Flex Leases Land Bubble and Profitability Henderson County January 12, 2011 Greg Halich Dept. Agricultural Economics University of Kentucky December, 2010.

Agricultural Economics Areas Covered Today 1) Land Bubble 2) Profitability by Soil Type 3) Communication 4) Leasing Game 5) Flex Leases

Agricultural Economics Hypothetical Story Central Kentucky: Profit Profit Knowledge Knowledge Competition Competition Greed Greed

Agricultural Economics True or False Cropland Prices drive Cash Rents? False!!!

Agricultural Economics What Drives Cropland Prices? Investor – Expected Land Rents Farmer – Expected Profits

Agricultural Economics What Is the Relationship Between Land Rents and Profits? Profits Drive Land Rents: Higher the profit, the more that a farmer can bid for land rent. Higher the profit, the more that a farmer can bid for land rent. In long-run, most of profit will be bid into land rents. In long-run, most of profit will be bid into land rents.

Agricultural Economics What About Land Appreciation? Yes, but… Except for Development Potential → Future land rents and/or profits determine appreciation.

Agricultural Economics Formula to Estimate Max. Cropland Value Investor Perspective: Land Value = Land Rent – Costs Interest Rate Interest Rate

Agricultural Economics Investor Perspective Example $220/acre Expected Land Rent $20/acre Expected Costs 5% Interest Rate Land Value = $220 – $20 = $

Agricultural Economics Formula to Estimate Max. Cropland Value Farmer Perspective: Land Value = Profit per Acre Interest Rate Interest Rate

Agricultural Economics Farmers Perspective Example $300/acre Expected Profit 5% Interest Rate Land Value = $300 = $

Agricultural Economics How is Interest Rate Determined? If self-financed: → Required return on investment. If Borrowing: → Rate of the loan.

Agricultural Economics Effect of Interest Rate As rate decreases: → Land value increases.

Interest Rate and Profitability/Land Rent Effect on Maximum Land Price Interest Rate 1) Expected Profitability or 2) Land Rent minus Costs $100$200$300$400$ %$667$1,333$2,000$2,667$3, %$1,000$2,000$3,000$4,000$5, %$1,333$2,667$4,000$5,333$6, %$2,000$4,000$6,000$8,000$10, %$4,000$8,000$12,000$16,000$20,000

Agricultural Economics What Interest Rate to Use? Returns on other investments → Lot of risk out there. → Farmland seems like safe investment.

Agricultural Economics Land Rent vs. Profit Approach Short-run: Farmers will have competitive advantage over investors in areas with less then perfect bidding. Long-run: Land rent and profit will be very close.

Agricultural Economics Ohio Valley Dynamics Most Competitive Land Rents: $200-$275 last year. $200-$275 last year. $300+ this fall. $300+ this fall. What land prices will this support?

Interest Rate and Profitability/Land Rent Effect on Maximum Land Price Interest Rate 1) Expected Profitability or 2) Land Rent minus Costs $100$200$300$400$ %$667$1,333$2,000$2,667$3, %$1,000$2,000$3,000$4,000$5, %$1,333$2,667$4,000$5,333$6, %$2,000$4,000$6,000$8,000$10, %$4,000$8,000$12,000$16,000$20,000

Agricultural Economics Projected Profitability 2012 Commodity prices down from late summer high. Commodity prices down from late summer high. Determine if land rents can be supported in 2012 at current commodity levels. Determine if land rents can be supported in 2012 at current commodity levels. Evaluate range of commodity prices. Evaluate range of commodity prices.

Agricultural Economics Critical Budget Assumptions 20 1.Does not include land rent. 2.Includes “non-cash” costs (e.g. depreciation/overhead, unpaid labor). 3.P and K application at removal rate. 4.Grain trucked directly to elevator.

Agricultural Economics Corn and Soybean Prices New Crop 2012 Price Scenario:CornSoybeans Low$4.50$9.50 Baseline$5.50$11.75 High$6.50$14.00

Agricultural Economics Agronomic Assumptions Corn Yield Soybean Yield Corn/Soybean Yield Ratio 125 bu39.0 bu bu45.5 bu bu51.5 bu3.4

Agricultural Economics Budget Assumptions Base Scenario Fertilizer:$/ton$/unit Anhydrous (N)$860$.52 DAP (P 2 O 5 )$680$.53 Potash (K 2 O)$640$.53

Agricultural Economics Projected 2012 Costs (per acre) Inputs: Corn (150 bu)Soybeans (45.5 bu) Seed$76$45 Nitrogen$83$0 P, K, and Lime$70$53 Pesticides$35$25 Total Inputs$264$123 Machinery and Labor$121$85 Other: Drying Grain$23$0 Crop Insurance$20 Misc.$20 Land RentVariable Operating Interest$7$4 Total Other$70$44 Total Costs$455+ Land Rent$252+ Land Rent

Agricultural Economics Summary Revenues/Costs (per acre) Yield and Price:CornSoybeans Expected Yield (rotation) Future's Price Fall 2011$5.50$11.75 Grain Revenue$825$535 Direct Gov’t Payment$20 Total Revenue$845$555 Total Costs (Less Land Rent)$455$252 Gross Return (Less Land Rent)$390$303

Agricultural Economics Baseline Scenario (per acre) $ Soybeans (elevator) $ 5.50 Corn (elevator) $.52-N; $.53-P; $.53-K Gross Return Corn Gross Return Soybeans Gross Return Rotation 125 bu corn $276$234$ bu corn $390$303$ bu corn $505$366$435 Note: Subtract land rent to get Net Return.

Interest Rate and Profitability/Land Rent Effect on Maximum Land Price Interest Rate 1) Expected Profitability or 2) Land Rent minus Costs $250$300$350$ %$3,571$4,286$5,000$5, %$4,167$5,000$5,833$6, %$5,000$6,000$7,000$8, %$6,250$7,500$8,750$10,000

Agricultural Economics High Commodity Price Scenario $14.00 Soybeans (elevator) $ 6.50 Corn (elevator) $.52-N; $.53-P; $.53-K Gross Return Corn Gross Return Soybeans Gross Return Rotation 125 bu corn $401$322$ bu corn $540$404$ bu corn $680$482$581 Note: Subtract land rent to get Net Return.

Interest Rate and Profitability/Land Rent Effect on Maximum Land Price Interest Rate 1) Expected Profitability or 2) Land Rent minus Costs $375$425$475$ %$5,357$6,071$6,786$7, %$6,250$7,083$7,917$8, %$7,500$8,500$9,500$10, %$9,375$10,625$11,875$13,125

Agricultural Economics Low Commodity Price Scenario $ 9.50 Soybeans (elevator) $ 4.50 Corn (elevator) $.52-N; $.53-P; $.53-K Gross Return Corn Gross Return Soybeans Gross Return Rotation 125 bu corn $151$146$ bu corn $240$200$ bu corn $330$250$290 Note: Subtract land rent to get Net Return.

Interest Rate and Profitability/Land Rent Effect on Maximum Land Price Interest Rate 1) Expected Profitability or 2) Land Rent minus Costs $150$200$250$ %$2,143$2,857$3,571$4, %$2,500$3,333$4,167$5, %$3,000$4,000$5,000$6, %$3,750$5,000$6,250$7,500

Agricultural Economics Land Bubble? 1970’s vs. 2010’s 1970’s vs. 2010’s → What are differences? → Let’s look at land values.

Agricultural Economics Land Bubble? Main difference today vs. 1970’s? Politically imposed demand for grain. → Ethanol used 40% of corn crop → Political issue, not market issue.

Agricultural Economics Summary Current farmland values not unreasonable at current profitability levels. However price levels will hinge on ethanol policy. How will market react to: → 40% of corn crop dumped on market. → 40% of corn crop dumped on market. → Market response to higher profitability.

Agricultural Economics Land Rents by Soil Productivity Question: If 150 bu ground rents for $200, how much would you pay for 125 bu corn ground?  We will look at partial budgets to help answer this. Note: Base rents are purely hypothetical.

Agricultural Economics Land Rents by Soil Productivity If productivity increases 20% → Land Rent increases by 20%. → Land Rent increases by 20%. Does this seem fair?

38 Corn - Partial Budget for Increased Yield Yield Increase (bu/acre) 25 Elevator Price ($/bu) $5.50 Increase in Revenue $138 Increased Costs: Seed ($/bag)$ $2.50 Nitrogen$0.5215$7.80 Phosphorous (P 2 O 5 )$0.5310$5.30 Potassium (K 2 O)$0.539$4.64 Harvesting ($/bu)$0.08 $2.00 Trucking (miles) 15$2.93 Drying ($/gal LP)$2.00 $3.13 Other ($/acre)$0.00 Total Increased Costs $28.30 Net Increase Revenue $109

39 Soybeans - Partial Budget for Increased Yield Yield Increase (bu/acre) 6.0 Elevator Price ($/bu) $11.75 Increase in Revenue $71 Increased Costs: Seed ($/bag)$450$0.00 Nitrogen$0.520$0.00 Phosphorous (P 2 O 5 )$0.534$2.23 Potassium (K 2 O)$0.537$3.50 Harvesting ($/bu)$0.08 $0.48 Trucking (miles) 15$0.70 Drying ($/gal LP) $0.00 Other ($/acre)$0.00 Total Increased Costs $6.91 Net Increase Revenue $64

Agricultural Economics Land Rents by Soil Productivity Productivity Change of 25 bu corn: $109/acre net corn. $109/acre net corn. $64/acre net soybeans. $64/acre net soybeans. $86/acre net rotation. $86/acre net rotation. Note: Based on assumptions previous two slides.

Agricultural Economics 150 bu Base Rent Yield (bu corn) Equivalent Land Rents 200$373$ $286$ $200$ $114$89 Note: Base Rents examples only.

Agricultural Economics 175 bu Base Rent Yield (bu corn) Equivalent Land Rents 200$336$ $250$ $164$ $77$52 Note: Base Rents examples only.

Agricultural Economics Land Rents by Soil Productivity Summary: 17% dec. yield → 43-50% dec. rent. 17% dec. yield → 43-50% dec. rent. Not linear relationship. Not linear relationship. Better ground may be underpriced. Better ground may be underpriced. Poorer ground may be overpriced. Poorer ground may be overpriced.