by Donald E Fraser
25% LEASINGGiven the recent predictable and relatively long term increase in payout for dairy farms it must be an opportune time to look at how rentals are calculated and charged.
Under a fixed price lease all the benefits of an increased payout goes to the lessee or the tenant. This has been the model that has been in existence for many years and of course the landlord is unable to get an increase in rent until the rent review date. More than that, it does not give an equitable return to the land owner on a rising payout. Let’s look at some of the examples and how they work:
1. Fixed Price Lease
100kg milk solids
110 hectares say, including shares $100,000
Rent reviewed every 2 years, lessee to pay all outgoings
So the net rent to the owner is $100,000
In this case the rent is fixed for the remaining period of the lease which is two years under normal lease agreements.
2. Variable Rate Leasing fixed to the Payout
With the rapid rise in payout, those on fixed price leases are unfortunately stuck to the rental waiting for the review. Given that farm leasing is an emerging tenure, the rental needs to reflect a fair return to the owner, and a realistic cost to the tenant. If you take 25% of gross dairy cheque as a fair rental then the figures are as follows:
100,000kg milk solids x $5.60 $560,000 x 25% = $140,000 rental
In this example the payout goes to say $8 per kg, then gross farm income is $800,000 x 25% rental = $200,000 rental
So how did I get to the 25% rental?
25% seems to be a realistic cost to capital allowed by banks and financiers. That’s the amount of income that you could reasonably expect to go toward debt servicing, interest costs and lease costs.
This percentage could vary slightly up and down depending on circumstances. For example, if it is a high cost operation with expensive irrigation and wintering off then the percentage could come back a bit. If it is an all grass easy operation with outstanding facilities then the percentage could rise.
Ratchet Clause
This clause sets out the minimum rental that the lessee will pay no matter what the circumstances. It is very important to have this in the lease so that if things go wrong, then you know exactly what your minimum income is.
Point of Sale
A big issue around getting money for anything is to get it at point of sale. Rather than the lessee receiving all the dairy cheque and then paying the lessor as per an agreement, it could be set up at the dairy factory, or the point of source, where 25% of the dairy cheque goes to the landlord and 75% goes to the tenant. In this model the tenant is not actually handling the landlord’s money, it is being paid direct to him by the dairy factory and this could avoid a lot of arguments later.
I am a great believer in trying to get your money at point of source under any circumstances. Under this model there can be no mispayments or misunderstandings. The owner’s rental is pegged and paid at point of source. It also means that the rental is paid in line with the factory payments. That means if there is a low income month then both parties share that reduced payment. Also, if there is a high payout month like during bonus time then both parties benefit from that.
A ‘dairying only’ clause could also be inserted in to the lease, specifying the farm is exclusively for dairying. This clause could set out the number of replacements (female cattle) that can be retained.
It could be argued that this may be a disincentive for the lessee, but existing fixed price leases have been at that 20 -27% of dairy cheque on a gross basis for some time now.
And what about the return on owner’s investment? Let’s go back to our original model.
1. Fixed Price Lease
100,000kg milk solids farm @ say $35 per kg, value $3,500,000
Fixed Price Lease of $100,000 return 2.86%
2. Variable Price Lease
100,000kg milk solids x $5.60 per kg $560,000
$560,000 x 25% = $140,000 return 4%
3. Variable Price Lease with a higher payout
100,000kg milk solids x $8.00 per kg $800,000
$800,000 x 25% = $200,000 return 5.71%
Under this model there is no doubt that if the payout rises to $8 per kg then the farm is likely to have risen in value, but it certainly demonstrates that the return to the owner is more realistic.
For a landlord, it may sound too good to be true and there may be some hooks in it. I’m sure the lessee will be relatively happy to have a variable rental in line with his income too. It’s along the lines of a 50:50 agreement but it avoids all the unhappiness and bitterness and interference that comes with 50:50 sharemilking agreements.
The details we are in the process of addressing, but it would seem to be fairer to both parties. The lease also sets out as to management of the property, correct fertiliser, asset maintenance and so on.
In summary, moving from a fixed price lease to a variable lease which is tied to the milk payout seems a logical way to go. The benefits are to both parties and would encourage the parties to work together to increase production on the farm. It also ensures the landlord is paid at point of source rather than the money going through the tenant and then him choosing whether he is going to pay the landlord or not.
