You’ve been briefed on the economy and trade. You’ve learned about commodity price prospects and input costs. As we approach the season for land sales and lease renewals, what should you consider to manage your risk? Our 3-part series concludes today with those bottom line balance sheet issues of land prices, cash rents, and farm financial management.

The Purdue Agricultural Economics Department’s 2008 Outlook provides a bright forecast for commodity prices, but with higher input costs, says there will be narrow margins to address land costs, for both cash rents and higher land mortgage payments.

Economist Luc Valentin says higher commodity prices and higher land prices mean that landowners and operators will have to renegotiate leasing arrangements. He says it is important for both sides to understand that higher risks should be accompanied by higher returns, and vice versa. Since cash rents provide low risk for the land owner, their rate of return should be lower than with a crop share lease which would carry a higher risk. For the tenant, the least risk is a crop share arrangement with a landowner. However, it offers less income than with a cash rent lease, which is more risky.

Owners and operators need to carefully think about their personal objectives, then enter a negotiation with understanding what each side hopes to achieve. It is entirely possible that landowners may want increased opportunity to profit from the higher commodity prices, and that may be achieved with a flexible cash lease. However, those need to be discussed with local FSA personnel to ensure goals do not vaporize inadvertently.

Throughout the Cornbelt land prices have climbed substantially, paralleling commodity prices that are expected to remain strong. Purdue economist Craig Dobbins says the higher prices have also brought more price volatility and increased risks. But how should risk be rewarded and how much reward from the market should go to the land? The land owner needs a return to land and the operator needs a return to labor, management, and the risk that is assumed. Dobbins calculates the total return to land and risk at $175 per acre for $3.25 corn and $7.80 beans. But he says a 10% increase to those prices boosts the return to land and risk to $220 or 26% more as a result of the price variability in the market.

One significant issue in the Cornbelt will be calculating cash rent in the wake of the highly variable weather that occurred in 2007. The eastern half was too dry, and much of the western half was too wet, both of which create problems for tenants and landowners to reconcile in their rent negotiations.

For many years the government safety net has provided revenue insurance for operators since farm program payments could be used to underpin farm budgets or used to pay cash rents. Those market-based payments will diminish this year and the direct payments may disappear in the new Farm Bill.

If cash rents rise along with commodity prices, then land prices are pushed higher as well. But Dobbins says there is uneasiness in financial markets that may force long term interest rates up as a cure for the undervalued risk in the housing market. Such a move would reduce the increase in farmland values and push some owners to sell. But currently, there are more buyers than sellers in farmland markets.

When all of the pieces (US economy, trade, commodity prices, input costs, land values and cash rents) fit together in the agricultural puzzle, Purdue economists Mike Boehlje and Chris Hurt say the strength of 2007 should carry over into 2008. They point to many companies in agribusiness which have posted good profits for the past year and provide similar expectations for the coming year. But they say farms are showing the same hint of success with greater equity positions, mostly driven by higher values for farmland. Additionally, the debt to asset ratio has declined to a 50 year low of 12.1%, less than half of what it was in the mid-1980’s. In other words, the picture is good. But will the good fortunes continue for farmers?

Boehlje and Hurt express some risk about the turmoil in the US financial markets from the subprime lending industry, since it would tend to increase interest rates. Even though there has been a recent cut in interest rates, the risk premium needed by the capital markets may result in higher long term rates that will impact farmland purchases. More immediately, the economists are concerned about profit margins for farmers in 2008 which will be compressed by higher rents and input costs, and then challenged by volatility in the commodity markets. Their concern is illustrated by an example of $2.75 corn and a 20% increase in production costs. The government safety net would not be available, but farmers could lose up to 45 cents per bushel if input and rent charges push the cost above the market price.

While the overall outlook is favorable for the next 1-2 years, the economists say the outlook is not guaranteed and the risk to a profit margin could increase dramatically. They urge producers to manage margins, not just costs or prices, but the total picture, and create trigger points that will trigger action if the threat to the margin is imminent. They also urge conservatism by avoiding a “hoped for outcome,” as well as diversification of an operation to increase the odds of survival by managing downside risks.

the farm gate blog expresses its appreciation to the Purdue agricultural economics staff for a very thorough Outlook report. You are strongly urged to visit the 14-page summary document, as well as visit the Outlook package that contains dozens of graphs and charts that accompany it.

Summary:
Strong commodity prices justify higher land prices, as well as rental rates, but those rents should be calculated to provide adequate returns to the landowner for his land and to the operator for the risk that is taken. Higher land values have helped farmers increase their equity position, as well as reduce debt to historic lows. Much of agribusiness is enjoying a similar bright outlook, however turmoil in US financial markets could impact long term interest rates and land prices. Farmers will be able to survive if profit margins are appropriately managed.