Farm leases are a balancing act between protecting the farm asset and gaining a good return. Kerry Dwyer gives advice for those thinking of entering into leases.
Over the past 35 years I have dealt with many farm leases, from both sides of the table, to find that the business is about relationships. If both parties can understand what the other wants and needs, and can nurture that relationship, then both parties can get a deal that is beneficial to all.
Land owners lease for various reasons, with the underlying theme of continuing asset ownership without being involved in the day-to-day farming business. The balancing act for them is to protect or maintain the farm asset while gaining some level of rental return from it. The tenant’s balancing act is to generate enough farming income to run the business while paying rental and gaining some profit. Leasing has been part of New Zealand farming from the very earliest settlement (initially from the Crown) and continues on that basis in many places, along with leases of freehold land from private owners.
In any business deal the three essential criteria are price, quality and service. For the landowner, what is the rental? How does the tenant maintain the asset? And what is the longevity and attitude of the tenant? For the tenant, what is the rental? How good a business income can be generated?
And what is the longevity and attitude of the owner?
If we look at how a lease rental can be calculated we can get an answer to the second two parts of the equation.
Rental per asset leased
If we take an ‘average’ sheep and beef farm of 300 hectares, with a house, woolshed and associated buildings in reasonable repair and state of subdivision and amenities, we get some interesting figures.
The whole farm is running 2000 ewes, hoggets and some cattle, to total about 3000 stock units. The farm is valued at $1000/su to total $3m, with improvements valued at close to $1m. The main improvements are a house, woolshed, stock yards, water supply and fencing.
The average house rental in NZ is more than $400/week, and talking with landlords I get the impression that their cost of maintaining that asset is about half of that. Maintenance being keeping the building painted, carpeted, curtained, insulated, plumbed and wired to acceptable standards. In a normal house tenancy the responsibility for this lies with the landlord, which is often forgotten in farm leases because it is deemed part of the farming business, but here I will take it as a separate issue. If the house is worth $500K then it needs about $10K per year maintenance paid by either party.
The 300ha is well subdivided, with sheep-proof fencing of 25km length. On today’s values that is worth about $20K/km or $500K to replace by contract. Fences can be depreciated at 10% by IRD ruling, meaning an annual ‘maintenance’ cost of $50K carried by either the owner or the tenant. The farm also has a reticulated water supply for stock and house, worth about $200/ha to replace. Industry figures show it will take about 1.5% of that to maintain, with depreciation of 8-10% on top of that, so a cost to either party of more than $6K per year.
There is also a woolshed, sheep yards and cattle yards and other sheds, worth maybe $300K or more. IRD depreciation rates for these are at least 4%, giving an annual ‘maintenance’ cost of $12K.
Total that all and we get $78K per year to cover ‘maintenance’ of the improvements on the farm. On a per stock unit basis that is $26/su. In practice there is not an annual cost for these items, either it is spent in lumps when something is broken, or the assets slowly erode.
As a comparison, commercial properties are commonly listed for sale as yielding 5% p.a. which equates to $150K on a $3m property. Commercial property may have some better locality value than the average farm, but the tenants are businesses just as farming is.
Rental cost
Most pastoral leases are calculated per stock unit, since that covers the tenant’s ability to pay the lease relative to income earning potential. Banks have some criteria that rental in the range of 20-25% of income is sustainable for the tenant. Recent Beef + Lamb statistics show a gross income average of about $140/su for sheep and beef farms. So a rental of $28-35/su fits their lending criteria, totalling $84-105,000 rental/year for this ‘average’ property.
Rental income
The modern calculation of income and profit uses kilograms of drymatter as a base point. Stock units don’t identify as well the actual consumption and production per animal. The benchmark for many pastoral farms is grazing young dairy stock, which over the past couple of years has returned about 20c/kg DM.
If the 300ha farm has 290ha effective and grows 9000kg DM/ha, of which 75% is harvested by grazing stock, then the gross
income would be about $400K, similar to the sheep and beef stock unit income. Rental per kg DM could be calculated at 4-5c/kg DM.
If the farm or the tenant are exceptional then more grass could be grown and harvested to expand possible rental. For example, if the farm grows 12t DM/ha/year, with 80% harvested then gross income could be more than $550,000, with a fair rental in the $110-137,000 range.
The point of doing this calculation is to query how many landowners or ingoing tenants have a handle on pasture production and therefore income potential?
Rental income/ha
If we assume prospective tenants do their figures, then rental per hectare will have some relativity to per stock unit or per kg DM figures. It is more common that intensive agriculture and dairying properties are rented on the basis of a per hectare figure.
Rental income or profit
As stated, banks have some criteria for sustainable rentals, at 20-25% of gross income. If this farm runs 3000su generating $140/su gross income to give $420,000, then expected farm working expenses for the tenant will be about $240K (55%). The tenant has to cover insurance ($8K), rates ($6K), interest on stock ($15K), depreciation on vehicles and machinery ($20K), which totals $49,000. That leaves $131,000 for rental and profit. If the rental is $84,000 the tenant makes a profit of $47,000.
The fastest way for a tenant to make more profit is to spend less on the farm; that may be fewer repairs and maintenance or less fertiliser etc. Spending less will have a longer-term impact on the asset but not be a problem for a shorter-term tenant. The tenant’s ability to generate profit is also very dependent on product prices.
Alternatively, to allow for sufficient profitability of the tenant and so spend more on the asset, rental could be set as a portion of their business profit rather than gross income. If the rental is set as a percentage of profit generated, the 20-25% range will yield a rental of $26–33,000 for the landowner.
Tenders
Many potential farm leases are put up for public offer or tender, which can give the landowner a very good rental income if optimism is common in the market. While it is often stated that the highest or any offer may not be accepted, in reality it is difficult to turn down the exceptionally high bids.
In summary for this average 300ha sheep and beef farm, we have:
- Asset value of $3m
- Asset ‘maintenance’ cost of $78K p.a. for the improvements
- A commercial property lease of 5% yield on a $3m asset is $150K p.a.
- Rental calculated per stock unit at $84-105K p.a.
- Rental calculated per kg DM at $78-99K p.a.
- Rental as % of profit calculated at $26-35K p.a.
The figures don’t quite match up, so we go back to the initial point that the success of the relationship depends on the wants and needs of both parties being substantially met. Does the landowner want the asset maintained or improved by the tenant? What costs are the landowner willing to cover to achieve that? And what value does the landowner place on rental income versus capital value?
Will the tenant make sufficient profit to be able to maintain the asset value of the property? Do they have the skills and time to do that?
My involvement in farm leases has been to provide an objective view, to provide some reality check for both parties. I have sat down with farmers who have been struggling to make a profit out of their farms, yet they expect a far superior income from leasing the property. I have sat down with prospective tenants who know the farm needs considerable investment to make it productive, yet they expect to make a good profit from income generated. Both these scenarios lead to poor long-term relationships.
I have seen farms that have been leased out and worn out, sell for very good coin to an optimistic buyer, in the right market conditions. In the wrong market conditions I have seen these types of farm sell very cheaply.
Have a robust discussion before entering into a farm lease, and it is good business to have a referee in place before you have a dispute rather than when it goes pear-shaped.
- Kerry Dwyer is a North Otago farm consultant and farmer.
