1. Fundamentals of Income  Translating a confusing mass of facts into a summary of the agricultural property potential focuses on its ability to return a stable income. 6-1

2. Objectives  The process of income capitalization  Estimating net operating income  Estimating and interpreting capitalization rates  Estimating a potential sale price from income characteristics 6-2

3. Objectives (cont.)  Pros and cons of cash lease income analysis  Pitfalls of share lease and owner-operator income analysis  Basics of government payments to agriculture  Income capitalization break down for non-income driven motives 6-3

4. From Income to Selling Price  Frequently buyers focus on income potential  Some want to add to their stock of land  Some are replacing land  Some want to balance their investment portfolio  Buyers tend to focus on economic rent  What income can an owner anticipate 6-4

5. Group Discussion 6-1 6-5

6. Income Capitalization  Translates estimated income into potential sale price  Involves judgements and assumptions  Reconciling physical  Reconciling economic  Reconciling legal  Reconciling social elements 6-6

7. Income Capitalization (cont.)  V = I / R  V is value  I is property income  R is overall capitalization rate  Relies on annual income (I)  Anticipated rate of return (R) times selling price (V) 6-7

8. Individual Activity 6-1 6-8

9. Income Capitalization (cont.)  Formula implies facts about property  Suited to estimating for unimproved land  Value is inversely related to capitalization rate  When the rate goes up value falls 6-9

10. Group Discussion 6-2 6-10

11. Income  Income in capitalization is a special income estimate  Net operating income (NOI)  Match property capabilities with expected outcome  Simulate the income the buyer can anticipate  Capabilities of the land  Capabilities of people 6-11

12. Income (cont.)  Three different tenure systems  Owner-operator system - owner incurs all expenses  Cash lease - farmer or rancher incurs production expenses  Share lease - landlord participates in production  The best should opt to own their land  Next best should opt for cash lease 6-12

13. Income (cont.)  Less capable should take a share lease  Least productive should work for an operator  Land quality affects leasing arrangement  May insist on cash lease for inferior property  Various tenure arrangements in local markets  Identify the prevailing arrangements 6-13

14. Group Discussion 6-3 6-14

15. Income (cont.)  Cash lease income estimation identifies gross potential income (GPI)  Avoid subjective judgements  Use a multiple year average  Previous years may not reflect future  cash lease amount provides stating point  Deduct all property related expenses 6-15

16. Individual Activity 6-2 6-16

17. Individual Activity 6-2 (cont.) 6-17

18. Rate  Finding proper rate to apply is critical  Analyze recent sales of similar properties  Large differences indicates analysis failed  Some income may have escaped analysis  Estimate requires informed judgement  Analyst should use indicated prices with caution 6-18

19. Individual Activity 6-2 6-19

20. Rate (cont.)  Small changes in lower rate has greater effect  Historically, agricultural property rate is 4 - 6%  Range land usually registers lower  Less than 1% in areas of non-agricultural use  Abnormally high rates indicates an imbalance  Rate is a useful estimate of probable selling price 6-20

21. Sale Price  Sale price is NOI divided by capitalization rate (R)  A logic approach  Operating expense ratio (OER)  Percentage of GPI that will cover expenses  Evaluate the property income characteristics  A great OER variance indicates difference in subject property 6-21

22. Non-Irrigated Crop Land 6-22

23. Non-Irrigated Crop Land (cont.) 6-23

24. Non-Irrigated Crop Land (cont.) 6-24

25. Irrigated Crop Land  Revenue must cover maintaining the system  Recover owner’s investment  Often the farmer covers maintenance  Irrigation systems wear out  Costs must be recaptured over lifetime  Capitalization rate should exceed unimproved land rate 6-25

26. Irrigated Crop Land (cont.) 6-26

27. Irrigated Crop Land (cont.) 6-27

28. Irrigated Crop Land (cont.) 6-28

29. Share Lease  Much more complicated  Cannot just identify a cash payment  Assume a typical crop rotation for the land  Identify inputs needed for the crop and prices  Must be aware of government payments  Must translate knowledge into capitalization regimen 6-29

30. Government Payments to Agriculture  Since 1930’s government has paid farmers  Congress adopts controlling features of payments  Can affect level of income a farm produces  Estimate of benefits can vary widely  Specialized courses are available 6-30

31. Warning 6-31

32. Government Payments to Agriculture  Administered by Farm Service Agency (FSA) of USDA  Involves several basic parameters  Established crop base  Target price  Loan rate  Direct payment and a counter cyclical payment 6-32

33. Government Payments to Agriculture (cont.)  Crop base - crop specific acres in program  Program yields - determined in the farm bill  Target price - Amount for covered commodity  Loan rate - Amount per unit CCC will loan  Direct payments - payments regardless of production or price  Counter cyclical payments - Increases / decreases with market prices 6-33

34. Calculating Government Program 6-34

35. Calculating Government Program (cont..) 6-35

36. Calculating Government Program (cont.) 6-36

37. Calculating Government Program (cont.) 6-37

38. Calculating Government Program (cont.) 6-38

39. Individual Activity 6-3 6-39

40. Government Payments to Agriculture (cont.)  Process is complicated  Many variables can influence the bottom line  Government programs can substantially increase income  Counter cyclical payment depends on market price  Counter cyclical payment can fall below zero 6-40

41. Government Payments to Agriculture (cont.) 6-41

42. Government Payments to Agriculture (cont.) 6-42

43. Government Payments to Agriculture (cont.) 6-43

44. Grazing Lease  Rangeland tenure arrangements vary  Units vary  Per acre cost  Per animal unit cost  Amount of digestible nutrients an animal requires 6-44

45. Individual Activity 6-4 6-45

46. Individual Activity 6-4 (cont.) 6-46

47. Grazing Lease  When recreation income vastly exceeds productivity  Buyers have other motives  Wish to preserve the natural state  When cost per animal unit soars  Aesthetic quality outweighs productive capability  Must learn to deal with non-agricultural buyers 6-47

48. Module 6 - Review  Understand the process of income capitalization ò Converts expected income to value ò V= NOI / R ò Sale price inversely related to capitalization rate 6-48

49. Module 6 - Review  Understand how to estimate net operating income ò Cash lease ò Share lease ò Owner-operator ò NOI is estimate of economic rent 6-49

50. Module 6 - Review  How to estimate and interpret capitalization rates ò R = I / V ò Estimates from sales of similar properties ò Abnormal rates may signal change in the market trends 6-50

51. Module 6 - Review  How to estimate a potential sale price from income characteristics ò V = NOI / R ò All sources of income must be considered ò Property related expenses only should be deducted 6-51

52. Module 6 - Review  The pros and cons of cash lease and owner-operator income analysis ò Cash lease estimates require few subjective judgements ò Data comes from market ò Knowledge of crops, commodity pricing, or exemptions not required ò Easy to calculate and explain 6-52

53. Module 6 - Review  The pitfalls of share lease and owner- operator income analyses ò Share lease is often most prevalent ò Must forecast crop yields, crop and input prices, input costs ò Requires much more knowledge ò Entails subjective judgements 6-53

54. Module 6 - Review  The basics of government payments to agriculture ò Consist of direct payments and counter cyclical payments ò May also include a CCC non-resource loan ò Do not depend on planting the base crop ò Payments can depend on target price and level of market 6-54

55. Module 6 - Review  How income capitalization breaks down when buyers have non-income driven motives for owning land ò Capitalization rates are very low ò Grazing land is sometimes priced by animal unit ò Extremely low capitalization rates are unstable 6-55

56. Self-Assessment Questions  Income capitalization  A net operating income of $1,500,000 and a selling price of $27,272,700  Cash lease, share lease, and owner- operator residual are 6-56

57. Self-Assessment Questions  A NOI stands for  To effectively estimate an income approach capitalized value, an analyst must  All of the following are legitimate expenses to be deducted in an income capitalization estimate of property value except for 6-57

58. Self-Assessment Questions  Abnormally low capitalization rates indicate that  Direct payment, counter cyclical payments, and target prices are 6-58