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Complexity adds risk

BROOKINGS, S.D. -- Flexible leases have gained popularity in recent years and these agreements offer both advantages and disadvantages to landowners and tenants, says Kim Dillivan, South Dakota State University Extension crops business management...

BROOKINGS, S.D. -- Flexible leases have gained popularity in recent years and these agreements offer both advantages and disadvantages to landowners and tenants, says Kim Dillivan, South Dakota State University Extension crops business management field specialist.

"Compared to a fixed cash lease, flexible leases allow for the avoidance of committing to a fixed rent amount prior to the determination of most market and production variables," Dillivan says. "However, flex leases are usually more complicated than fixed cash leases, and this complexity adds additional risk for both parties."

A flexible cash lease is a contractual arrangement between a producer and landowner in which the final rent payment is determined after the crop has been harvested.

Depending on the type of flex lease, the rental payment is a function of crop yield, price, revenue or cost of production.

"Often, a flex cash lease requires that the landowner accept the possibility of lower rent payments in poor production years, in exchange for the opportunity to receive higher rent payments in good production years," Dillivan says.

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Advantages

• Shared risk: For the tenant, some production and marketing risks are shared with the landowner (similar to a crop-share lease).

• Lower payments: For the tenant, the amount of rent paid might be lower (compared with rent in a fixed cash lease) in years when crop price is low, yield is poor or production costs are high.

• Market-based payments: For the landowner, the amount of rent received might be higher (compared with rent in a fixed cash lease) in years when crop price is high, yield is good or production costs are low.

Disadvantages

• Sharing risk: For the landowner, some production and marketing risks are shared with tenant.

• Market-based income: For the landowner, the amount of rent received might be lower in years when crop price is low, yield is poor or production costs are high.

• Market-based payments: For the tenant, the amount of rent paid might be higher in years when crop price is high, yield is good or production costs are low.

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• Complex contracts: For both parties, contract complexity is greatly increased.

Flexing on costs

In this arrangement, Dillivan explains that landowners and tenants agree to flex rent based on a ratio of input costs.

"This arrangement allows landowners the opportunity to share with the tenant the risks associated with cost variability," he says.

To flex lease on production costs, both parties must first agree on a base per-acre rent and a base per-acre cost of production (before land charge). The procedure to calculate annual cash rent is as follows: Base rent multiplied by (base input cost divided by actual input cost) current year rent.

"Flexing on cost of production shifts some risk from unexpected increases of input costs from the producer to the landowner," Dillivan says. "This method also allows the landowner to benefit financially should the cost of inputs be lower than expected."

He stresses the fact that this type of arrangement requires the tenant to keep accurate and verifiable records regarding production costs.

Setting parameters

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Compared with a fixed cash lease, flex leasing can result in higher rent payments in good performance years, but lower rent payments in years when performance disappoints. As a result, Dillivan says, many flex lease contracts specify a minimum rent payment and a maximum applicable rent payment regardless of crop price, yield or input costs.

"Landowners and tenants should carefully consider whether to establish minimum and maximum per-acre rent amounts for their flex lease contracts," he says.

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