Land Leases: Cost-Contribution Approach

Part II in a two-part series

Published in the December 2012 Issue Published online: Dec 08, 2012 William H. Bohl and Paul E. Patterson
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As mentioned in last month's UI column, both parties to a land lease should share the crop income potential based on the proportion of costs contributed and the risk they bear.

Developing a land lease in this manner is called the "cost-contributions approach." The contributed value provided by the tenant of operating inputs (seed, fertilizer, etc.) is fairly straight-forward. The three most difficult issues to deal with in a cost-contribution lease are placing values on the tenant's time or management, the tenant's machinery and the landowner's land.

In a cost-contribution approach, the tenant should be compensated for both a return on the value of the equipment provided, as well as a recovery of depreciation. These values need to be apportioned to the acres the equipment is used. For example, if the total value of the equipment is $800,000 and used on 500 acres, the tenant is contributing $1,600 per acre.

The rate of return on equipment investment is a point of negotiation. Assuming a 5 percent rate of return, the tenant would be contributing $80 per acre ($1,600 x 0.05), plus the value of depreciation. Assuming the equipment has an estimated salvage value of 10 percent and an average life expectancy of 15 years, annual depreciation would amount to $96 per acre ($800,000 x 0.90 ÷ 15 years ÷ 500 acres = $96). Therefore, the total contributed machinery value provided by the tenant would be $176 ($80 + $96).

The process for assigning a contributed value for the land and irrigation system is similar to that used for machinery. The landowner is looking for a rate of return on the investment in the land and irrigation system, plus a recovery of the irrigation system's depreciation. Assuming a land and irrigation system value of $5,000/acre and depreciation of $75/acre on the irrigation system, the contributed value of the landowner based on a 5 percent rate of return would be $250/acre ($5,000 x 0.05), plus the $75 depreciation on the irrigation system for a total contributed value of $325/acre.

This represents the value across a normal crop rotation, so this value would be too low for a one-year lease to raise potatoes. Increasing the rate of return on a crop like potatoes is one way to deal with this. For example, charging a 4 percent rate of return on the grain years and an 8 percent return on the potato year may be appropriate. The depreciation on the irrigation equipment would be the same each year.

The University of Idaho publishes crop costs and returns estimates that can be useful in this process of negotiating a lease as our enterprise budgets provide a detailed list of all the inputs used. We also have an Excel spreadsheet (Idaho Crop Lease Calculator) that can be helpful in helping a landowner and tenant work through this process. Both can be found at www. cals.uidaho.edu/aers. Click on "Resources" and then "Crops."

Changes continually impact agriculture, so it's essential to periodically review lease agreements to ensure both parties agree on the terms and share costs and returns equitably. A lease agreement that worked 10 years ago may no longer meet the needs of the landowner and tenant given the increasing volatility seen in commodity markets. This winter may be a good time to review these agreements.

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