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How will cash rents respond to higher prices?

Bullish news is rampant in agriculture, at least where there is a significant demand for grains to use in making biofuels.

Although the production of ethanol has been on the increase for several years, corn prices have reacted sharply only in the last six months. Soybean prices have been pulled along for the ride. Recent price increases are due almost entirely to increased demand, however. How long the ride will last is very uncertain.

Higher grain prices will eventually reverberate though other agricultural markets, including the market for land. Surveys of farmland values have shown considerable strength, and most of the factors causing it are impacting the rental market as well.

In Iowa, cash rental contracts must be terminated by September 1 each year or they continue in effect for another year under the same rates and terms. Therefore, many rents will not respond to the higher grain prices until 2008. Some landowners routinely cancel contracts so that rental rates for the following year can be negotiated after the current year's harvest. Terms can always be adjusted by mutual agreement.

Setting a fair cash rent can be done several ways. Many people simply want to match what other farms in the same area are renting for. In addition to some state surveys, informal information about cash rental rates is plentiful, too, but often focuses on extreme cases. Most farm rental agreements in Iowa, for example, are not required to be recorded, so there is little factual information available to the public.

Rental rates should be in line with expected income from the crops to be produced. In the past decade, average cash rents in Iowa compared to gross revenue per acre have been in the 35% to 40% range for corn and the 45% to 50% range for soybeans. Gross revenue was estimated as the state average yield multiplied by the average cash marketing price for that year's crop. USDA loan deficiency payments were included in gross revenue.

Another approach is to estimate the net return to the landowner based on a traditional 50-50 crop share lease. The calculation would be 50% of the expected yield multiplied by the expected market price, minus one-half of the seed, fertilizer and pesticide costs. Estimates of crop production costs for 2007 can be found in Information File Estimated Costs of Crop Production.

Traditionally the same cash rental rate has been paid for acres planted to corn or to soybeans. Under current market price relationships, the approaches just outlined will result in significantly higher rates for corn than for soybeans. The overall rental rate should still be an average for both crops, though, based on the actual acres planted.

Several cautions are in order. First, much of the 2006 crop was priced prior to harvest, when prices were considerably lower than they have been since September. Bushels to be produced in 2007 can be forward priced at very profitable levels today, but most producers will not sell 100% of their expected production in advance.

Prices could decline by harvest time, if they follow traditional patterns. Costs for seed, fertilizer and pesticides continue to increase, as well. Estimates are that farmers will spend approximately $20 per acre more on corn inputs this year than last year.

If grain prices stay at historically high levels, higher cash rental rates are both inevitable and financially feasible. Past history tells us, however, that other sectors of the economy will eventually adjust and push prices closer to more traditional levels. Producers who obligate themselves to high cash rents need to consider ways to limit their downside risk. Several tools are available.

Volatile grain prices have created a great deal of interest in flexible cash lease agreements this year. Under a flexible lease, the tenant and owner agree that the cash rent to be paid will be determined after harvest, based on actual yields and/or prices.

One common formula is to set the rent equal to a percent of the gross value of the crop, much like the approach explained above for estimating a rate in advance. Another approach is to set a base rent and add a bonus payment if gross revenue is above a certain level.

Some owners and tenants are considering switching to traditional 50-50 crop-share leases. This would give the landowner the opportunity to benefit from higher prices, but reduce the tenant's financial risk in case of lower prices or poor yields. Crop revenue insurance is also an important risk management tool for tenants.

Gross income guarantees are based on average farm yields and the average futures price during the month of February. The number of dollars that can be protected this year promises to be the highest since revenue insurance was introduced in 1996. Of course, premiums will be higher, as well.

High crop prices have added a great deal of uncertainty to the farmland rental market in 2007. Fortunately, the prospect of above average profits is a problem that is more pleasant to deal with than when the pendulum swings the other way.

Bullish news is rampant in agriculture, at least where there is a significant demand for grains to use in making biofuels.

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