS One main goal of the NRCS is to promote conservation programs that will improve both the water quality and water quantity of a watershed. Conservation programs are normally cost share programs where the NRCS bears part of the landowner cost of the improvement practice. The new farm bill maintained the allocation for conservation. However, the participation AGI level was reduced from $1million to $900,000. The most common conservation program used in agriculture is the Conservation Reserve Program or CRP. Under this program, cropland that is marginally productive is taken out of production and planted to a permanent stand of grass. The producer is paid a per acre rate during the term of the contract. Additionally, the government will cost share on the expenses needed to plant the farm in permanent grass cover. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 26 of 46

28 The NRCS also uses a program called Environmental Quality Incentive Program or EQUIP as a principal program in meeting the agency conservation objective. EQUIP provides cost sharing for practices such as pond construction, water system development, re-seeding, brush control and fencing. High operator demand and allocation of conservation funds make it difficult to get into the program but participation allows the operator to increase the impact of the selected practice by doing additional work at the same cost or it lessens the cost of the planned project. A program similar to the EQUIP is the Wildlife Habitat Incentive Program. This program also supports improvement practices but with the emphasis on wildlife instead of crop or livestock production. The NRCS also has programs similar to conservation easements. These include: Farm and Ranch Lands Protection Program Agricultural Conservation Easement Program Grassland Reserve Program Wetlands Reserve Program Healthy Forests Reserve Program If a client expresses an interest in a conservation easement for their agricultural property, the above conservation programs should be investigated more fully. CONSERVATION EASEMENTS A conservation easement is a legal agreement between a landowner and a government agency or private land trust. The objectives of conservation easements vary depending on the location and use of the property. However, generally a conservation easement limits use to protect a land s conservation values. For example, in the previously noted USDA Wetlands Reserve Program, landowners have the opportunity to protect, restore, and enhance wetlands on their property. The USDA cost shares on the improvement practice used and landowners receive payments based on the difference in the value of their land caused by placing an easement on a portion of it. In other easements, development rights are donated to a charitable organization (land trust) and the value to the landowner comes via a reduction in the value of the asset (the value of the donated rights) and a resulting tax deduction. While this is not an in depth review of conservation easements, the following are points relating to easements granted by fiduciaries: Conservation easements are permanent and will thus run well beyond the duration of most trusts or estates. As a result, conservation easements should only be considered for properties owned by directed agency type accounts The recipient of the easement needs to be carefully considered as they will have power to directly influence activities on the property The legal and financial implications of granting the easement should be thoroughly investigated prior to making any recommendations to the client. Because of the complexity and duration of conservation easements, a team of qualified experts will need to be utilized: Attorneys specializing in drafting conservation easements, appraisers with experience in determination of value of easement grants, and accounting professionals that can give advice on the financial impact of the conservation easement. The USDA Conservation Easement programs are very limited and difficult to be approved. Granting a conservation easement is perpetual and irreversible. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 27 of 46

29 RISKS OF AGRICULTURAL ASSETS The risk of fiduciary management of an agricultural asset is largely similar to managing real estate in an urban setting. A discussion of the risk associated with any fiduciary management of real estate is found in the OCC Publication Unique and Hard to Value Assets. However, because of differences in leasing and use, variations of risk, different from other types of real estate are present. The following is a discussion of risk issues specific to farm and ranch assets. INVESTMENT RETURN RISKS CASH FARM LEASES The cash on cash return of investment quality farmland is often compared to the financial returns generated by a bond portfolio. However, as more and more investors have entered the farmland marketplace, the value of farmland has increased thus lowering the return on market value. The risk associated with farmland arises from the variability of the underlying commodity prices. For a cash lease, the rental is based on the amount of a commodity that a farm can produce as well as the price of that commodity. As commodity prices fall, farm lease prices lag behind the commodity price fall but eventually there will be a correction and lowering of the gross farm rental. Similarly, as commodity prices rise, the cash rental rates will lag behind but eventually will too rise. The risk to the owner of a farm lies in not keeping cash rental rates in line with production and price levels. To minimize the risk, the owner of the asset should: Keep lease durations as short as possible as a general rule one to three years with an annual lease being more favorable to the landowner Check local cash prices at the time of lease renewal. Consider the appropriateness of a crop share lease Monitor the market value of farm assets so that accurate returns can be reported to the owners of the asset CASH GRAZING LEASES (RANCH) The typical return for ranches and recreational properties is very low (i.e. currently less than 2%). Cash grazing leases are based on the carrying capacity of the ranch. The higher the carrying capacity (expressed in Acres/Animal Unit), the higher the rental rate per acre. For example, if the local market for grazing leases is $200/animal unit/year and the carrying capacity of the ranch is 20/acres/animal unit, the cash grazing lease rate is $10/acre (i.e. $200/AU divided by 20/ac/AU). To ensure proper returns are being met: CROP SHARE LEASES 1. Know the carrying capacity of the ranch 2. Research the local grazing lease rates 3. Know premiums/discounts attributable to improvements, proximity to markets, size etc. 4. Capitalize on additional revenue streams such as hunting lease revenue, water sales and oil and gas surface damages. Crop share leases are leases where the lessor of the farm receives a percentage of the crop produced rather than a cash rental per acre. In a typical crop share arrangement, the landowner also pays a share of PDS Companies Fiduciary Management of Agricultural Assets Part II Page 28 of 46

30 production expenses. The expenses shared vary depending on the area and what is typical for that area as well as the type of crop produced. Additionally, as the landlord s share in the crop increases, so too will his share of the expenses. The percentage received varies by location of the farm, the commodity produced and the level of expense burden borne by the landlord. While the return from a crop share lease can be greater than that of a straight cash lease, there is also more risk involved. 1. Production risk 2. Commodity price risk 3. Client s risk tolerance does not match lease risk level 4. Client s income level will not support expense ASSET APPRECIATION INVESTMENT RISK The chart below illustrates the appreciation of Iowa Farmland since As illustrated, agricultural assets can carry with them high appreciation rates. The accelerated run up in prices in the 2000 s shown above was primarily the result of two factors: a dramatic increase in the price of two main commodities (soybeans and corn) as well as an increase in the number of investors entering the market purchasing farmland. A similar appreciation curve can be seen in rangeland with recreational appeal. The following price graph example is for four counties found in the Texas Hill Country. From a production standpoint, the area produces almost no crops and has low stocking rates for livestock. However, because of the scenic nature of the area and its proximity to Austin and San Antonio, the increase in value was driven by purchasers buying land for second homes and recreational use. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 29 of 46

31 Source: Texas A&M Real Estate Center - Rural Land Prices Hill Country - South (LMA 17) Counties: Bandera, Blanco, Kendall, Kerr As illustrated by the two examples, in the right area, agricultural assets can be an excellent investment through appreciation. To minimize risk to the fiduciary, if as asset is being held for appreciation a fiduciary should: 1. Make sure that if an asset is held for appreciation, it is appreciating 2. Use realistic and accurate estimates of market value 3. Communicate the value and return estimates to clients 4. Make sales recommendations when appropriate ASSET CONCENTRATION RISK Asset concentration is the percentage of one asset class as part of a total investment portfolio. Often, individuals that are making a living in agriculture acquire large holdings of land relative to their total net worth. Many of these individuals are very comfortable with agricultural assets but are extremely uncomfortable with financial assets such as stocks. As a result, a fiduciary may receive through a trust or an estate, an account portfolio that is almost exclusively land and operating cash. A concentration issue can also result as a result of rapid asset appreciation. For example, in the case of the Iowa farmland value table shown previously, if the farm(s) were purchased prior to 2000, the value of these assets may have quadrupled in the 13 years since. If the balance of the portfolio did not keep pace with the appreciation of farmland, a high concentration of farmland in the portfolio may result. There is no set in stone level for real estate concentration in a portfolio managed by a fiduciary. Different clients have different levels of comfort and knowledge of the asset class. Those that have been lifelong investors in agricultural assets are typically comfortable with high concentrations of the class in their portfolio. However, remaindermen or income beneficiaries may not share the same level of comfort. Thus, PDS Companies Fiduciary Management of Agricultural Assets Part II Page 30 of 46

32 high concentrations of agricultural assets can present risk to the fiduciary. To minimize this risk, the following is suggested: ASSET SALES RISK 1. Know the background and history of the asset(s) is this a legacy type asset 2. Why was it purchased (investment or part of operation) 3. What is the preference of the current clients/owners 4. Specific language in the governing instrument 5. Communicate with clients and use retention letters if necessary Selling an agricultural asset carries with it a high amount of risk to the fiduciary. Care must be taken to minimize the risk if a sale is required/desired. Risks associated with selling an asset include: 1. Perception that the price was too low 2. Co-owners (beneficiaries) wanted to purchase it 3. Sale was not arms-length 4. Conveyed interests not intended to convey (minerals, water) 5. Title problems arising after conveyance To reduce the risk associated with a sale, a procedure must be developed and followed that should include the following items: 1. Obtain qualified appraisal 2. Review appraisal with respect to quality of comparable sales 3. Develop marketing plan and communicate plan to account principals 4. List with qualified land broker 5. Ensure contracts are consistent with marketing plan (e.g. surface only, Special Warranty Deed etc.) 6. Don t practice law AGRICULTURAL ASSET ENVIRONMENTAL RISK Depending on the type and use of the farm and ranch asset, the environmental risk associated with agricultural assets is potentially the same as other real estate assets. However, agricultural assets sometimes have environmental issues that are not common to other real estate assets. FUEL STORAGE TANKS Often, an agricultural asset will have some type of fuel storage. Fuel storage is most commonly above ground but often can be through underground storage tanks. Storage facilities are typically found around improvements such as barns, pens or houses. The most easily identifiable fuel storage tanks are the above PDS Companies Fiduciary Management of Agricultural Assets Part II Page 31 of 46

33 ground type shown below which typically hold gasoline or diesel fuel. Below ground fuel storage is more difficult to identify. If it is an active facility there will normally be a pad site where equipment is parked during fueling. Additionally, there is typically a pump and fill and vent pipes visible. Below ground tanks present the same type of liability as underground storage tanks located in urban settings. The challenge of an agricultural setting is finding tanks that have been taken out of use for a number of years. In this case, above ground facilities may be buried, hidden by weeds or located where improvements used to be. If an appraisal is available, carefully review the appraisal for description and location information for both active and inactive tanks. Additionally, interviews with people familiar with the history of the place can also be of value. In evaluating the risks associated with above or below ground storage tanks, a fiduciary should be familiar with AST/UST rules and exemptions. For example, in Texas an above ground storage tank of less than 1,000 gallons is not regulated. If storage tanks are identified during an asset pre-acceptance inspection, the fiduciary should determine if additional investigation is required (i.e. phase I environmental survey). To remove unnecessary risk, if the tanks are no longer an important part of the operation, they should be removed by qualified contractors. If the tanks are deemed to have utility, then the fiduciary should ensure that all rules and regulations are followed. CHEMICAL STORAGE While not as common as it once was, on farm storage of herbicides, insecticides and fertilizer can be a problem. Typically, if a tract has been leased for a number of years, the operator will either have the product applied by a third party such as the coop or will store the chemicals at their own headquarters. In a preacceptance inspection, one should look inside and behind all improvements for barrels or containers that contain herbicides or insecticides. Moreover, if there is a farm use dump site, this too should be inspected for containers. If for example, a barrel of unknown liquid is found, you may want to have the contents determined by a qualified third party and removed if necessary. As a further step to minimize risk, leases written by a fiduciary should contain a clause that prohibits storage and disposal of hazardous chemicals on the tract. DUMP SITES Dump sites are normally found on agricultural assets with improvements. Because commercial trash pickup is expensive or is not available, owners would construct an earthen pit and dispose of household trash. Over PDS Companies Fiduciary Management of Agricultural Assets Part II Page 32 of 46

34 time, more hazardous items such as used car batteries, empty insecticide containers and waste oil, may have been disposed of as well. While most of these sites have been removed, they may be present. Knowing the history of the asset will help identify the location of the site(s) and if any remediation was done or is necessary. Agricultural assets can also attract unauthorized disposal by local residents. These too can present environmental problems if hazardous materials are disposed. LIVESTOCK DIPPING VATS Livestock dipping vats are unique to agricultural assets. These were constructed under a USDA program and used from 1900 to about The purpose of the vats was to drench livestock with an insecticide to control ticks and thereby help eradicate tick fever. Initially, the liquid used contained Arsenic based insecticides but around 1940, most operators switched to organochlorinated pesticides. Environmental risk occurs as a result of the vats leaking the insecticide into the surrounding ground, the accumulation of those insecticides over time and eventual leaching into groundwater. When they were in use, dipping vats were easily identifiable but after years of non- use, they can be very hard to identify as indicated by the two photos below: The photo on the left shows cattle being dipped in the insecticide. The photo on the right shows a dipping vat that has been filled with concrete and the surrounding livestock handling equipment removed. AGRICULTURAL ASSET REGULATORY RISK Agricultural properties are often subject to regulations that are different than those of urban/commercial properties. When an agricultural asset is managed, the manager of the asset must be familiar with regulations governing use of the property. Examples include: CHANGES IN GOVERNMENTAL POLICY Example: 2014 Farm Bill PDS Companies Fiduciary Management of Agricultural Assets Part II Page 33 of 46

35 Risk WATER RIGHTS 1. Removed direct and countercyclical payments thus altering the profitability of farming enterprise 2. Requires farm owners to certify base acres and yields 3. Increased AGI participation threshold to $900,000/owning entity easier to qualify 4. Reduced AGI Participation threshold from $1 million to $900,000 for conservation programs 1. Potential reduction in return to operator. This is a direct impact on crop share leases and will indirectly affect cash leases 2. Failure to certify base acres and base yields may adversely change the future value of the farm 3. The changing of AGI may result in entities now being able to participate in commodity and conservation programs. Example: Edwards Aquifer Authority The Edwards Aquifer Authority was established in 1959 but modified many times since. The most recent modifications placed tight controls on water well drilling and production. The authority also controls the use of water for irrigation. Risk 1. Water availability has a direct effect on the potential development of the tract 2. If a farm/ranch has water rights the appropriate reports must be filed to maintain those rights (use it or lose it) 3. Different areas are governed by different Underground Water Conservation Districts and the rules regarding water use, well registration and water rights may differ by region All fiduciaries managing agricultural assets should be aware that the ownership of water rights adds value to the asset. The manager of the asset should investigate water rights ownership and be familiar with the rules and regulations governing those rights. Also, as modifications are made by governmental entities these too should be reviewed to determine the effect these may have on the value and use of the asset. ENDANGERED SPECIES Example: Golden Cheeked Warbler and Black Capped Verio Edwards Plateau of Texas In the Edwards Plateau region of Texas there are two primary endangered avian species: the Golden Cheeked Warbler and the Black Capped Verio. The habitat requirements of the two avian species are different and both may be found on the same tract. Modification of habitat for increased forage production will likely result in destruction of endangered species habitat. Thus, prior to performing any improvement practices on a ranch in the area, the existence of the species on the tract PDS Companies Fiduciary Management of Agricultural Assets Part II Page 34 of 46

36 should be evaluated as well as the influence of the proposed practice on the species habitat. In this area, the Texas Parks and Wildlife is responsible locally for laws and regulations. Additional protection is provided by the Fish and Wildlife Service at the Federal Level. Risk LIABILITY 1. Know the potential endangered/threatened species in the area 2. Know both the state regulations as well as the federal regulations prior to implementing any wildlife habitat modification practices 3. Reputational risk is high Generally, the liability issues found in other real estate asset classes are similar to that of farm and ranch assets. As a fiduciary, liability insurance should be required on ALL farm and ranch assets. Moreover, all leases and agreements requiring access to the property must contain strong indemnification language drafted by an attorney. Below are three liability issues common to farm and ranch assets. HUNTING LEASE LIABILITY Leasing of hunting/recreational rights can be an important source of revenue. Commonly, one issue that keeps most landowners from leasing hunting rights is potential liability. Prior to entering into any hunting lease, the existing liability policy must be evaluated to determine if hunting is covered. Note that liability resulting from hunting is normally specifically excluded from general liability policies. If a check of the current liability policy reveals that hunting is excluded from the policy, a liability policy specifically for hunting must be obtained. Fortunately, companies currently issue hunting liability policies at a reasonable cost/acre. In addition to purchase of hunting lease liability insurance, it is advisable to also have an attorney prepare a landowner indemnification agreement for all hunters and guests to execute. Often, hunters will bring their minor children hunting. While having an attorney prepare and indemnification agreement, review this possibility with him as an indemnification agreement executed by a minor probably is not effective. As an alternative, require that the owner of the ranch be added as an additional insured to the parent s liability policy. An additional way to minimize risk in a hunting lease is to have an attorney craft a hunting lease containing camp rules as well as regulations for use of the property. Then careful selection of the hunters leasing the tract should include a review and understanding of the lease and rules with the hunters prior to leasing. Additionally, most hunting groups will also have rules for the group. These rules should mirror the rules and regulations found in the lease. Because of the importance of hunting and recreation as a revenue source, many states have adopted regulations regarding hunting liability. To minimize risk, know the regulations governing hunting lease liability in the state where the property is located. ATTRACTIVE NUISANCE Farms and ranches have features such as ponds, farm equipment, trees, old houses etc. that can be irresistible, particularly to children. Many farms or ranches have over time, accumulated old equipment or PDS Companies Fiduciary Management of Agricultural Assets Part II Page 35 of 46

37 piles of lumber or pipe. Additionally, old dilapidated barns and outbuildings can attract unwanted visitors. A large pond or creek on the property may have historically been used as the local swimming hole during the summer. Or finally, often the confinement of animals near a road will invite passers buy to stop and pay a visit. Use on the ground inspections to identify anything that may be an attractive nuisance. If something can be identified as potentially attractive to children or passers buy, it should be removed. Risk is greatly increased if the cost or removing the attraction is minimal and the utility of the feature is low. It the feature cannot be removed (e.g. large lake), then an owner should consider fencing and signage that will at least discourage unauthorized use. WORKMEN S COMPENSATION This concern is found when the account employs farm or ranch workers on a full time basis. As most are aware, farm and ranch work is among the most hazardous professions. Workman s compensation insurance will protect the owners of the property from liability arising from work related accidents. If an account pays an employee, then workmen s compensation should be required. As is typical of other types of real estate, worker s compensation insurance should be required of contractors doing work on the property. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 36 of 46

38 MANAGEMENT REQUIREMENTS The OCC Publication Unique and Hard to Value Assets details minimum management requirements for fiduciaries engaged in managing real estate assets. A copy of the document can be found on the internet at: Value_Asset_Booklet.pdf. The booklet raises the bar for fiduciaries that manage real estate asset. No longer can a bank fiduciary simply hold title to real estate assets. Rather, the booklet pushes a movement towards viewing all fiduciary managed assets from an investment standpoint. TRACKING AND REPORTING SYSTEMS Modern computer systems are available for the effective management of real estate assets. In its simplest form if only a few assets are involved, spreadsheets (Excel) or desktop databases (Access) can be developed to track important information. As the number of managed assets increases, movement to a specialized system should be considered. Rentals - Both systems and procedures should be in place to track the payment of rentals and the collection of past due rents. The tracking system should be maintained so that rents and rent schedules match each lease. The system should also show lease escalations, options, rent adjustments and any lease provision that will modify the rent received or the payment schedule. An appropriate system should also be able to provide listings of aged past due rents showing total amount due and number of days past due. When a past due rental is identified, appropriate action should be taken for the collection of that rent and any penalties imposed by the lease. Lease Expiration A fiduciary should also have a system that will track lease terms. The ability to identify leases prior to their expiration is essential to being able to negotiate leases quickly and effectively. Any system should be able to provide listings of leases about to expire as well as those expiring. Crops in Storage As a part of a crop share lease, the landlord receives a percentage of the crop produced. If this crop is not sold at harvest, it is stored at the grain elevator. A lessor should require and maintain warehouse receipt records showing the commodity type and amount stored. As the crop is sold, reductions should be made to the total stored. A simple spreadsheet method is normally the best approach. Using this method crops can be recorded as they are stored and then the amount of the crop can be reduced as they are sold. An important component of this system should be the date(s) when storage fees will apply and the cost of storage. This should be recorded as an offset to the gross crop sales. Livestock Owned Occasionally, a ranch will be operated by the account and the livestock will be an asset of the account. In this case, records should be kept indicating the number of each class of livestock held (bulls, heifers, cows). From a management standpoint, it is also useful to track conception rates for breeding livestock, feed inventories and health supplies inventories. Lease Options While options are not common in agricultural leases, if a lease contains options, these must be tracked. The most common option used in farm and ranch leases is the option to renew. It is essential to track renewal options to ensure that all option requirements are met. Ad Valorem Taxes Ad valorem tax tracking and processing is an important requirement. Systems and procedures need to be in place to ensure the prompt payment of ad valorem taxes. While this does not appear to be a large challenge, on agricultural assets such as large ranches, the number of tax statements can easily be more than 100. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 37 of 46

39 Tax Exemptions/Valuations Agricultural properties carry with them some specialized tax exemptions or valuations not commonly found in urban settings. Special Use Valuations: Agricultural Use Valuation properties actively engaged in production agriculture may qualify to be valued based on productive value rather than market value. This valuation can reduce the tax burden on a property by tenfold. A manager of agricultural assets needs to take advantage of all potential agricultural exemptions/valuations. Further, a system to track and maintain the applicable exemption/valuations is required. Participation requires communication with the county tax assessor and will likely require sending copies of all agricultural leases to them for review. Wildlife in some states, wildlife use can also qualify as a special use and a reduced valuation is available. Wildlife use valuations also result in dramatic reductions in the ad valorem tax burden. The reporting requirements typically are greater than those found with agricultural use. Additionally, these programs normally require active management of the wildlife resource. Roll Back Taxes When a property changes from agricultural use to any other use (e.g. development) the taxing authority commonly has the right to re-assess taxes for previous years using the full market value and in some cases, impose penalties. Because of this, it is important to ensure that tax valuations from the taxing authority are reviewed and protested where appropriate. If the property changes use and the asset is re-assessed using the prior years full market values, the amount due will be less if conservative market values at the tax office are maintained. Insurance It is important that fiduciaries have in place a robust system for tracking important insurance dates, amounts and values. It is also necessary to ensure that all insurable improvements are covered, the coverage type and amounts are reasonable and that these are reviewed periodically. Liability liability coverage should be in place on all fiduciary owned agricultural assets. While it is not recommended, if the fiduciary account is a named insured on a policy carried by another entity such as a beneficiary or co-owner, there must be a tracking system in place to ensure renewals are made and premiums are paid. Further, the policy needs to be reviewed periodically to ensure that the coverage limits are consistent with established policies. Unique to agricultural assets is the necessity for hunting liability insurance. Note that most liability policies exclude hunting liability and additional insurance is required to cover the potential added liability. Casualty Casualty insurance needs to be purchased on all insurable improvements. Unique to farm and ranch properties are insurable items such as center pivot irrigation systems, windmills, grain storage facilities, barns and outbuildings. Procedures should be in place to establish coverage on items found by inspection or installed after account initiation. Similar to liability coverage, a system should be in place to track renewals and payments. Crop insurance Crop insurance is specific to agricultural properties. Crop insurance needs to be purchased for properties leased on a crop share basis. The cost of this insurance will vary with the type of crop and level of coverage. Note that the same insurance company used by the tenant for the majority of the crop should also be used by the owning account. Vehicle While not recommended, often on agricultural properties, particularly if they are used for recreation, there are various vehicles. These vehicles should all be insured with PDS Companies Fiduciary Management of Agricultural Assets Part II Page 38 of 46

40 PROPERTY INSPECTIONS liability coverage at a minimum. The addition of collision insurance depends on factors such as the value of the vehicle and the desires of the account principals. If vehicles are owned by the fiduciary account, liability coverage should be maintained. PRE-ACCEPTANCE INSPECTION Unlike an annual inspection, a pre-acceptance inspection requires a great deal of research. The goal of the preacceptance inspection is to gather as much information as possible about the asset so that an informed decision can be made regarding the acceptance of that asset in a fiduciary account. Prior to accepting an account, a fiduciary should have all of the farm and ranch assets owned by that account inspected. The inspection should be used to evaluate any potential risks to the fiduciary such as environmental risk or financial risk. Used in concert with the pre-acceptance review, the inspection should also be used to evaluate the suitability of that asset as an investment. The pre-acceptance inspection is extremely time consuming if done correctly. The pre-acceptance inspection should include all items found in a periodic inspection plus additional information needed for future management of the asset. The inspection should include pre-work including research into the prior and current use of the asset, background on the existing tenant, ad valorem tax payments and exemptions in place as well as insurance issues. If possible, source deeds for the asset should be researched and if found, be included in the report. Because of the amount of pre-work required, it is essential that as much information as possible be provided to the farm and ranch manager inspecting the asset. Documents such as leases, deeds, and tax statements can often be easily be provided by the owners of the assets. After the inspection has been done and the information has been gathered, prior to acceptance of the asset a fiduciary needs to review the objectives of the account principals to ensure that their objectives are consistent with the potential demonstrated by the property. For example, they may wish the account to direct manage a farm but the proposed account will not have the financial capability to support the cash flow or the risk involved. PERIODIC INSPECTIONS (ANNUAL INSPECTIONS) During the management of an agricultural asset, the manager of that property should perform a physical inspection of the property at least on an annual basis. For different property types, more frequent inspections may be required. For example, an irrigated farm with a crop share lease should be inspected during different stages of crop production. Inspection at planting, during early stages of crop growth and prior and after harvest may be appropriate. The annual inspection should be the most detailed and descriptive of the inspection types. It is recommended that each inspection should build on the information found in the previous inspection and that information no longer relevant from the prior inspection should be updated or deleted. Property inspections are one of the most important aspects of farm and ranch management. During the inspection, the manager should evaluate the tenant s activities and practices to ensure that they are consistent with the ownership goals and with the improvement of the quality of the asset. Also, the inspection should reveal any potential problems that can be resolved and any improvement practices that need to be implemented. The inspection should also include improvement observations to ensure that the construction quality and type present match those reported to the insurance carrier. A quality inspection should include a list of follow up items that need attention or review. Finally, the inspection should be in a form sufficient in quality and content to present to a client or other party such that any reader will have a clear indication of the condition and operation of the property. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 39 of 46

41 Accurate Description of the Asset Unlike urban assets that are composed of very few features (e.g. a warehouse and a lot or a residence and a lot), agricultural assets may contain a variety of features that influence use and value. A good inspection is one that describes the asset in a way so that the reader can visualize the asset. Inspections too, should be in a form that can be improved over time. It would be difficult to describe every feature of a large ranch or farm after only one inspection. The subsequent inspection should pick up from the prior inspection and include evaluation of both the features previously identified as well as those found or revised. 1. Buildings Buildings include residential improvements as well as barns and storage facilities. If the inspection is an initial inspection or a pre-acceptance inspection, the inspection should describe the construction of the structure clearly and should include a rough sketch and measurements so that square footage can be determined. This will aid in the getting the appropriate insurance coverage for the improvement. If the asset has been managed and a prior inspection is available, the inspection should note any improvements that have been made to the structure as well as any condition issues that need to be resolved. 2. Fences Fences include boundary fencing, cross fencing and in some cases pens. While it is common to have a simple check box indicating the condition of the fencing, a more practical approach is to include text describing the fencing. On most places, condition and quality of fencing depends on where the evaluation is made. A farm or ranch can have fences that range from new condition to 50 year old patched fencing that is in poor condition. In evaluating fencing, a quality plat of the ranch is helpful in identifying placement and condition of the fence. 3. Storage On farm storage of commodities is quite common in agricultural assets. Quality storage structures can add value to the tract and prior to the inspection, a manager should be familiar with the types of structures available and their potential utility. An approach similar to inspection of barns and houses indicated above should be taken. 4. Pastures/Fields The way that a ranch is fenced influences that assets use. Similarly, the field layout on a farm also has a direct effect on that farm s utility. Often, changing the layout can improve the utility of a farm or ranch thereby increasing its lease value. Use of aerial photography is a valuable tool in determining the layout of the tract. Any changes to the layout proposed should be noted in the inspection and reviewed. 5. Water Systems Water systems include wells, windmills, water storage facilities, pipelines and livestock waters. If a water system is in place, each component of the system should be inspected. Water systems are extremely important particularly for properties being grazed by livestock. Placement of water is commonly used to improve grazing distribution over the ranch. During an inspection, a manager should consider whether or not development of a new water system or improvement of an existing water system should be recommended. 6. Irrigation Systems Depending on irrigation type, irrigation systems can include multiple wells, pumps, power units, pipes, controls and center pivot systems. Irrigation is an area where a great deal of technological innovation has occurred. As each component of the system is important to the efficiency and value of the system, it is important to thoroughly review the whole system and the component parts during the inspection. The inspection is also a good time to review any water use reporting requirements with the tenant to ensure that all requirements to maintain the landowner s water rights are being met. 7. Drainage Improvements Drainage improvements can include farm terraces, grassed water ways and underground drainage tile. While the improvements are often subtle and hard to evaluate, drainage systems are important to maintain farm productivity. A common method to determine the PDS Companies Fiduciary Management of Agricultural Assets Part II Page 40 of 46

42 condition of the installed systems is to look for standing water after a rainfall event. Standing water or bare spots in fields where part of the crop was drowned out are indications that maintenance needs to be done to the existing system or that a different method needs to be recommended and implemented. Review of the Tenant The inspection should, if possible, be done with the tenant present. The tenant will then have the opportunity to point out the improvements they have made, the challenges that they have met and the projects that they feel should be considered. The tenant is essentially the on the ground partner to the lessor and as a result is uniquely positioned to suggest improvements that will increase the utility and value of the farm or ranch. The inspection is also time to review the property under the operation of the tenant. 1. Condition of improvements Discuss the improvements and find any potential problems that can be resolved. During the inspection, observe the improvements from the standpoint of the level of care the tenant is providing. 2. Condition of crops/pastures When you evaluate the tenant s operation, compare the subject asset to those surrounding the property as well as to what your expectations are. If there is a crop growing, compare the tenant s crop to other farms in the area. The condition of the crop will give insight into the timing of planting, fertilization and weed control. In a pasture scenario, a similar comparison can be made to surrounding grazed tracts. The inspection should determine if the property is being over grazed and if that problem was caused by weather or by over stocking. A look at the condition of the livestock will give information regarding the tenant s technical expertise as how they care for their livestock is a direct reflection on how they will care for the property they lease. Pictures and Maps 1. Digital photography has enabled easy incorporation of asset photos into the inspection report. The inspection report should include photos of any problems encountered as well as improvement pictures. Note that all pictures should have short descriptive text accompanying each photo. 2. Maps. At minimum, a quality inspection should include a location map showing the asset location relative to the nearest town. Also, a topographic map with the asset boundary should be included as well as a recent aerial photograph showing the same boundary. More intensive management or improvement planning may require additional features delineated on the map. For example, additional detail can include, soils, ecological sites (i.e. range sites), fences, wells, roads and water features. The features represented will depend on the practices planned or implemented. Projects One of the hardest aspects of property inspection is implementing projects revealed by the inspection. If a project is necessary, then there should be some follow up to determine the feasibility of the project. You do not want three annual inspections of the same asset to each recommend replacing the same cross fence. If the replacement of the fence was not financially possible after discussion, then this should be noted on subsequent inspections. 1. Status of ongoing projects As indicated earlier ongoing projects, depending on the type of the project, require more frequent inspections. In this case, a shortened inspection form or other documentation should be used. It is important to note that the trip to the property was not to do a full inspection but to evaluate the progress of the practice implemented. If a manager is doing a full inspection, there should be a section that includes the description of the project and the progress being made. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 41 of 46

43 2. List of projects/items to be considered It is seldom that an inspection will not result in a list of items that need correction or projects that need to be done. If the inspection reveals an issue that needs to be monitored then this should be noted and reviewed during the next inspection. If there are potential projects, these need to be researched, budgeted and submitted for approval. Many times, projects that on the surface look good, will fail to be practical from a cost benefit standpoint or from the standpoint that the practice is not consistent with the future use of the asset. SPECIAL INSPECTIONS Special inspections are used where a specific activity or improvement is evaluated. For example, if a fencing project is being implemented, a trip to the property will be necessary to meet with proposed contractors and then to monitor the progress of the project. Often, these inspections are performed but documentation is not recorded. A procedure should be in place that requires simple documentation of the inspection to be recorded. ASSET VALUATION The OCC Publication Unique and Hard to Value Assets contains an in depth discussion of the importance of asset valuation as well as the challenges of asset valuation. A copy of the document can be found on the internet at: Value_Asset_Booklet.pdf Historically, many fiduciaries have relied upon ad valorem tax valuations for market values of managed farm and ranch assets. This procedure, while giving a third party estimation of market value, may result in a very conservative estimation of market value which has low utility when evaluating asset concentrations and asset returns. Realistically, since many fees are based on market value, the estimate of value should be conservative but at the same time realistic. Clearly the most accurate method of determining market value is by obtaining a third party market value appraisal from a qualified farm and ranch appraiser. Because of cost, this is not commonly a utilized approach. As an alternative, a fiduciary may need to use the ad valorem tax value as a baseline value and then supplement the value recommendation value information with additional data. Sources can be: Comparable sales from brokers or from appraisers Area value range estimates from universities that track land values Market Value analysis supplied by land brokers Current listings of comparable assets in the area Once additional data is obtained and reviewed, an analysis should be done that reflects the additional data plus any additional characteristics that would influence the market value. Small undivided interests a discount may be necessary Limited use or access an un-fenced, landlocked tract with little or no use may merit a discount Exceptional improvements or water features if the quality and quantity of improvements is above what is typical, a premium may be appropriate The thought process should then be put in writing and the data used should be included in the documentation. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 42 of 46

44 The OCC booklet correctly notes an inherit conflict of interest with respect to determination of market value and fiduciary fees based on market value. It is certainly difficult to approach a client with a recommendation to purchase an expensive appraisal that, in their minds, will solely result in an increase in market value fees. An alternative would be to modify the farm and ranch fee schedule such that fiduciary fees are no longer based on market value. For investment quality farmland for example, a fee based on a percentage of gross revenue is a common and accepted approach. For assets that are being held for appreciation, a negotiated flat fee may be an alternative as revenue based fees will not provide adequate fiduciary compensation. If the farm and ranch fiduciary fees are uncoupled from market value estimates, the conflict of interest risk noted above is removed. ASSET REVIEW Review guidance fiduciaries managing real estate assets can be found in the OCC publication titled Unique and Hard-to-Value Assets dated August The asset review sections of this booklet are well written and straight forward and should provide guidance to any fiduciary managing agricultural assets. PRE-ACCEPTANCE REVIEW Prior to accepting an asset into a fiduciary account a pre-acceptance review should be done. The process should include a pre-acceptance inspection as indicated above. Additionally, a review should be performed to determine the financial capability of the asset. Potential return needs to be estimated as well as an estimate of market value. These should be utilized to determine if the asset meets the requirements of the proposed fiduciary account. The pre-acceptance should evaluate: 1. Environmental risk During the property pre-acceptance, the inspector should look for indications of environmental problems. If any are found to be present, these need to be discussed with respect to necessity for a more in depth evaluation (Phase I). The account should not be accepted until environmental issues are cleared. 2. Title Prior to acceptance as much title work as possible needs to be gathered. The objective is to make sure that the proper type and percentage of ownership is used if the account is accepted and the asset is set up. 3. Financial/investment Based on a ball park estimate of value, a rough concentration level for the asset class can be derived. The review should determine the acceptability of the estimated concentration both from the fiduciary s and the owner s perspective. Further, an estimation of annual net revenue should be made in order to estimate the return and evaluate the suitability of this return for the account. POST ACCEPTANCE REVIEW A post acceptance review is recommended for all assets. The objective of the review is to determine any missing documentation as well as to further evaluate the suitability of the asset as an investment for the account. The post-acceptance review should be about 60 days after funding and should assess: 1. Investment objectives determined 2. Missing documentation (deeds, leases, etc.) 3. Initial valuation 4. Taxes/insurance setup PDS Companies Fiduciary Management of Agricultural Assets Part II Page 43 of 46

45 ANNUAL REVIEW Each year, all farm and ranch assets should be reviewed. The review ensures that the asset(s) continue to meet the financial objectives of the account. The review also is used to monitor the management of the asset. An annual review should include: 1. Financial return The manager of the asset should check to make sure that all rents have been collected and that all leases are current. The return on market value calculation should be made and that return should be compared to other similar properties or to industry norms. If there are potential additional revenue streams being considered, these should be noted and the impact, if implemented, on the cash on cash return should be stated. This should be included only if the probability of receiving the additional revenue is realistic and short term (i.e. Oil and gas exploration is beginning and there is an opportunity for surface damages in the next 12 months). 2. Asset Appreciation If the market value of the asset had been tracked accurately over a number of years, annual appreciation can be calculated. Sources such as those previously illustrated can also show land appreciation over time. If the asset has shown marked appreciation over time, careful consideration needs to be made as to whether or not to continue to hold the asset. In the Iowa example provided earlier, the farmland values are based on productivity and price. In the case shown, much of the increase in value was driven by high commodity prices. Given the drop in the underlying commodity price, it may be time to sell. In the second example of recreational rangeland, the price rise was driven by use and not production or commodity price. The demand for recreational properties in close proximity to urban areas may continue. In either case, the appropriateness of a sale should be thoroughly investigated. 3. Insurance review As part of the annual review process, the insurance purchased for an asset should be reviewed. The coverage should be adequate and the payments should be current. The coverage type such as replacement cost, depreciated value or stipulated value should be reviewed to ensure they are appropriate for the account objectives. Liability coverage should be in place. If the account is a named insured on any insurance policy, these policies should be reviewed to ensure that they are current and the premiums have been paid. 4. Ad Valorem Tax Review A review of the taxes should be made at the time of the annual review. The review of taxes should match all the tracts owned by the account with a tax statement or a series of tax statements. The number of statements received should be the same as the number received in the prior year. Missing statements or statements with different descriptions need to be investigated and clarified. The review should include review of tax payments made to ensure that all statements received during the year were paid. While reviewing each tax statement, the exemptions and special valuations should be reviewed as well to ensure that all appropriate exemptions are in place. 5. Recommendations During the review, the manager of the asset should make a recommendation with respect to whether or not the asset should be held or sold. The instruments governing the account should be reviewed for language preventing a sale of the asset or for specific language that allows retention of specific or low returning assets. If this is the case, the review should reflect that the asset is being held per terms of the governing instrument. If the asset would benefit from a change of use or operation that would generate additional revenue and thus change the annual return, the change should be included in the review as well. Regardless of the recommendation, there should be written justification for the recommendation as a part of the review. The recommendations should be discussed with the principals of the account and appropriate actions based on those discussions should be taken. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 44 of 46

46 6. Letters of direction Often, an asset does not fit from an investment standpoint. However, the beneficiaries of the account may be comfortable with the return or may have non-financial reasons to hold the asset. While it is not an iron clad approach, use of letters of direction may be considered. The letters should state the reason to be held, acknowledge the recommendation of the fiduciary and then state that the asset is to be retained in the account. Each party to the account should be required to execute and return the letter. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 45 of 46

47 SUMMARY Agricultural assets can be excellent investments for fiduciary accounts. Farms and ranches too may be legacy type assets that are an important part of a family s heritage. Management of agricultural assets does however require a unique skill set that is not commonly found in banks. While the overall level of risk is not high when managed by skilled managers, the risk increases if the knowledge level and expertise in this asset class is low. The OCC handbook provides guidance for the management of farm and ranch real estate and all sections relating to real estate should be applied to agricultural assets managed. Anyone managing farm and ranch assets in a fiduciary relationship should obtain a copy of the OCC Handbook, carefully review and understand all guidance relative to real estate assets. PDS Companies Fiduciary Management of Agricultural Assets Part II Page 46 of 46

48 Free Continuing Education Credits Virtual Events For the CTFA & CFP Designation I attended the Webinar on provided by PDS Systems, Inc., entitled Fiduciary Management of Agricultural Assets Part II, and wish to receive Continuing Education Credit for the following designation: CTFA CFP # Name: Signature Please Print Clearly Please Print Clearly Date Please Fax back to: Or scan and to: Misti Davis at mdavis@pdscompanies.com THANK YOU Please Note: All Credit Applications must be back to PDS no later than one week after webinar presentation to be assured Continuing Education Credits. Thank you. PDS Services, Inc So. Bowen Rd, Suite 335; Arlington, TX PDS Companies Fiduciary Management of Agricultural Assets Part II Page 47 of 46