Flexible Cash Leases

This article was originally published on August 13, 2002 and expired on December 31, 1999. It is provided here for archival purposes and may contain dated information.

URBANA – Flexible cash rent leases may aid farmers and landowners in setting rents during a period of variable commodity prices, according to a University of Illinois Extension study.

"Commodity prices likely will be more variable over the next several years, more so than in previous years," said Gary Schnitkey, U of I Extension farm financial management specialist, who prepared "Flexible Cash Leases Based on Crop Insurance Parameters," (http://www.farmdoc.uiuc.edu/manage/newsletters/fefo07_13/fefo07_13.html), available on Extension's farmdoc website.

"Variable commodity prices cause difficulties in setting cash rents as farmland returns will vary because of commodity price changes. Flexible cash rent leases may be helpful in this environment."

Schnitkey referred to a flexible cash lease that bases its payments on parameters used in setting revenue guarantees on Group Risk Income Plan (GRIP) crop insurance policies. As structured, this flexible lease causes landlords and farmers to share in commodity price changes that occur between years.

"Generally, hedging is not effective at reducing revenue risks associated with between-year price changes," he explained. "As structured, the lease causes farmers to bear all risks associated with yield shortfalls and price changes within the year–but not between years.

"If desired, farmers can use crop insurance and hedging to offset some of the risks associated with yield shortfalls and price changes within the year."

The payment mechanism in such leases for corn production is based on expected county corn yield x base corn price x rent factor.

"As an example, take a farm in Macon County in 2007," Schnitkey said. "In 2007, the expected county corn yield in that county is 178.8 bushels and the base price is $4.06 per bushel. If the landlord and the farmer negotiate a .35 rent factor, the cash rent is $254 per acre–178.8 bushel county yield times $4.06 base price times .35 rent factor."

Flexible cash rents based on crop insurance parameters have several advantages as well as some disadvantages.

Among the advantages, Schnitkey noted are:

--cash rents will vary as prices change between years;

--cash rents are determined when crop insurance decisions are made and farmers can use crop insurance and hedging to protect against yield shortfalls within-year price declines;

--information needed to determine cash rents is available from the USDA's Risk Management Agency's website (http://www.rma.usda.gov);

--the lease does not require any data from the farm being leased;

--the level of cash rent will be known relatively early in the production year; and

--the Farm Service Agency will regard this lease as a cash lease. Hence, direct and counter-cyclical payments do not have to be shared between the landlord and tenant.

On the other side of the ledger, he added:

--farmers still bear considerable yield and price risk. The lease only adjusts for risks associated with between-year price changes;

--over time, the rent factor may have to be adjusted to account for changes in costs and risks. This lease only adjusts rent payments based on price changes and expected yield changes;

--the actual cash rent will not be known until the spring in the year of production. Many cash rents are negotiated prior to this point.

"Flexible cash leases based on GRIP parameters shift some of the risks associated with between-year price changes to the landlord," Schnitkey said. "Risks associated with within-year price changes and yield shortfalls are borne by the farmer.

"This lease is appropriate for cases in which only the transfer of between-year price changes are desired. If risk shifting associated with within-year price changes and yield shortfalls is desired, cash rents based on a farm's revenue likely would be more appropriate."

Source: Gary Schnitkey, Extension Specialist, Farm Management, schnitke@illinois.edu

Pull date: December 31, 1999