Cash Rent Options Limit Risk

Strong harvest 2006 corn prices renew interest in variable cash leases.

Looking back, landowners can see how a variable cash rent with an escalator linked to prices could have shifted more of the 2006 gross corn income to their pockets. Looking ahead, operators might see a variable cash lease with a relatively low base rent and an escalator clause linked to prices as less risky than a fixed cash rent at a sharply higher fixed rate.

Advantages, William Edwards, Iowa State University economist, sees to flexible leases include:

  • The owner and operator share risks, as well as profit opportunities.
  • The actual rent paid adjusts automatically as yields, prices or government programs change.
  • Owners are paid in cash; they do not have to be involved in decisions about crop inputs or grain marketing.

"Owners and operators can choose among several types of leases depending on whether they want to share yield risk, price risk, or both," he adds.

1. Share of gross income
The most common type of flexible lease calls for the owner to receive cash rent equal to a specified share of the gross value of the crop. The value of the crop is determined by multiplying the actual harvested yield by the market price.

Under this lease, tenant and owner share both price and yield risks in the same proportion as the gross income.

2. Base rent plus bonus
This lease specifies a minimum rent. Plus, the owner receives a share of the gross income in excess of a base amount. Base revenue may approximate the tenant's costs of production. The bonus may vary from one-third to one-half of the revenue over base rent.
Both parties must agree on:

  • how to calculate gross income
  • whether other payments are included in the profit calculation
  • whether receiving a gross income below base level will cause the actual rent to be less than base rent value

If the base rent is actually a minimum rent, it should probably be set lower than a fixed cash rent for the same land; otherwise, the landowner would not share any of the downside risk.

3. Adjustment for yield only
Some flexible leases base the rent on the actual harvested yield only. The most common type specifies a fixed payment per bushel harvested, or a base rent plus a fixed rate for each bushel over a minimum yield.

4. Adjustment for price only
When yield risk is low, the cash rent can vary according to the actual commodity price each year. Several formulas can be used to calculate the rent. The most common is to multiply the actual market price by a fixed number of bushels. The USDA loan rate may be used when prices are lower than this.

A variation is the "bushel lease." The tenant actually delivers a fixed number of bushels of grain to the landowner each year. The owner then takes all the marketing risk on those bushels.

Understand trade-offs

Owners and tenants should carefully consider the type and degree of risk they want to assume. Some tenants are more willing to assume yield risk than price risk, so they can reap more benefits from superior management. However, if climate or soil type are such that a significant chance of a poor yield exists, consider some other means to reduce risk, such as crop insurance.

Leases that base the rent on price only or yield only may actually increase the tenant's risk in some years. This is because prices may be high when yields are low, or prices may be low when yields are high. Thus, adjusting the rent based on only one factor does not always reflect the actual profits received in that year.

Owner and operator must agree on how the yields or prices that drive rents will be determined. Test the formula under a wide range of prices and yields. The idea is to confine the rent in a range that's acceptable to both parties.

To check out a helpful worksheet, click here.

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