Two Perspectives on Setting a Cash Rent
This article by Tina Barrett, executive director of Farm Business Inc., is the second in a series by UNL experts focusing on farm profitability despite low commodity prices. Watch for more Belt Tightening articles this fall and winter to aid in your farm management. Also see:
- Tightening Your Belt; Refocusing on Profitability
- Reeling in a Decade of Family Living Cost Increases
Nov. 14, 2014One of the greatest debates of the next few years will be between landlords and tenants over setting cash rent.
Unfortunately, there is no right answer for all farms. In addition to the productive capabilities of the ground, risk tolerance and leverage rate may affect the cash rental rate. It will be important that the landlord and the tenant look at each other's perspective. The only real winners will be those who find a way to ensure both parties make a reasonable profit.
The issue of cash rent is often between two individuals. There's no corporate headquarters in another state. There's no chain of command between the person you're talking to and the person who sets the price. It's personal between the tenant and the landowner and when things become personal, they become tough.
The Landlord's View
When setting a price, the landlord considers many factors, including:
- Return on investment
- Tolerance for risk
- What the market will bear
Using a return on investment sounds like an easy choice for setting land rent, but it doesn't traditionally work for farmland due to the market value being higher than the productivity value. Also, is the investment the $1,000 per acre that was paid for the ground 20 years ago or the $10,000 per acre it could be sold for today (your opportunity cost). Just because a landlord wants a 5% return on the opportunity cost doesn't mean $500 per ac re is the right cash rent value. If the tenant is only grossing $700 per acre (200 bu x $3.50/bu), a $500 rent would put them out of business. In the same case, asking for 5% of the initial investment doesn't make sense because $50 per acre won't cover the real estate taxes. In either case, setting a price based strictly on a return on investment doesn't make sense.
Evaluating risk tolerance is an important element in deciding between cash rent or share rent. Cash rent is a high risk/high reward contract for the tenant which provides a guaranteed low risk/low reward return for the landlord. For a guaranteed income, the landlord is giving up the right to take advantage of $7.00 corn for the stability of not having to risk $3.50 prices. This means cash rent should be based on a factor that is equal to an average corn price; however, it would be difficult to set a good average based on the past few years. We can't count on $6.00 corn and we hope $3.50 isn't here to stay.
In the past few years, the concept of "what the market will bear" has prevailed. Landlords have wanted to take their share of the profits and cash rents have shot up as corn prices did. Many landlords will argue they didn't raise rent as fast as the corn prices increased so they shouldn't lower it as fast as icorn prices decreased.
If corn continues to hover near $4.00, many of these issues will take care of themselves. Land value will have to drop because the profits won't be there to spend $1 million on a quarter. That means your opportunity cost will drop and so will a calculated return. Eventually counties will have to lower valuations, which will lower real estate taxes (barring any levy changes). Multiple years with $4.00 corn also will eventually take care of the "coffee shop" rents. For the next couple of years some producers may still be able to offer $400 per acre, but eventually they will go out of business.
The Tenant's View
The tenant's view is simpler. Deciding how much to pay for cash rent can be brought down to numbers. How much is the tenant willing to risk for the right to farm the ground. Will they hold out to guarantee a profit or risk not covering overhead costs for the chance at a long-term profit? Is the tenant willing to pay a price that is enough to cover farm costs, but not enough to cover family living costs? How long is the tenant willing to lose money farming that particular parcel?
For tenants it comes right back to knowing your their costs. Each tenant's costs are different than the average and different from a neighbors' because of decisions the tenant made, not only this year, but in the past. Once costs are known, a tenant can make an informed decision about how much cash rent to pay. If this decision is based on someone else's cost numbers, the final answer won't be right for that farm.
Comfortable Risk Level
A typical cash rent lease is a high risk/high reward contract. This means if everything goes right, the tenant wins big; but if it doesn't, the tenant stands all the risk of failure. Compare land rents to the stock market. Like cash renting, buying individual stocks can return high profits, if the right companies are picked. It is a high risk/high reward strategy. If mutual funds are purchased, the risk is spread across a wide range of companies. Some of them will make money, some won't. With mutual funds you share in the risk and reward with others, similar to share rental arrangements.
When determining costs, direct and indirect costs should be considered separately. Direct costs are those needed to farm a particular piece of ground, such as seed, chemicals and fertilizer. Indirect costs are part of the business regardless of whether the farm has 500 or 600 acres; these include insurance, machinery, or tax costs.
Ideally, the income will cover both direct and indirect costs and return a profit to the tenant. In tough times, the tenant may settle for covering the direct and indirect costs, without covering labor and management. In extreme circumstances, only the direct costs and a portion of the indirect costs are covered. This makes for a high risk cash rent, similar to buying stock in a startup company. You could do well, but you have to be willing to part with your money if it doesn't work. Farms that are well established, low in debt, and high in working capital can do this in the short run to ensure the right to farm this parcel, but this is not sustainable in the long term. It relies on profits from previous years or another enterprise (field) to sustain the operation. Big risk-takers will be more comfortable with continuing high cash rents longer than those who are less comfortable with risk. An individual tenant's financial situation also plays a role. If a tenant is highly leveraged and in a tight cash position, their bank isn't likely to allow them to take the risk. On the other hand, someone with only a few term payments and operating on cash can afford to take the higher risk.
The reality is that in the coming years there will be a compromise. The current cash rental rates are just not viable for the long run and will have to come down. The great thing about cash rent is that it IS personable. If both parties are willing to find a fair solution, everyone can win. It is a tough conversation to have without greed, but knowing your costs can be a great way to open the conversation.
If as a landlord, you think you need to share in the profits of $7.00 corn and as a tenant you want to share in the risks of $3.50 corn, a compromise of a share rent or bushel rent may need to be made. They are not as clean or as simple, but they do share in the true risks and rewards of farming. A strict cash arrangement is always going to make one party feel as if the other is getting the better deal.
Director, Nebraska Farm Business Inc.