Using Budgets to Establish 1998 Rents
November 18, 1997
Howard Doster, Extension Economist*
Rents for 1998 will be influenced by a number of factors but key among these will be the expected level of returns. Some factors are already known. For example, 1998 government payments will be down $8-12 per acre of corn base. Some factors can be anticipated such as crop pro-duction costs that on average are unchanged for 1998. Finally, some factors such as yield and price remain highly uncertain.
Everyone has expectations about future costs, yields, and prices. These expectations can be quantified in budgets. The author’s budgets for 1998 are shown in Table 1. Rotation contribution margin (revenue minus variable costs) is shown to be $169 for the low yielding Miami soil, $218 for the average yielding Crosby soil, and $280 for the high yielding Brookston soil. For each soil, the budgeted per acre contribution margin is the return to the machinery, the labor-management performance, and the land. Use the revenue and variable cost items to fit the terms of your lease or a lease you may be considering. For example, if you’re a cash rent tenant, subtract cash rent from the contribution margin to determine the amount expected to be available for machinery replacement and labor-management, including yourself.
In Table 2, the budgeted increase in contribution margin is shown for each year after setting the 1995 contribution margin (not shown) equal to zero. Referring to the average yielding Crosby soil, note the 1996 budgeted contribution margin increased $20 over the 1995 budget. The 1997 increase is another $22 per acre. The 1998 budget is $55 higher than the 1995 budget, and $13 higher than the 1997 budget. The 1998 budget for the low yielding Miami is $11 higher and the high yielding Brookston is $18 higher than the 1997 budget.
These numbers indicate that returns have been increasing, and are expected to increase again for 1998. Higher potential returns pro-vide a strong economic incentive for 1998 rents to move higher again.
Price expectations are expressed daily in the Chicago Board of Trade (CBOT) futures contracts. Until October 10, 1997, from the time trading began for futures contracts for November ‘98 soybeans and December ‘98 corn, prices for those contracts were lower each day than prices for year earlier November, ‘97 beans and December, ‘97 corn contracts.
On October 10, 1997, right after the USDA October 1, Crop Report, November ‘98 soybean contracts closed at $6.90, and December ‘98 corn closed at $2.90. A year earlier, however, futures prices moved lower all fall. From August ‘96 to December ‘96, November ‘97 soybean futures dropped $.90 per bushel and December ‘97 corn fell $.50 per bushel.
This year, while starting at lower price levels in July ‘97, November ‘98 soybeans and especially December ‘98 corn moved higher. By November, if fall ‘98 futures contracts do not drop below their October 10 closing prices, budgets for 1998 will indicate higher rents for 1998, compared to 1997 budgets.
As referenced in the Table 1 budgets, the prices for harvest ‘98 are based on October 10, 1997 futures contracts of $6.90 for beans and $2.90 for corn. On November 15, 1996, the fall ‘97 futures were $6.78 for beans and $2.70 for corn.
Rents are negotiated throughout the year, but especially in the fall. For rents negotiated last summer, 1998 rents could be lower than 1997 due to lower price expectations at that time. For rents negotiated after you read this paper, rents could be higher than in 1997.
Landowners are encouraged to pre-pare so-called “benchmark” budgets before negotiating a rent with a prospective tenant. With access to computer spreadsheet software, it’s possible to quickly create precise budgets using expected government payments, costs, yields and prices for the next year.
Approximate government payments are now known for each farm for each year through 2002. Expected yields by soil type are available from local NRCS (Natural Resources Conservation Service) offices. Yields can be assumed to increase about 1.1%per year, based on the change in average Indiana crop yields since 1975. Cost estimates can be made as soon as next season price quotes from dealers for seed, fertilizer, and chemicals are announced a few days after Thanksgiving.
Anticipated harvest prices for the next year’s crops are expressed daily in Chicago Board of Trade futures contracts. Futures prices can be converted to expected local elevator prices by using a normal difference or “basis” for each elevator for each date.
The basis may be quite different for different locations on the same date. It is quite different for the same location at different times of the year. However, for any specific location and date it is generally fairly close each year. Therefore, a normal harvest basis for any elevator can be subtracted from November soybean futures prices and from December corn futures contract prices. The result is an estimated local elevator harvest price, based on the current futures contract price.
Many elevator operators, if asked, will share their normal basis levels for specific dates. A basis of $.25 for beans and $.20 for corn was subtracted from the futures prices to arrive at prices used in Table 1 and Table 2.
The author recommends that landowners create representative or benchmark budgets. It is useful to get representative budgets for costs, yields, and prices. Whether stated or unstated, every landowner and every prospective tenant has expectations about likely events for the next year. It is not necessary and may not be desirable for the landowner to use a specific prospective tenant’s expected yields, costs or prices.
Production performance of ten-ants in any community varies considerably. For example, at the 1997 Purdue Top Farmer Crop Workshop, thirty-two tenants indicated an aver-age expected corn yield difference of 25 bushels between the next-to-best and next-to-worst tenant if both could farm the same farm, the same year, with the same machinery, weather, etc.
Once a landowner creates a benchmark budget, they can negotiate with prospective tenants as to how to share the contribution margin. For example, if given the opportunity to bid, a tenant will likely bid up the rent until the expected contribution margin each year is about the same, after paying their share of the variable costs including cash rent.
Highly skilled tenants may expect to produce higher yields than in the landowner’s benchmark budgets. They may expect to have excess funds after recognizing their machinery replacement and labor-management services. Lowly skilled tenants may be forced to stop bidding and not rent the farm.
Once a landowner creates a benchmark budget for their farm, they can quickly update it. For example, benchmark budgets can be made on the same date, say, December 15, or March 15, every year. Given a series of benchmark budgets made on the same date every year a landlord has evidence to support a change in rent. This is likely the situation as you read this paper.
The November 15 date for calculating prices in Table 2 was used for a number of reasons. The current year crop size and expected year-end carry-out has been widely circulated by USDA and others. Thus, persons interested in buying or selling futures contracts are well informed about market conditions at that time. Also, leases may have a December 1 notification date for terminating a lease.
Budgeted costs are based on the same criteria used to prepare the per acre production costs information in the annual Purdue Crop Guide, ID-166 by Doster, D.H., et al. For 1998 budgets, the total variable costs are essentially unchanged from the 1997 budgets.
You are invited to adjust the budgets for your own needs. You may want to substitute November 15, 1997 prices. You may want to substitute your costs and/or check the 1998 Purdue Crop Guide, ID 166, which will be based on early-order 1998 seed, fertilizer and chemical prices and is expected to be published in January. Currently, the total variable costs as shown in Table 1 are less than $1 per acre different from 1997 budgets.
Once a cash rent based on a bench-mark budget is agreed upon, the landowner and prospective tenant can negotiate how to share changes in government payments, costs, and especially yields and prices. The agreement can be simple, merely agree to share 50/50 any changes from the benchmark budgets. Now you have a type of crop-share lease.
The lease with adjustors need not include any information about actual performance on the farm. Thus, the tenant will not be pressured to plant/harvest this farm on the best dates and the tenant will not need to keep separate cost or yield records for this farm. The lease adjustors can be based on events that occur outside this farmgate. For example, bench-mark budget yields can be adjusted by the percentage change between expected and actual county average yields. Benchmark budget prices can be adjusted by the change between expected and actual local elevator prices for a pre-specified date or dates. USDA reports an index of average input prices. This index can be used to adjust variable cost changes.
The Right Rent
No attempt is made in this paper to estimate the “right rent”. However, this benchmark budget comparison information supports the conclusion that persons who negotiate their rents annually will increase their rents in 1998. Assuming the expected rent was right for 1997, a higher amount will be the right rent for 1998, if fall ‘98 futures prices stay at their October 10 levels or go higher. The budget comparison information also supports the conclusion that persons who adjust their rental rates infrequently will increase their rate if they negotiate a change for 1998.
When rents are market deter-mined, such as by a rent auction, tenants can be expected to bid the known government payment into their rent offers. For both cash rents and share rents, the next year government payment can be expected to somehow get to the landowner, if the landowner chooses to allow prospective tenants to compete for the next year’s lease. Likely, most prospective tenants will want to bid only part of any budgeted increase in contribution margins caused by higher crop prices. As demonstrated in recent years, prices can move rapidly both higher and lower. Particularly for 1998, many persons are concerned about possible weather effects on yields. Perhaps landowners will want to offer to share yield and price risk. You might decide what percent of the change from your benchmark budget each party will get. In return for accepting some of the risk, land-owners can expect to negotiate a higher base rental rate.
Many factors besides budgets affect rents. For similar soil and location, rents negotiated by the same tenant may differ considerably. For example, at the 1997 Purdue Top Farmer Crop Workshop, thirty-two tenants with an average of 10 rentals each, indicated their share of the expected returns per acre varied by$50 per acre between their most profitable and their least profitable rental. This reported variation may be indicative of the current difference in lease terms and rates within a specific township or county.
Share Rents and Privilege Payments
Suppose you are a tenant with a 50/50 crop share lease on Brookston-type soil and produce corn and soybeans. On average, you grow one-half each of corn and beans, and expect to have the revenue and variable costs as shown in Table 3.
Perhaps you realize that $120 contribution margin per acre is more than most tenants expect to receive as the return to their resources of machinery and labor-management. Some tenants will bid away part of this amount plus all of the government program payment into a privilege payment in order to get a 50/50 lease instead of a cash rent lease on the high yielding Brookston-type soil for 1998.
In the Table 3 benchmark budget for the low yield Miami-type soil the 50/50 tenant’s per acre contribution margin without government payment is $70. In the average yielding Crosby-type, it is $91.
Without stating what rent is right, the author used the following charges for machinery replacement and labor-management in 1997 budgets published in The Purdue Crop Guide, ID166. In that publication, charges were $83 on low yielding soil, $87 on average yielding soil, and $92 on high yielding soil. On the low yielding Miami-type soil, one-half of the $28 government payment plus the $70 tenant’s budgeted 50/50 contribution margin equals $84.
As presented in this paper, the budgets indicate rents negotiated after November will likely be higher than rents negotiated in fall ‘96 for 1997. The budgets also indicate rents will likely be much higher for leases re-negotiated for the first time in several years.
In addition to a cash rent based on a benchmark budget, tenants may propose adjustors for yield and prices. Landowners may concur, assuming they expect over several years, to realize a higher average rent. Once created, a cash lease with adjustors can be a simpler alternative for sharing risks than a crop share lease.
On higher yielding soils, the budgets for a typical 50/50 share lease in 1998 suggest tenants could pay a privilege rent plus all the government payment. On low yielding soils, the 1998 budgets suggest a typical 50/50 lease will include sharing the government payment 50/50 with no provision for a privilege payment.
* The author thanks Professor Chris Hurt for the numerous changes he suggested to earlier drafts of this paper.