About a year ago, I got a call from my brother-in-law. He had learned that his landlord, the University of Illinois, had received a cash-rent bid of $360 per acre on the 700-plus acres he had rented the previous year. This was an increase of about $160 per acre. The question was whether he should match the $360 bid and keep the 700 acres that had also been farmed by his father and grandfather for more than 50 years. After some discussion, my brother-in-law said he was uncomfortable paying such a high rent. He let what had been his family’s “home farm” go, so that Illinois’ land grant university could earn the highest possible return on land it had received as a gift several years before.
My brother-in-law is not the only one faced with whether to pay considerably higher rents. I’m sure the vast majority of farmers have been asked to pay higher rents given that corn, soybean, and wheat prices were all exceptionally strong last fall and winter.
Do the math
Landlords should expect to earn returns on their land that are on par with the returns they could earn from other investments, such as stocks and bonds. But they should also understand that as they raise rents, they create situations where it is actually cheaper for tenants to purchase the land versus pay the higher rents.
In my brother-in-law’s case, he would have been paying $6,000 per acre and financing the entire purchase with a 20-year mortgage carrying an interest rate of 8 percent. This financing arrangement would have resulted in my brother-in-law paying $611.11 per year for land he could have instead rented for $360 per year. It would seem that leasing would have been cheaper than purchasing land at $6,000 per acre. But only $480 of the first-year mortgage payment would have been interest. The remaining $131.11 would have been principal. Hence, the cost of land ownership would not been as high as it would seem at first glance. Still, an interest payment of $480 would be considerably more expensive than $360 in rent.
A key advantage of land ownership is that land can appreciate in value. This appreciation, even at modest rates, can greatly reduce the net cost of owning land. (See the table which reflects the net cost of owning land for various rates of land-value appreciation. The values here reflect the annual net cost of owning land and selling it at some point in the future. The values were obtained by converting the present values of mortgage payments and property taxes and the present value of the proceeds from the future sale of land into annual net costs that can be readily compared to annual cash- rent payments.)
The rent-equivalent values in the table show that when land values are increasing at an annual rate of 2 percent or more, it is less costly to purchase the land for $6,000 rather than pay a rent of $360 per acre.
Know your cost
Admittedly, purchasing land is a lot riskier and complicated than paying cash rent for a year’s use of land. But don’t blindly pay higher cash rents without considering the option of purchasing land. You should be aware of what it would cost you — net of real estate appreciation — to own land versus meet the demands of a landlord.
More importantly, you should be knowledgeable of ownership cost so you can determine whether landlords are indeed pushing rents up to levels where it now pays to buy the land versus renting it.
Bruce Jones is a professor of farm management at the University of Wisconsin-Madison.