MY RENT JOB

D. Howard Doster, April 7, 2013

 

I now own some SW Ohio land thatís been in our family for 200 years; including some that is cropped, some that was cropped, and some that Dad never cleared, after he bought mostly woods from his cousins.Itís now my job, or my agentís job, to do a rent appraisal, using both a comparable rent survey and an income approach, estimating the earnings potential for a typical operator, of each soil site-specific area of my land.Since I know right rents typically lag estimated tenant earnings on many farms, I use mainly the income approach appraisal.

I also need to consider what fertility, drainage, field size/shape improvements to do, (including entering CRP in irregularly shaped places that qualify), and estimate the cost and extra yield to expect during the transition years and after each improvement is completed.

Whether you own a little or a lot, you have the same job for your land.Plus, if your goals are like mine, itís your job to teach the next generation how to do right things with your land; do those things in right ways; and enjoy doing them.What fun.

Today, my wife of 57 years held the ladder while I trimmed branches, one that was 16 feet long, from some of our, now, 11-year, 1,000 young walnut trees. Maybe 150 of them will make good lumber for our grandkids, the eighth generation owners of our land.

I start my rent job by estimating the expected contribution margin from corn/bean cropping each site, now, before doing any more improvements.Contribution margin is expected revenue minus variable costs.Revenue is (yield x price) + any government direct payment.Variable costs are quantity x price for expected seed, fertilizer, chemicals, fuel, repairs, crop insurance, and interest on these items. Although I created the ďsite-specificĒ term in a Purdue publication thirty years ago this fall, and continue to be fascinated by how others are creating their recipes and monitoring their performances, I still use soil type areas on my own farm.

After estimating my site-specific yields, by soil type, I base my variable costs on the quantities and prices used in a current Purdue Crop Guide budget (www.agecon.purdue.edu/extension/pubs;).I calculated these budgets for thirty years, and I appreciate how the unbiased, expert, authors discover and report current prices for right recipes.

I learned to manage farms professionally while living near here fifty + years ago.I continue to study the performances of the local farmers, and I have a list ranking potential tenants.Iím aware of the huge difference in value a tenant can earn on a well-drained farm with large rectangular fields versus what he can earn on poorly drained land, where he has fewer days suitable for fieldwork, and/or irregular size/shape fields, where he has fewer productive hours.††

And Iím aware of the huge difference in value farmers can earn on the same farm.When I asked them, tenants at a Purdue Top Farmer Crop Workshop told me there was a 15 bushel yield difference between the next-to-best and the next-to-worst tenant in their area, and more difference than that in owner-operator performances.I conclude the best tenants will tend toward the best land.Why? Because they can produce more on it, they can pay more rent for it.

I still remember my professional farm manager mentorís advice to try to pick a tenant who will improve his own profits while also improving the ownerís.My cousins still have a tenantís widow and son that I helped pick 54 years ago, when my mentor shared that advice as we drove out the lane of their poor, but, well-kept farmstead, just before my mentor offered them the better farm that they still rent, although they now also own and rent other land.

My Tenants

My present tenant improved his profits by renting my land.Itís reliably his highest yielding rental.He applies slightly more fertilizer than soil test maintenance recommendations. While the fields are irregular, Iíve put some sites in CRP.Also, Iíve applied lime on the whole farm twice since any of the neighboring land has been limed. And, by paying the rent I ask, he improves my earnings.I think he pays me more rent, and also earns more himself, on my land than on his other rentals.Mainly, we just respect and like each other.

I also respected and liked my previous tenant, the son, and grandson of our neighbor two generations ago.I still do; although Iíve turned him down recently, heís still high on my list. We used a version of my tenant margin lease for several years to keep our rent current with current economic conditions.I took the big swings in rent.He made about the same each year, plus the extra he made for his outstanding production and pricing performances.

Then, one year, prices went up during October, the time we had agreed to set the price, and he had already sold his crop at a much lower price.He paid the rent, based on our lease.With the same tenant on a 50/50 crop share lease, my brother got $75 per acre less at harvest. Across the fence, with a different cash rent tenant, our church got $150 less rent per acre.Of course, that was an extreme situation, but it happened, on adjacent farms with similar soils and weather.

The next year was also different.The tenant planted my brotherís land in April, but not mine.He finally called me on May 30.He said, ĒIíve done what you suggested.Iíve rented more land in big fields.I canít take the time to plant your farm.Ē ††Then, prices dropped, and had he stayed with me, he would have paid me much less per acre rent than he paid other owners that year.Why? Tenant margin leases are intended to be current with current economic conditions at the time you set the rent, and we had set the rent based on prices in October.

Oh, what did I do that May 30 ? I just walked across the road, and asked my neighbor to custom farm my land that year.He planted it the next day.The next year, he became my tenant.While living next to him, I had watched his performances.

Although I offer it, we still donít have a tenant margin lease.I do show him my contribution margin budget each year, based on the Purdue Crop Guide variable costs and reported average February fall futures.If/when heís interested in seeing it, Iíll show him similar calculations, based on reported average October fall futures, and USDA -reported per cent change in county yields.

I could also show him appropriate budgets for a flex-like, a crop share-like, or a custom work-like, tenant margin lease.So far, he just prefers a traditional cash rent, and I like the amount he pays.

I donít know any owners personally who have had a cash rent auction.I didnít get all the recent increases in contribution margins.I did get more than anyone I know locally.Assuming trend yields, if prices donít drop much more, at our current rent, my tenant will still have a good-sized tenant margin this year.Next year, maybe heíll want to give me more of the risks.

I think all the different types of tenant margin leases can be considered a cash lease by FSA.All adjust the rent for beginning year changes in contribution margin.In theory, almost all the change goes to the owner, but the parties can decide how to divide it.

Itís the ownerís job:

1.     to choose which prospective tenants to consider,

2.     to choose which lease types to consider, and

3.     to decide whether to conduct the negotiations by a public cash rent auction, by inviting specific prospective tenants to make sealed bids, or by a less formal process.

 

My Tenant Margin Lease

I created the tenant margin lease to solve a problem; namely, to create a way to keep a rent current with current economic conditions, year to year, almost automatically, for up to 15 years.That was the length of time the owner wanted to give the tenant an annual option to rent the farm.The parties agreed on the amount of the tenant margin, and actually used it for 12 years.I then described the lease in a 1998 Purdue publication.

Before I became a professor, I managed 16 SW Ohio Farms.Iím still an accredited farm manager and Indiana real estate broker.I expected to manage professionally again after I retired.I thought I would suggest owners use a tenant margin lease.I could be extremely productive while using very little time per client.Once I finished a good site-specific rent appraisal, perhaps with the help of an expert agronomist, and had negotiated a tenant margin lease, I wouldnít need to spend much time on anything else.Although Iíve found that playing senior softball and basketball is more fun than managing farms, Iím not aware of a professional manager who uses such a lease.Perhaps managers just like to negotiate a new minimum flex rent amount each winter with each of their tenants.

Above, I told you I calculate a contribution margin budget.This margin is the returns to the tenantís resources, the tenant margin; plus the returns to the ownerís resources, the ownerís rent margin.If you know any two of these margins, you can calculate the third.

Traditionally, when prospective tenants are calculating what rent to bid, I think they are also calculating the tenant margin they want.

I say, just bid your tenant margin.Why? An owner and tenant can agree on the tenant margin, at any time, long before the next year.AND, itís easy to use a tenant margin to keep rents current, from year to year.††

If an owner shows you his sample contribution margin budget for the present year, you can use it to adjust your tenant margin bid, based on his budget, which he agrees to calculate in the same way in future years; using future prices, trend yields, and then current government payments.

Then, on the previously agreed date, the owner and tenant can calculate the ownerís current year contribution margin budget.On that date, they subtract the previously agreed tenant margin from the ownerís contribution margin.The remainder is the ownerís rent margin.

I like a tenant margin lease for multiple reasons:

1.     First, you can negotiate it at any time, long before you know the next year crop and variable cost prices.You just agree now on the type of tenant margin lease, the amount of the tenant margin, and how you will divide the year to year change in the ownerís budgeted contribution margin.

2.     Second, itís current with current economic conditions when you set the rent; you donít need to conduct a cash rent or sealed bid auction each year to discover current economic conditions.

3.     Third, the tenant owns the crop and decides when to plant/harvest, and when to buy/sell in all tenant margin leases. Thus, an owner doesnít have to buy/sell or worry about when his farm is plant/harvested.A tenant gets 100% of his buy/sell, his crop recipe, and his timely performances.

4.     While the owner takes most of the risk for within-year unexpected price and weather outside-the-farm-gate consequences, these risks are less than for an owner-operator, who also takes the risks associated with his own inside-the-farm-gate performances.

 

Now, I need to add a questionnaire asking prospective tenants to make a per acre tenant margin bid, based on an ownerís contribution margin budget, for say, the next March 5, for each of the types of tenant margin leases.A tenant should bid on each lease type he would consider.

A prospective tenant can do the same appraisal analysis as the owner, except he can also do it for each of his other land parcels, based on his own expected performance, and based on his expected yields if he were to plant/harvest each farm last, when his expected yields are lowest.

Why last?Because one of his farms will be plant/harvested last.Thus, when he is bidding on a new farm, a tenant is making multiple comparisons;

1.     one for replacing his poorest earning rental, and

2.     one for renting his present farms, plus adding a rental at slightly lower yielding plant/harvest dates.

3.     Of course, a tenant might also test for trading for larger, more timely, machinery.

 

Tenant Bidding

Much more has been written about how a tenant should calculate what he can bid.Iím assuming a prospective tenant is already farming, is good enough, financed and committed enough to be somewhat competitive in his bids.I think itís important for a tenant to recognize five things:

1.     First, he needs to bid, including non-money satisfactions, no higher than enough to barely outbid his competitors.

2.     Second, he needs to bid low enough so that this lease will be the best use of his labor/management/machinery/money resources.

3.     After considering the risk/reward differences in the lease types, a tenant should bid an amount so as to be indifferent as to which type the owner picks.

4.     If a prospective tenant wins most of the farms he bids on, perhaps he is bidding higher than he needs to bid.

5.     If a tenant repeatedly loses out on renting more land, or on retaining his present land, perhaps itís his time to become a farm or ag business employee or to exit the industry, and use his resources elsewhere.Everyone has a comparative advantage for doing something of value.

 

The Contract

The owner can then pick the tenant and type he prefers.

The parties will sign a lease only if each thinks this contract represents the best use of his resources.

While there are many bids that will not meet these criteria, there may be a range in amount where both the winning tenant and the owner think they are better off.The best negotiator gets the majority of this range, What fun.