A Basic Overview: Fiduciary Management of Agricultural Assets (Farm and Ranch)

Transcription

1 A Basic Overview: Fiduciary Management of Agricultural Assets (Farm and Ranch) June 17, 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 A Basic Overview: Fiduciary Management of Agricultural Assets Join Us for Our Next Webinar Marital Deduction Planning Thursday, July 24, :00 AM-11:00 AM CDT Life Insurance Management Requirements According to the OCC Unique & Hard-to-Value Assets Handbook Tuesday, September 9, :00 PM-2:00 PM CDT Click on the following link for a list of our upcoming webinars: questions to: info@pdscompanies.com Page 2

3 Introduction: This webinar will focus on management issues specific to agricultural assets. It is only meant to be a brief introduction to these topics. Agricultural Property Types Ownership Farms Ranches Recreational Property Orchards and Groves Timber Vacant Land Urban Fringe Typical Family limited partnerships Life estates Specialized mineral classified and checkerboarded ownership 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: 1. 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 2. Check local cash prices at the time of lease renewal. 3. Consider the appropriateness of a crop share lease 4. 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 Page 3

4 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: 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: 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 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 above 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 Page 4

5 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. 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. However if as asset is being held for appreciation a fiduciary must be aware of the following risks: 1. Make sure that if you are holding an asset 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. Page 5

6 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, high concentrations of agricultural assets can present risk to the fiduciary. To minimize this risk, the following is suggested: 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 Asset Sales Risk: 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. 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: 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 Page 6

7 the above 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 pre acceptance 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 Page 7

8 pickup is expensive or is not available, owners would construct an earthen pit and dispose of household trash. Over 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. Page 8

9 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 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 Risk 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. Water Rights 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. Page 9

10 Endangered Species Example: Golden Cheeked Warbler and Black Capped Verio Edwards Plateau 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 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 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 Liability 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. Page 10

11 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 kids. Many farms or ranches have over time, accumulated old equipment or 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. Leases and Operation 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 the feed store may also be a referral source. Neighbors near the property are clearly prospective lessees as well as possible referral sources. The worst method of finding a tenant is to place an advertisement in the local paper. For every one qualified Page 11

12 tenant that will call, there will be ten that clearly will not work. A tenant s technical ability can be gauged by touring their currently operated places. This should include those owned by the prospect as well as those that they lease from others. The tenant s operations should reflect how ultimately you would like the owned tract to look over time. If the tenant s places are weedy and the fences are falling down, he will likely apply the same standard of car to the tract you want to lease to them. Too, 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. They must also have the capacity to fully utilize the tract leased. Take note of their equipment if a farm is to be leased. They should have the appropriate type and amount of equipment to effectively operate the additional acreage. Finally, be aware that although a college degree in agriculture can be valuable, often there are very well qualified candidates that have grown up in the family farming or ranching operations. 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. In this example, the purchase of 1,000 cows will require an investment of greater than a million dollars. To add to this, there will be an additional burden of the lease payment and maintenance and labor expenses with the additional operation. Feel free to ask for financial references and then call those references to ensure that the tenant can handle the additional expense. Cash Leases In most areas, cash leases are the most common agricultural leases. 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 good lease should be drafted by an attorney specializing in this asset class. If a prior lease has been drafted and used, it may be utilized in leasing the subject tract. 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 lease rate than a farm that produces 120 bushels of corn/acre. Similarly, if corn is currently selling for $6.50/bushel the 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. 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 execution and the balance prior to the beginning of hunting season. With some real estate accounting systems, this payment schedule can be hard to track. Cash Farm Leases Keep terms short one year initially with a three year maximum once the owners are satisfied with the tenant Do not give the farm tenant a power of attorney to sign up for USDA farm programs Page 12

13 Include clauses to require control of undesirable plants, maintenance of facilities and fences, participation or cooperation with participation in farm programs. Cash Grazing Leases Terms of no more than three years Include over grazing clause Terms should require cooperation with any conservation programs entered into by lessor If hunting rights are included, the rate should be reflective of a reasonable grazing lease rate plus a hunting lease rate If hunting will be leased to a different party, ensure that grazing tenant will cooperate fully with lessor and hunting lessees Consider sharing surface damages with tenant but if damages are shared, a cap on the total amount received by tenant should be included Hunting Leases Preparation of a good hunting lease will require the assistance of an attorney familiar with hunting leases Can be season only or full year with season only being preferable Certain wildlife programs can extend the hunting season making it more valuable. If this type of program is used, ensure that hunting parties will cooperate with the governing regulations of the program Consider using a wildlife biologist to conduct wildlife surveys and set limits. Require hunting lessees to follow limits set. Require a logbook showing game harvested and any needed data on those game (i.e. age, weight, antler dimensions etc.) Put strict guidelines on the construction, operation and removal of any hunting camps 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, insecticides, 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. Page 13

14 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). 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 construction limits were imposed. Because of scarcity of available sites, the value of the lease may have increased dramatically. Cell tower site leases are 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. Page 14

15 Wind Energy Leases electricity production. 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 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 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. Because of the complexity and the specialized nature of this type of lease, an attorney that has experience in wind leases should be used. Pipeline 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 are called common carriers and will probably have condemnation rights. Gathering lines are used by oil companies to move production from a 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, gathering lines are extremely important to get the production from the owners Page 15

16 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 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: 1. 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 ix. If possible make the easement non exclusive Page 16

17 x. Specify beginning and ending construction dates xi. Require double ditching in most cases and specify depth xii. Ingress/egress from ends of the easement only or via a defined road xiii. Remediation requirements after construction re seeding and erosion control 2. 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 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 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 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 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. The only 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. 5. Appraisals are not required but you will be more successful if you have one. Page 17

18 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 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 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. Understand that the condemning company does not have to offer market value. 4. Know that companies will ask for more rights than are allowed. 5. Always negotiate the terms of the easement prior to negotiation of compensation 6. Negotiate in writing 7. Have the pipeline/powerline 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. 8. 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. 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 this state, 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 on the accommodation doctrine. 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, Page 18

19 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 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. Eagle Ford Well Types of oil and gas sources of compensation to the surface owner include: 1. Drill sites a drill site 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 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 Page 19

20 operation of a center pivot irrigation system, it may be possible to move the site to a dry corner of the farm. 2. Lease roads and 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 you need to go, the new 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 being 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. 3. 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 and sell what is produced on the oil and gas lease. It is common for companies to construct these 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. 4. 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. 5. 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 by the per acre or per pit. When negotiating the placement and compensation for a frac pit, ensure that there are remediation provisions in place. 6. 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. 7. 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. A resource for damage rates in West Texas can be found at The University of Texas Page 20

21 schedule will give you a benchmark to use in negotiating damages in your area. The document also includes information on additional sources of oil and gas related revenue such as salt water disposal wells that may be of interest. 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. Farm Programs 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 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 Page 21

22 tenant on the base acres and base yields adjustments to maximize those that will bring the most value to 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. 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. 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. Page 22

23 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. Management Requirements Operational Requirements 1. Tracking and reporting systems a. 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. b. 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. c. 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. d. 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 Page 23

24 standpoint, it is also useful to track conception rates for breeding livestock, feed inventories and health supplies inventories. e. 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. f. 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. g. Tax Exemptions/valuations Agricultural properties carry with them some specialized tax exemptions or valuations not commonly found in urban settings i. Special Use Valuation 1. 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. 2. 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. ii. 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 year s full market value, the amount due will be less if conservative market values at the tax office are maintained. h. Insurance i. Liability ii. Casualty iii. Crop iv. Hunting liability v. Vehicle Property Inspection Types There are three types of property inspections: Page 24

25 1. Pre Acceptance 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. It should also be used to evaluate the suitability of that asset as an investment. A pre acceptance inspection should be more than a physical on site inspection. 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. 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. 2. Periodic 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. 3. Special Inspections Special inspections are those 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. Property Inspection 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. Finally, a quality inspection should include a list of follow up items that need attention or review. 1. Accurate Description of 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 Page 25

26 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. a. 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. b. 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. c. 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. d. 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. e. 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. f. 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 Page 26

27 requirements with the tenant to ensure that all requirements to maintain the landowner s water rights are being met. g. 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 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. 2. Review of 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. a. 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. b. 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. 3. Pictures and Maps a. 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 the photo. b. 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. Page 27

28 4. 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. a. 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. b. 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. 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: bytype/comptrollers handbook/unique_and_hard to 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 Page 28

29 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. 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 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: a. 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. b. 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. c. 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. Page 29

30 Post Acceptance 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: a. Investment objectives determined b. Missing documentation (deeds, leases, etc.) c. Initial valuation d. Taxes/insurance setup 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: a. 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). b. 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. c. 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. d. 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 Page 30

31 Summary: 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. e. 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. f. 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. 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. Page 31

32 Free Continuing Education Credits for the CTFA & CFP Designation I attended the Webinar on June 17, 2014 provided by PDS Systems, Inc., entitled Fiduciary Management of Agricultural Assets, and wish to receive Continuing Education Credit for the following designation: CTFA CFP # Name: Address: Please Print Clearly Please Print Clearly Please Fax back to: , Or scan and to: Misti Davis at mdavis@pdscompanies.com Signature Date 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 So. Bowen Rd, Suite 335; Arlington, TX June 17, 2014