Renting land is an activity where two or more parties contribute resources. The economic objective is to share the rewards of the venture in the same proportion as the parties contribute resources.
Some parties rent land on shares. Others use cash rental agreements.
Cash rent leases take two forms: traditional and variable. Under a traditional lease, the land owner and operator negotiate a fixed amount of cash rent, typically at the beginning of the cropping year.
Variable cash rent arrangements are gaining popularity, rising from 11% of leases in 2010 to 21% in 2011. That's according to surveys conducted by the Illinois Society of Professional Farm Managers and Rural Appraisers. Moreover, 71% of farm managers responding indicate that they are using more variable cash rent arrangements in 2012.
"Variability in commodity prices is likely driving the trend toward more variable cash leases," says Gary Schnitkey, a University of Illinois economist. "Owners and operators use various approaches to calculate a variable lease. The common element is that the amount of cash rent depends on revenue."
Simple to complex
William Edwards, an Iowa State University economist, sees leases that specify the rent will be anywhere from 25% to 40% of gross crop revenue. The challenge is agreeing on the percentage. The percentage may be higher on soybeans, which typically have lower per acre cash expenses for the operator than corn.
An approach Schnitkey sees has a fixed base payment and then a "bonus" payment, which is a percentage of gross revenue when gross revenue exceeds the specified level.
A twist on that approach which Edwards sees has a fixed base payment and then a "bonus" payment, which is a percentage of the amount gross revenue exceeds a specified level when gross revenue exceeds the specified trigger level.
"Some flexible leases include a base plus a bonus rent using only price or/and production factors. One formula includes actual farm yield times a local market price that's determined based on the average of several pricing points through the season," notes Schnitkey. "Other leases involve an extensive evaluation of each year's input costs, as well as yield and price.
Test your formula
"Owners and operators should run 'what if' scenarios over a wide range of yields and prices before they settle on a variable rent formula," recommends Schnitkey. "That's because results can vary widely. In southwest Illinois, 2010 yields were above average. Bonus payments based on yield only ran $10 to $40 per acre. However, bonus clauses that were based on yield and price provided some large dividends, thanks to the rallying grain prices beginning in September. The upper range for these bonuses was $85 to $125 per acre.
Fixed rents also flexing
"At the same time that variable cash rents are becoming more popular, traditional cash rent arrangements are becoming more like variable cash rent arrangements.
"Many farm managers negotiate cash rental arrangements each year," explains Schnitkey. "Unfortunately, setting a rental amount at the beginning of the year that adequately shares returns between the land owner and operator is difficult. Seventy-seven percent of survey respondents indicated that cash rent arrangements are re-negotiated. In addition, 88% of cash rent leases have only a one year term, indicating that participants are positioned to change cash rents on a yearly basis."
In some cases, owner and operator agree on a multi-year lease term. But the lease agreement calls for negotiating the rental rate each year. This approach may result in the rental rate for this year reflecting last year's crop profit situation rather than this year's situation. Over several years this approach will likely result in sharing earnings fairly equitably between owner and operator. Conceptually, a flex lease, with well-defined yield and price triggers feeding into the revenue calculation, should more equitably share earnings each year.