We are continuing to see land sales climb to unprecedented levels. The strong demand for land is supported by the record low interest rates, high commodity prices and favourable seasonal conditions. In terms of purchasing property or leasing, the disadvantage of this rising market makes it hard to determine the market value of a property. The uncertainty around the future state of the current buoyant commodity prices increases the risk of meeting land repayments in the future, be it lease costs or servicing debt at these high land prices. So it begs the question, are the current market prices for land reflecting the productive potential of that property?
Leasing can be a safer way to grow a farm business. In a study on farm succession recently completed by Meridian Agriculture, 88% of businesses which will remain in the family beyond the third generation grew in stages by leasing.
The lease price
For many years, the rule of thumb for land owners and land operators to determine a lease price was using a percentage factor of the market value of the land. Rates between 3 – 6 % are often thrown around. The leasing rate of 3 – 6 % of the land’s market value is the return the land owner receives on their capital. The 2021 Rural Bank Farmland Values report shows that the 20 year capital return for farmland is 7.2%. This results in a return on capital of 10-13% for the landowner. In comparison, the 2021 Vanguard index chart shows that the 20 year average return on Australian shares is 9.7% per annum.
The same Rural Bank Farmland report indicates that farm land in South West Victoria for 2020 averaged $9,884/ha and ranged from $4,448/ha to $15,385/ha. This demonstrates the importance of determining the potential productivity of the land, which will be strongly linked to generating sufficient profit to meet lease payments and build farming assets in livestock and cash. The productivity and carrying capacity of this land will vary depending on location, fertiliser history, pasture species, paddock sizes, land class and rainfall.
Agriculture Victoria’s Livestock Farm Monitor Project (LFMP) is a useful resource to explore the performance of farms. The dataset provides the average Gross Margin (GM) figures across Victoria. The GM figure is the Gross Farm Income (GFI) minus variable expenses. These are the two components that will vary with leasing land and can be a good starting figure to determine if the proposed lease is affordable. Examples of variable expenses include animal health, seed and pasture costs, fodder, and casual labour. To determine a more accurate number use figures based on your own data, analysis and budgeting.
After variable expenses are paid, the ‘remaining funds available’ still need to go towards any overhead costs, interest, tax, any principal/capital payments, and pay the owners. With the strong demand for property and the continuing rise in land prices, is it important to determine if the asking price for leasing is beyond the earning capability of the land, consequently increasing the risk to your business.
So where do you start?
Assessing the property’s productive capacity
The starting point will be establishing what the farm’s current productive capacity is. Then work out what the potential might be and what it will take to get to that potential productivity level. To determine the productive capability capacity, gather information about the land; what the effective area for grazing and spreading fertiliser is, rainfall, growing season, and soil fertility. Try to obtain information on historical yields and livestock numbers over a minimum of 3 years as this will eliminate seasonal differences.
This information may or may not be readily available. In some cases you will be able to make a judgement call on potential yields or stocking rates. However, take caution and be more conservative with your budgets. In the instance when such information is not available, the Victorian Livestock Farm Monitor Project can be a great place to start.
Determine your expected earning capability
Once you have this information you can determine YOUR expected earning capability on that land. You can do this by calculating a “modified” gross margin (m-GM). This figure is the expected income minus the variable and potential overhead expenses that you will incur with the lease. The variable expenses will all change, such as feed, fertiliser, and animal health costs. However, there may also be some overheads that change, such as repairs and maintenance, fuel/oil, and cost of your labour. If you are an existing farming operation, overhead expenses such as rates, accounting, and administration costs won’t change. However, if you are a start-up business you will incur these costs and they will need to be accounted for.
Another important point to consider is if additional livestock, labour or machinery is required to operate the lease land. If they increase costs, profit reduces. Ideally (but not in all cases), the additional land will be managed with the current labour and machinery to increase asset utilisation. Careful forward planning will be required if you are going to keep livestock to move to the new leasing property, or if purchasing additional stock. Both scenarios will postpone any profits, and will be essential to include in cash flow forecasting. They are all essential to your operation and will need to be included as capital cost items. After accounting for all expenses the resulting figure can be used to determine a lease price you should be willing to pay for a property.
It is important to use 3-5 years of YOUR historical data to give you a range of figures across different seasons. The worst case year should be used to indicate a base price, as you will still need to meet lease payments regardless of the season, prices and yields. It will give you an indication of the maximum price you should be willing to pay.
In negotiations for leasing, we strongly recommend that a formal written agreement is established between land owner and land operator. This will confirm the costs and expectations of each party. Lease negotiations should include who pays for what and how much for certain expenses, e.g. capital fertilisers, soil ameliorants, fencing repairs, water repairs, rates, and insurance. These will all impact and change the price that you should be willing to pay. There might be other conditions that may need to be considered, commonly land owners may wish to remain on the property with access to certain parts of the property. This may also influence your decision.
The pros and cons
- Economies of scale – if current assets are underutilised, spreading the machinery and labour units across a larger area of land and stock will improve efficiency. Alternatively, if additional machinery or labour is required the additional land can reduce efficiency.
- If purchasing land is out of reach, leasing is a way of getting into farming – leasing requires less equity upfront than purchasing land which typically requires 40% equity to go towards the purchase.
- Increase scale – a common scenario is that the current property is not large enough to support multiple families, and this can be a way to increase scale to support this, or gear up for a future property purchase.
- Capital growth – as mentioned earlier, the average capital growth on farmland over the past 20 years was 7.2%. Land owners can lease out their land and expect strong capital growth over time. Alternatively if you are leasing land you won’t reap the benefits of this capital growth.
- Asset improvement – a landowner will want to lease to someone who is going to improve or at minimum maintain the state of the land. The risk of land being degraded can be minimised by having standards set within the lease agreement. As a land operator you are improving someone else’s assets.
- Freedom of farming – As the land operator you may be restricted and not free to farm exactly how you wish at the request of the land owner.
- Loss of use of the property – There may be the possibility that the use of the property is lost during the leasing term due to unforeseen circumstances.
- Increase production of your current land – Before looking to operate more land, it is important that opportunities are explored for the producer to increase the productivity on the land currently operated.
Leasing land is a common way of farming, and for many years the rate to pay for leasing land has been based on the market price for the property, but with land selling for historically high figures, do those land values reflect the productive capability of the land? For those no longer farming the land this is a positive outcome, however for those producers looking to lease it’s not the same story. In order for a land operator who is seeking to lease land to quantify a reasonable and fair price to pay for leasing that land, they need to look past the usual percentage rate of the market value.
Independent advice is available and is often helpful to support decision making by providing sound advice tailored to your business to ensure the lease agreement is conducive for a sustainable operation and will maximise the return on your investment.
Read our previous article Expanding my business – Leasing explained.