Economics of Leasing Introduction Lease or Buy: The average annual per acre rental rate in Virginia for the period of 2002-2013 is been $43 for cropland and $19 for pastureland (NASS, Quick Stats). Over that same time NASS valued all Virginia farmland at $4283 per acre. Anecdotal evidence about farmland sales in Virginia indicates that in productive farming regions of the state and farmland near urban areas may sell for more than $10,000 per acre. Regardless of the value or selling price, purchasing farmland to begin or expand a farm business it may be difficult to finance. For example, to purchase a 50 acre farm, based on USDA values, would require (50* $4283) access to $214,150 in capital just for the land, with an annual payment of $20,632 if all of the purchase price was financed at 5% for 15 years. The manager would still need additional financial outlays to create a farm operation. In contrast, at $43 per acre that same 50 acres would require an annual rent payment of $2,150, clearly less. This does not mean that purchasing farmland is unwise but it does point out that leasing farmland provides a means to gain control of a land base and minimize the fixed investment and/or debt required for a purchase. Objectives of leasing: The main objective of any lease or rental agreement is for all involved in the arrangement to be treated fairly. That is, to secure a fair return on their investment or their contribution in the form of land, labor equipment, machinery buildings, and so on. The tenantlandlord relationship should be fostered and at periodic intervals evaluated to insure that new technology advances and new production practices are adopted or implemented to maintain the resources base of all parties involved. In addition, parties must recognize that factors outside of their control may contribute to lower profitability and decreased returns. These factors include changes in land valuations driven by non-agriculturally related speculation and/or higher taxes and policy changes that directly affect input or output prices. Where to start: The first thought, when it comes to leasing is, how much? This often occurs before the tenant or landlord have meet or discussed any terms. This does ground the process on financial terms yet it short-circuits" the process of systematically valuing all the attributes of land and improvements offered by owner, and the skills, management, machinery, livestock, and so on offered by the tenant. So the next thoughts should be what do I have offer to this lease arrangement? The landlord might think, what s the agricultural value of this land and how does it s productivity compare to other land, what is the fertility and ph, cropping history, weed problems, is there a good supply of water for livestock or irrigation, age and state of repair of fence and water systems, buildings, and roads? The tenant s questions: will this farm optimize my fixed capital investment, can I manage a larger land-base or added animals, does this land have the potential to return a profit, can I invest in improvements and updated technology, does this farm increase or decrease my overall risk, are there additional restrictions/easements or environmental concerns with this land base? Basic economics: One-on-one transactions usually start with exchange or collection of information so that each party can estimate their offer price to establish a negotiation range. For farmland leasing the negotiation range is between the tenant s and landlord s, I quit points, long-term wants, and short-term got to have s Regardless of the type of lease, cash, share, 1
flexible, livestock, and so on, each party should establish value for their contributing to the lease. This process is key to understanding what each party is contributing and the initial stage in creating a lease that all parties consider fair. To start this process a few definitions are needed: Fixed costs or sunk costs are just what their name implies a set amount that the farm business must pay annually for the opportunity to use that asset in the farm business. These assets have a life greater than one year and include general categories such as, machinery, equipments, fence and water systems, buildings, breeding livestock, and so on. Fixed cost are not just one value but are made up of the following, depreciation, taxes, insurance, and interest. o Depreciation reduction in value or obsolescence of an asset (machinery, fence, buildings, and so on) over time (not tax depreciation). Consider that a new tractor, annually it wares-out a little bit and the technology will becomes a bit less cutting edge and at sometime for the farm business to remain viable it must be replaced with like-kind, albeit updated technology. This annual loss in function or value over the life of the asset is depreciation. So an ongoing farm operation will need to generate sufficient net returns to be accumulated (in cash or additional borrowing capacity) to make repairs until the time to replace the tractor, or any fixed asset. Even though this valuation process is a challenge to estimate it represents a true a costs to the farm business and should be accounted for when valuing contributions to a lease arrangements. Thus, if a farm operation is to remains viable annual depreciation of all assets need to be recognized as cost. o Taxes on assets should be included at actual cost. Taxes are normally billed once or twice a year by the local jurisdiction and are easy to identify. Depending on the Virginia locality taxes are levied on land, improvements, livestock, equipment and machinery, vehicles, etc., and the tax rate is set by the local government where the asset is registered. If the rate is unknown consider using 0.5% of current asset value or contact the local Commissioner of the Revenue to determine rates. o Insurance on assets is a cost of doing business and may be required to obtain financing to purchase machinery or build an agriculturally related building. As with taxes, farm business often receive annul or semiannual bills for these service and can allocated the actual costs to the leasing enterprise. One the costs of liability insurance is know it can be a directly allocated on a per unit (acre, head, tree, etc) or to the whole farm. If the rate is unknown consider using 0.5% of current asset value as the total insurance rate. o In summary fixed costs do not change with the level of production, for example the annual deprecation of a tractor or bulk tank will remain the same regardless of the annul usage. However, the greater the annual usage of that asset the lower the per unit costs. Conversely, if the asset is not used the fixed costs remain the same. Consider a grain bin with annual deprecation costs of $10,000 and the bin is only used to store 1,000 bu. of corn during the year, total fixed cost per bu. is $10.00, conversely if that same bin is used to store 50,000 bu, then total annual fixed costs would be $0.20 per bu. o Depreciations, taxes, and insurance are fixed costs and define the long-term wants for both tenant and landlord. 2
Variable or out-of-pocket costs: The variable nature of these costs are related to physical inputs used to produce a product. For example, consider fertilizers, higher yields of a crop or forage require increased levels of fertilizers. For example, if a ton of grass hay requires $80 of fertilizer, then the first and/or last ton of hay will still incur total fertilize costs of $80 per ton. Or an example of a tractor or truck, the more they are used the more fuel is consumed and if they are not used fuel usage goes to zero. Thus variable costs increase or decrease with usage. Conversely, total variable costs per unit produced remain the same regardless of how many total acres or miles the tractor or truck are used. Variable costs define the short-term got to have s. Opportunity costs: By definition, opportunity cost is the next best alternative to any action or choice taken, for example, a choice to invest in a baler rather than cross-fencing to subdivide pastures. The funds used to acquire the baler cannot be used for another investment, the forgone benefits the farm may have received from the cross-fencings are the opportunity costs. The main point to make is that you recognize, all choices have a cost, regardless of the source of funds owned and/or borrowed. Our time also has an opportunity costs, for example attend your child s ballgame or drill a fall cover crop. For financial consideration, opportunity cost of capital (investment in assets) is usually expressed as an interest rate and should reflect a similar level of risk. Your choice of opportunity costs for capital invested in agriculturally related capital can be based on your farm business s return on assets if known. Otherwise you can choose to use current savings bonds rates or other long-term assets. The main objective is that tenant and landlord discuss and agree on a rate to be used in their valuations of capital assets involved in the lease arrangement. Opportunity costs define the long-term wants for both tenant and landlord. In summary a tenant must have sufficient returns to cover all of the variable costs plus lease payments. If the total returns from sale of products just cover the variable costs plus rent, then the tenant would be better off not leasing the farm. This is often referred to as the shut-down point, walk-away point or I quit point. The owner also has a I quit point, that is, where the lease payment just equals the owners expenses for taxes, maintenance, lease related travel, time and management costs, insurance, and legal fees. Thus if the lease payment only covers these costs the owner will be better off not leasing the farmland. These I quit points define the bottom-end lease rates for each party. Long term wants and short term got to have s apply concepts of fixed and variable costs to help both parties reach a fair lease. The best way to define these concepts is to consider a simple example. Larry Landlord (LL) owns 125 acres of pasture and hay land with good fertility and ph, and has the following improvements attached to the land, a hay shed, fence and a water system in all fields. LL want a fair returns on his investment and time allocated to the lease arrangement. Tom Tenant (TT) owns his own machinery, 50 beef cows with replacement heifers, and bulls. He will provide all labor and management for the farm. TT also want a fair return on his investment and labor. In an ideal world LL would like: 1) to cover all repair and depreciation costs for the hay shed, fence, and water system so that when these improvements wear-out they can be replaced with comparable technology; 2) cover taxes and insurance on all improvements and liability insurance for the land; 3) pay legal fees associated with the lease agreement; 4) 3
returns to his labor and management of the lease; and 5) returns to ownership of the land and improvements. TT would like: 1) to cover all repairs, insurance, taxes and depreciation for livestock and machinery associated with the 125 acres; 2) cover all additional variable costs for this leased livestock operation; 3) returns to his labor and management for this leased farm; and 4) returns to ownership of his livestock and machinery. To help the description of LL and TT to take shape a few illustrative values will be assigned. LL s 125 acres of land valued at $ 375,000 with improvements worth an additional $75,000 (Table1). LL has annual expenses for taxes and insurance of $2,250, his labor valued at $2,000 and he estimates he will spend $500 to have a final lease agreement drafted by a local attorney. Thus his annual contribution to the lease is $35,167 or he would like to charge $281 per acre for TT to lease the farm. The annual contribution/expense are detailed in Table 1. For average farm land in Virginia in 2013 this exceeds the going market rates of $47 per acre published by USDA-NASS (http://www.nass.usda.gov/quick_stats/). Table 2 details TT asset base and annualized costs. He has set a current value $65,000 of both machinery and beef cattle. His beef operation has no depreciating as it is is an ongoing enterprise with heifers being raised to replace cows that leave the herd, thus the costs are reflected in the net income of the farm. Machinery deprecation is straight line over the 15 year average life. TT s expenses and annualized costs are details in Table 2 yielding total contribution of $43,234reducig that by his estimated net income from cattle sales shows a loss of -$13,234 and we quickly conclude this will need some negotiation if it s to work out. Tables 1 and 2 illustrate how both LL and TT would go about estimating their total investments, total costs, and what each would like from the lease arrangement. In simple terms the bottom-line from these calculations yield nothing of value. LL would like to have annual payment of $281 per acre and TT s cattle operation is losing money and would prefer LL to provide a subsidy to his business. (Note: This exercise does illustrates some of the discussions the author has had with landowners unfamiliar with agriculture and leasing in Virginia.) However, the values, methods and calculations yield the starting point for rational negotiation. Table 1: LL s investment and total costs or what he wants Items (years of Life) Current value Annual repairs at 5% of current value Depreciation (straight line) 4 Annualized costs Hay shed (20 years) $25,000 $1,250 $1,250 $2,500 Fence (15 years) $25,000 $1,250 $1,667 $2,917 Water system (20 $25,000 $1,250 $1,250 $2,500 years) Investment (land, hay shed, fence, and water*) $450,000 n/a n/a $22,500 Taxes and insurance $2,250 n/a n/a $2,250
Labor $2,000 n/a n/a $2,000 Legal fees $500 n/a n/a $500 Total LL would like to have $35,167 Per acre lease rate $281 *Annual return to ownership @ 0.5% Table 2:TT s investment, total costs, and net returns TT s situation Current value Depreciation Annualized costs Items (years of Life) (straight line) Breeding livestock (7 years)** $65,000 n/a n/a Machinery (15 years) $65,000 $4,334 $4,334 Labor 400 hrs $12/hr n/a $4,800 Management 0.05% of gross sales $30,000 n/a $1,500 Insurance $600 n/a $600 Operating costs (includes repairs) $23,000 n/a $25,000 Legal fees $500 n/a 500 Investment (Livestock and $130,000 n/a $6,500 machinery*) Total costs $43,234 Total income $30,000 $30,000 Net Income -$13,234 Total TT would like to have n/a Per acre lease rate n/a *Annual return to ownership @ 0.5% **Assume that TT has a stable herd with replacements being raised on farm. Table 3 illustrates the process that LL and TT might use to reach a lease rate that allows each to receive funds to cover their financial needs and contribute to their fixed and opportunity costs. Both LL and TT look at their variable costs (must have s) and consider their fixed an opportunity costs may need to be postponed otherwise an agreement may not occur. Note that these costs have been incurred and any returns over variable costs will go to help pay a part of these costs. Not an Ideal situation yet realistic in most Virginia farmland leasing agreements. Working through this simple example LL learns that he must have $54 per acre otherwise he would be better off financially not leasing the farm and likewise, TT knows he cannot pay more than $72 per acre in rent or he will be better off looking for an alternative farm or not to farm at all. Well they reach a rental rate between $54 and $72? It would seem logical but maybe not practical. Maybe they can trade non-cash services and help each other, e.g., TT plows snow and maintains the road to LL house, LL checks and feeds the cattle while TT goes on vacation, TT repairs the fence, hay shed, and water system and LL buys all the materials, and so on to reach a fair exchange. Table 3: Creating a negotiation range Items (years of Life) Annualized LL s TT s Type of costs Hay shed (20 years) $1,250 n/a Repairs Variable Fence (15 years) $1,250 n/a Repairs Variable 5
Water system (20 years) $1,500 n/a Repairs Variable Investment (land, hay shed, fence, and water*) $0 n/a Return to investment - Fixed Taxes and insurance $2,250 $600 Variable Labor $0 $0 Opportunity their time only Legal $500 $500 Variable Machinery n/a $0 Return to investment - Fixed Management n/a $0 Opportunity Investment (Livestock and machinery) n/a $0 Opportunity Operating costs (includes repairs) n/a $23,000 Variable Total costs n/a $24,100 Variable costs only Total income n/a $33,000 Net Return n/a $8,900 LL must have per acre - I quit point $54 n/a Lowest lease rate TT per acre - I quit point n/a $72 Highest lease rate Negotiation range $54 <=========> $72 Summary: A few points need to be made about developing the negotiation range based on the needs of each party. First, no amount of calculations will not overcome: Lack of profitability o Of an individual farmer. o Of an entire sector of the agricultural economy. o Brought on by a costs-price squeeze within commodity markets higher costs combined with stagnant or declining prices. Local market conditions that drive rental rates up and/or down, thus changing the supply and/or demand for property to lease at the local level. Change in policies, leading to changes in land markets o Farm Bills, e.g., eliminated quotas for peanuts and tobacco o Energy, e.g., Renewable Fuel Standard Poor landlord/tenant relations Lack of common sense and/or willingness to cooperate to reach a fair rate. A few additional questions that are hard to quantify yet need to considered when negotiation a lease. What is the value of? A great tenant or landlord - What s the value of a good relationship where rents are paid on time, the land is maintained, you are informed ahead of time about any concerns, the landlord understands agriculture, lets you know if there are problems with land or livestock, and so on. A great location what are you willing to pay for the next-door farm verses the one 20 miles away? Knowing soil productivity Should you pay more or less based on soil productivity? A longer lease period? What s the added benefit of a landlord willing to consider a 10 year lease verses a year-to-year lease? 6
All these attributes are hard to value but we know that they can reduce the financial and business relationship stress when addressed before a lease is signed. Even with all the calculations, there are drawbacks to leasing, the obvious one is termination of a lease and loss of that land base, increasing financial risk and reducing the farms efficiency and cash flow. This a very serious problem with the all-to-common annual/verbal handshake lease. There are no commitments by either party beyond one year and the tenant or landlord can give notice and walk away from the agreement. This arraignment is flexible yet loss of the lease may reduce net returns for the farm business so that the tenant cannot meet cash flow, remain profitable, supply feed, and so on. Written leases for times greater than one year provide a window to adjust the farm business or look for replacement land and reduce financial and production risk. The length of a lease is dependent on many factors and should include: Cash flow and debt service. Tenant, if this land is no longer leased, how long can the farm business remain viable with the reduced cash flow? Owner: if the tenant leaves how long before a new tenant must begin making payments to maintain the property and cash flow. These two points help set the minimum lease length. If we know the minimum, the next questions is what s the best length of a lease? This will depend on many factors yet one many consider an annually renewed lease or a rolling lease. For example, if the minimum time required to adjust to loss of a lease is 5 years, then establish a 5-year rolling lease. That is, at the end of each year at the annual review or landlord tenant meeting renew the lease for the next five years. Thus, both parties will have a 5-year planning horizon. Capital investments and cost-share. Tenant, if you want to make a capital investment on this leased land, the lease will need to cover the life of the useful life of the investment or to retire the debt incurred for that investment. Landlord, will this capital investment provide value to the land and what do I do with the improvement when the lease is up? First, the tenant should have a business plan that lays out the estimated financial performance and specifically when and how this capital investment will generate cash flow to retire the debt. What financing is required, and what risk management strategies will be in place to reduce risk of default. Also include a discussion of any cost-share arrangements, restrictions, and or liens placed on the land for the tenant to participate in State and Federal programs. Many of the cost-share programs require that the property owner sign to maintain the practices even if the tenant leaves the farm. Leasing provides an alternative to owning land and will meet the needs of beginning farmers just starting out, established farmers seeking to expand, older farmers seeking to slow down as they approach retirement, rural residents seeking to maintain productive land yet not wanting to actively engage in farming, and investors holding land as a part of an investment portfolio. Regardless of which categories you fit sound knowledge of the economics of leasing will serve both the tenant and landlord to establish fair lease rates that meet the needs of both parties. 7