Farmland leases are the agreements between land owners who do not farm their land and tenants who desire to farm the land but do not own it. The ability to match landlords and ten-ants is critical to keeping our food system productive. While leases are common in all farming communities, the understanding of how rents are determined is not. Here we discuss a number of concepts about rents and lease arrangements and provide our opinions of whether the concept is valid or not.

The Truths

Rent is the expected excess return above costs? True. To illustrate this point, assume land has no alternative use and rent is paid only in terms of its use for crop production. If a likely tenant expects crop revenue to just equal variable pro-duction costs for seed, fertilizer, chemicals, fuel, repairs, plus machinery replacement costs, plus personal opportunity costs for their time, then the rent would be zero. In fact this could be the definition of marginal land, where the revenues will just pay for the costs of cropping. If the likely operator expects revenues to more than cover the production costs this amount would be bid to the landlord as rent. Thus, expectations of returns in excess of costs tend to be bid into rent. Alternatively if expected revenues are less than costs, this land is subject to move out of crop production, especially after several years of negative returns.

Economic conditions change the level of excess returns? True. Economic conditions improved dramatically in the early 1970’s and many acres were switched to crop-land from pasture and from government set-aside. Economic conditions changed again in the early 1980’s as revenue from crops dropped. As a result, land use changed on the lowest quality acres including low quality acres being placed in the 10-year Conservation Reserve Program. Eco-nomic conditions appear to have improved again in the mid-1990s.

The point is that revenues and expenses do change over time and land that was once farmed may become sub-marginal land, moving out of crop production. Improved eco-nomic conditions may cause this same land to move back into crop production. In the 20th century the federal government has greatly assisted the process of moving crop land out of, or into production.

Some tenants can pay higher rents? True. There are large differ-ences in production and marketing skills among farmers. With similar resources, some can produce 15 bushels of corn yield per acre or more than their neighbors. In addition, some expand their businesses to reduce per unit costs particularly on overhead items, and larger size may also allow them to acquire superior technology. With higher revenue potential and lower costs, they can bid higher rents.

Tenants must also consider the riskiness of expected returns? True. When positive changes in the economic outlook occur, prospective tenants are willing and able to bid most of the expected contribution margin (yield times price minus variable costs) increase into higher land rents. However, because of the increased price vari-ability currently, and continued large yield variability, tenants should not bid all of the expected increase into rents. Thus, prospec-tive tenants will likely bid only part of the expected increase into land rent.

Land rent markets are far from perfect? True. Finding the “right rent” or a “fair rent” can be tricky. Rental auctions may provide a way for tenants and landowners to identify what the current market rent is. While rental auctions tend to provide an opportunity for a number of tenants to compete in an open market, there is generally a lack of these auctions to provide a good reading on rental values for various locations and land types.

Another imperfection is that rents are “sticky.” This means that rents may not change as quickly as market forces that alter revenues and costs. The reasons are easy to find as some landowners retain the same tenants and the same leases over a number of years. In addition, the costs for making tenant and lease changes may be perceived by the landlord to be greater than the benefits.

As a consequence of these this less than perfect market situations, the average rent across a community often may not fully reflect current economic conditions. In fact, this average rent will tend to change more slowly than economic conditions, thus it tends to lag the true market value. Consequently, those who use average rents will tend to lag the true market. Suggestions for how to adjust rents to better take into consideration highly variable factors such as yields, costs, and prices are covered in a new publication “What’s the Right Rent?.” This is Publication Number EC-708 and is available from Howard Doster or through your county’s Purdue Cooperative Extension Service Office.

Rents and lease terms can be affected by government policy? True. Government policy has been an important determinant of rents for many decades. In the mid-1980’s, when governmental payments were high, the amount of corn base acres relative to soybeans was important. In the recent 1996 Farm Bill the question of who could receive the transition payments once again was important. In general, it can be said that transition payments tend to be bid into cash rents and to land values.

There is often a set of community standards regarding lease arrangements? True. Leases in the same community often have similar terms. For example, landowners may have 50/50 crop share leases. The land owners may supply the land and pro-vide for one-half of the cost of the seed, fertilizer, and chemicals, and receive one-half the crop. In some areas of Indiana, the 60/40 lease is common the tenant pays 60% of specified costs and receives 60% of revenues.

The Part-Truths

The landowner sets the rent? The landowner decides on the rental terms, including the amount of rent payment; however, a tenant must be found who will accept this agree-ment. Otherwise, the landowner must make changes in proposed rental terms to attract a tenant. But, rents may also be greatly influenced by prospective tenants who are aggressive to rent a new farm. In this case some landlords may change tenants by accepting the offer, or may permit their present tenant to match the prospective tenant’s offer.

Tenants and landowners should know their costs before negotiating land rents? The statement is true, but misleading if the implication is that you’ll get to rent a farm only if you have an accurate budget. If prospective tenants cannot produce competitive performances, they likely won’t be able to pay competitive rent. By preparing a budget, a prospective tenant can calculate what rent to offer. The budget should consider each individual farm as well as a whole-farm budget that examines the implications of the new rental on the entire operation. The budget will help provide guidelines for how much rent can be paid. How-ever, landlords differ greatly in their perception of acceptable lease terms. Many tenants rent from several landlords. Because of quite different lease terms, the variation in expected rents can be large. In a sur-vey of our July 1997 Purdue Top Farmer Crop Workshop participants, we found $50 per acre variation in the expected returns they received from their most and least profitable lease arrangements. It is important to identify what a specific landlord wants, and try to match the offer to these desires.

You get higher returns from farming better quality land? This would not be true in a perfect land rental market because higher return potential would be bid into higher rents. However, as we have dis-cussed, land rental markets are far from perfect. It reality it may be true that tenants do make more money on high yielding land. One reason is because in any specific community, leases for farms with greatly different soil types tend not to reflect the true difference in soil productivity. Often, the lease on the high quality land favors the tenant; the lease on the low quality land favors the land-owner. A second reason tenants appear to make more money on high quality land may be that the most highly skilled tenants can outbid less skilled operators. Thus the best ten-ants get higher yields from the best soil and they earn more themselves even after paying more rent.

However, the important point is that tenants should not just seek certain qualities of land, but should examine opportunities in their com-munity on various land qualities. The business goal is to maximize returns to their resources. Some-times that may be accomplished by farming below average land.

Market rents are set by competing prospective tenants. If the market worked perfectly, tenants would be indifferent as to the type land they rented.

Rents should be adjusted for exceptional events? It’s true that landlords and tenants sometimes make adjustments in the rent for next year because of performances realized this year; however, there is no economic justification for this action, except that it may enhance the personal relationship between the two parties. Either party can terminate their lease at the end of the current period. Thus, there is no opportunity in their contract for making any adjustments unless, on their own, they wish to do so. If they do wish to do so, they may want to formalize the adjustment terms and include them in their lease? For example, the parties can write in their lease how they will share in changes in returns from a base budget they made at the beginning of the lease.

A crop-share lease, like a 50/50, automatically adjusts for unexpected changes? This is true to the extent that these changes can be considered as occurring randomly over time. If so, these changes may “averaging out” over time. However changes which are perceived as being permanent or occurring for a longer duration, should tend to encourage changes in lease agreements. For example, when fundamental economic conditions improve, tenants will offer to pay more rent. They may alternatively offer to pro-vide more services for free, or to pay more than 50% of specified costs, or to pay a cash privilege payment.

The Un-Truths

Property taxes have increased therefore rent must increase? Untrue. Property taxes have no effect on rent. However, an increase in property taxes may cause land values to drop. For example, a $6 per acre increase in taxes might cause land prices to drop $100 per acre due to lower earnings potential for the land owner.

Mortgage interest rates have increased therefore rent must be increased? Untrue. Higher farm mortgage interest rates have no effect on rent. However, they may affect land values. On the other hand, changes in interest rates paid by tenants for production and machinery loans may impact rents. In this situation, higher interest rates tend to reduce rents, and lower interest rates have the opposite impact.

When crop prices are high, a share lease tenant won’t lose a rented farm? Untrue. The land-owner may be willing to accept a change in share lease terms, a privilege payment, or a switch to cash rent in order to realize more rent. If the present tenant doesn’t offer to adjust the rent or the terms, the landowner may accept an offer from a prospective tenant.

50/50 share leases automatically adjusts for wide differences in land quality? The market recognizes this statement as untrue. In some parts of Indiana on lower productivity soils, tenants receive 60%of revenues and pay 60% of specified costs. Highly productive soils may also be rented on a 60/40 sharing but with the higher percentage applied to the landlord. A tenant with a 50/50 share lease on low quality, near marginal land likely will be unable to realize an acceptable margin. If the landowner and tenant wish to share yields and seed, fertilizer and chemical costs 50/50 on this low quality land, the landowner will need to pay the operator in cash and/or for services such as combining, grain hauling, spraying, etc. The tenant must at least anticipate covering variable costs, replacing machinery, and some return for personal opportunity cost.