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Rural land: rent, buy or both?

Michael Vail, Tre Ponte Corporate, Brisbane, 13/03/2012

In previous articles we have asked “Are we valuing rural land correctly?” and “What is a ‘Living Area’, and does the concept have currency today?”.

In this article, I will discuss how current and future generations of landholders may be able to buy into the farming game, eventually having a seat at the table, and in a sustainable way.

If the next generation of farmers or graziers are unable to buy-in and build a future, because of structural issues like the income and capital disconnect in an investment in rural land, and the unreliability of ‘farm-gate’ prices etc, then the only other option open to them is to rent/lease a property of suitable scale, and one able to produce an economic profit.

With the average age of current farmers and graziers over 60, and with too few of the following generations willing and/or skilled enough to take over, one of the largest inter-generational asset transfers of all time is coming. This is both in dollar terms and land area as Baby Boomers retire over the next ten to fifteen years.

My sincere hope is that instead of selling assets into a crowded market-place, vendors look at other ways to meet the market, and sell a ‘going concern’ investment; which is operational to the incoming owner from day-one.

The opportunity may well be a Rent/Buy Agreement contract.

An opportunity to consider

Existing generations of landholders, being mainly baby boomers bookended by Depression Era and Gen X generations, must consider their ownership as an investment. This may mean they have the land held/owned separately to the operating entity, as a risk reduction and succession/estate planning strategy.

In most older farming and grazing entities, my observation is that the land is usually owned in individual’s names (this may be a requirement of the type of land title), who also operate the business, maybe in partnership with other family members.

Michael Vail, Tre Ponte Corporate, Brisbane.Usually there is no charge to rent expense in the Profit and Loss Statement, which means that this resource is not being brought to account anywhere. The figure in the Balance Sheet (if applicable), is the historical cost of the land when purchased, and the profit (if there is one), is certainly incorrect; an accounting profit maybe, but not an economic one! It goes to a question of viability.

There is an Opportunity Cost in owning the land; else the money may be invested elsewhere, and be earning an appropriate Return-On-Investment.

So, to explore this further, it might mean the entity which ‘owns’ the land, will have the land and improvements valued by the appropriate professionals, and expect an appropriate return, in Present Value terms, as a Yield on that value. Then, it will adjust the lease terms in an ‘arm’s-length’, and registered, Commercial Leasing Agreement, to ensure the Return-On-Investment is valid.

On the other side of the transaction is the operating entity, which leases the land and improvements from the landowner, at an appropriate amount; payable per month, per quarter, or per annum.

This implies there is a strong and liquid market for leasing/renting of farming and grazing land; or there definitely should be a market of this type.

I do not believe this is currently the case, and most sales I have observed over the period have not been sales of a going concern, including all things necessary, but land sold on a ‘bare’ basis, like a forced asset sale.

This has the effect of breaking-up everything the farmer/grazier has built-up over the past 40 to 60 years.

Yet it may not be a ‘forced sale’.

Why not consider a Rent/Buy Agreement contract.

Definitions of Terms

A Rent/Buy Agreement is where you might advertise, or put out to Tender, the long-term commercial leasing/rent of a going concern property (including all things necessary), with the intention for the applicant to buy all the resources at some future date.

Whereby the Stock, Plant and Equipment are purchased initially (say a $2 million loan to be repaid over 10 to 15 years), in conjunction with an attached Call Option, to buy the Land & Improvements at a certain price, at some future time.

An Option gives the holder the right, but not the obligation, to exercise the option at a future date, and at an agreed value.

The Mechanics of a Rent/Buy Agreement

Instead of outright purchase of the property, the applicant agrees to a Rent/Buy Agreement with the vendor.

A Rent/Buy Agreement is a type of vendor finance, where the leased property funds the purchase of the operation over time. By definition, to be suitable, the property must be a going concern, with all things necessary to operate. It is funded outside normal banking channels, yet the vendor is no-worse-off than if it was a cash sale at settlement.

The main point of which is, the Vendor receives the same amount of money, on a time-value-of-money basis, as that which he would have received, had he been paid, in-full and up-front, and had invested that money over the term of the Agreement.

A Rent/Buy Agreement is an instrument in which the monthly, quarterly, or annual rental payments, based on the value of land and improvements (and often above going rental yields), count toward an eventual sale; if the applicant exercises the Call Option.

The price of the Call Option may be 4pc of the agreed sale price; such amount is typically included in each rent payment via instalments, but may be a lump-sum paid in advance.

If the applicant decides not to exercise the Call Option before the expiry date, then the Agreement is rescinded, and the vendor has the option to evict them, or renegotiate a further long-term lease, or continue with the current lease to expiry.

All Agreements/Contracts are read as part of one Agreement/Contract. If the Applicant does not wish to proceed to exercise the option to buy the land and improvements, then the vendor is free to please themselves.

You may insist, in the first instance, that any applicant may have to work with you for a short period of time (say two to three months), so the vendor may ‘road-test’ their abilities and character.

Another option is that an applicant may just lease the operation as a going concern for a few years; prior to the Rent/Buy Agreement being drawn-up.

A lease may be entered into initially with terms of three years, on a ‘share-farm’ basis of a 1/3 of turnover to the lessor, or similar for rent.

This allows the vendor to ‘see’ if the applicant has the ability, work ethic and sustainability credentials to continue to the next level, and buy the land and improvements; in the absence of an ‘Option to Purchase’.

Therefore, those unable to buy now, may rent/lease for a minimum period of, say three years, with the option of a further 12 as ‘3 x 3 x 3 x 3’. Longer terms are of course negotiable, if just wanting to lease.

Rent will be paid per the Rent/Buy Agreement as is normal, but the transaction to buy the going concern is broken-down into two tranches; 1) Stock-on-Hand and Plant & Equipment, and 2) Land & Improvements.

The next question is, do both parties continue to the land buying exercise; albeit the applicant may have taken an option, or ‘first-right-of-refusal’, over the land parcel, at the time the first Agreement was agreed and signed? Maybe there is a Put Option in place also, to protect the downside for the Applicant.

The term of the Rent/Buy Agreement varies by contract, but is typically between six and 15 years.

The Call Option may be exercised at any time after year-six and before year 10, and all must be paid for before the expiration of year 15.

At that point, the renter chooses to buy the land and improvements at the original agreed price; less, of course, the equity he or she has built by exercising the option.

All prior payments made to the vendor will pay down the principle, if the option is exercised. Which means all rent paid is taken off the purchase price on exercise, at nominal value, and the interest is added-on.

If the Applicant does not proceed to buying the Land and Improvements by exercising the Option, the vendor may offer to repurchase the Stock, Plant & Equipment from the applicant; at a substantial discount, of course; or continue with the lease until the term runs out.

Regardless, the vendor will keep all payments made during the term of the agreement.

The opportunity for the Applicant is that the Vendor has the ability to pass-on and teach the Applicant the ‘knowledge’ he/she has gleaned over the years; a mentor if you will.

They will also see their seed-stock and/or commercial blood-lines continue; especially important to the Vendor, and to the industry as a whole, especially if they are above-average quality.

It is imperative to seek the services and advice of a commercial lawyer and/or an appropriately experienced corporate accountant, to assist you to draw-up the Rent/Buy Agreement, and the cost of this service is usually borne solely by the applicant.

There are Income Tax consequences, of course, and Capital Gains Tax Event B1 will be triggered; however, if the option to purchase is not exercised, the tax returns lodged during the period of the Agreement may require amendment

It may be necessary to request a Private Ruling from the ATO, which will be binding on the parties; but at least you will have certainty.

The vendor may be eligible to access the Small Business Concessions to further reduce any Capital Gains Tax obligation, if the property was purchased by the vendor after the 19th September, 1985. Ensure to seek advice from an appropriately qualified Tax Accountant and/or Tax Lawyer.

Example

How might a Rent/Buy Agreement contract work?

The Enterprise Valuation (EV) has just come back from the Applicant’s Business Valuer/Accountant, at $7.925M. This is the economic enterprise value of the business (Walk-In/Walk-Out), including all things necessary, a going concern, and with nothing further to pay.

This will be less than Intrinsic (or Full) Value; else the Applicant will pay too much.

The agreed value of the asset apportionments are as follows:-

Land $4,297,000
Improvements $800,000
Stock-on-Hand $2,328,000
Plant & Equipment $500,000
Total: $7,925,000

The first step is for the parties to the Agreement to agree the apportionments on purchase and sale, and the Real Opportunity Costs Foregone of Investments for the vendor; so he is no-worse-off than he might have been if he had taken the proceeds of sale in cash, on settlement.

The value for this example is 2.90%; which I am sure you will agree is quite appropriate. This equates to gross income earned on the capital over fifteen years of $4,240,729.

The Applicant will agree to pay rent per Annum of 6.0% compound (in advance), of the land apportionment; a sum of $257,820 per year.

The vendor will offer the Stock, Plant & Equipment apportionments to the applicant over fifteen(15) years, at 8.25%pa compound, paid annually, in arrears; a payment of $335,455.

At the same time a Call Option contract will be entered into by the parties, to buy the Land and Improvements component of the operation; at a value of 4.0% of the agreed apportionment value; being $317,000.

These payments will be in advance, and may be paid as a lump-sum; or spread equally over the six years (from time zero), and may be paid with the rent. This option may be exercised anytime after the commencement of year six, and before the end of year ten.

Upon exercising the Call Option, the Applicant will pay an exercise price of $246,854; being the original Enterprise Value, less the total rent payments made up to the exercise date, at 4.0%, the call option interest rate.

The vendor finance ‘loan’ to buy the Land and Improvements at the apportionment value less payments already made (a figure of $3,233,080), is then ‘drawn-down’, and payments of $558,126 are made to the vendor annually over the next 8 to 9 years.

The total amount the parties agreed to at time zero, was a present value (on $7,925,000 @ 2.90% over fifteen years) of $12,165,729; to be no worse-off. The table below shows how that may occur; and shows the break-down of the different contract components. Please view the Table below to see pictorially how the above scenario might work.

The above demonstrates a way to equitably transfer a going concern property, at agreed apportionments, over a fixed term of fifteen years, to allow the Applicant to get set-up and to pay-down the debt, as able to do so.

If the term goes over fifteen years because of circumstances beyond the control of the Applicant, then a bank loan may be taken-out by the Applicant in full and final satisfaction of the Agreement; unless otherwise agreed between the parties.

To Sum Up

 

  1. There needs to be a mechanism to allow a structured transfer of grazing assets, as a going concern, to the next generation; even if they are not family members.
  2. This mechanism may be the Rent/Buy Agreement.
  3. There does not appear to be a liquid market operating in Australia for leased grazing land, as a going concern.
  4. A market of this type would act as a counter-foil to the current system of selling land, and would act to reduce the Income and Capital disconnect observable today.
  5. The current average age of farmers/graziers/pastoralists is around 60.
  6. Coming to a market-place near you over the next fifteen years, is the biggest inter-generational transfer of grazing land this country has ever seen; except maybe the one to the banks back in the 1890’s.
  7. Most of these farmers/graziers have built-up systems and genetic pools that should not be lost to the industry; rather be passed-down to the next generation.
  8. Breaking-up a going concern, to maximise value for the retiree, makes no sense.
  9. Better to have some control in the selection process by passing the baton slowly; and receive the same money regardless; by being ‘no-worse-off’ in a Present Value sense.
  10. Applicants and Vendors may decide to ‘suck-it-and-see’ in the first instance, by choosing to rent for a three year period as a condition of triggering the Rent/Buy Agreement.
  11. Once the Rent/Buy Agreement is ‘on foot’, the total period for the transfer to complete is 15 years.
  12. The parties sit down and agree the apportionments on sale, between Land, Improvements, Stock and Plant.
  13. The Applicant should engage a Business Valuer/Accountant; to understand the value and risks of the enterprise, and to prepare a Business Plan for the transaction.
  14. The sale will be in two parts: 1) Stock and Plant; and, 2) Land & Improvements.
  15. Initially the Applicant agrees to buy the Stock and Plant at agreed apportionments over fifteen years, at 8.25% compound (in arrears).
  16. The rent is calculated at 6.00% simple (in advance) of the Land apportionment.
  17. The parties also agree to a Call Option to buy the Land and Improvements apportionments at 4% of this combined value (in advance). The payments may be made in lump-sum, or paid in equal payments with the rent.
  18. The Call Option means that the Applicant has the right, but not the obligation, to exercise the option at a previously agreed price; usually after the expiration of six years and before the passing of ten years.
  19. All payments made count towards the purchase of the going concern entity.

 

If the term goes over fifteen years because of circumstances beyond the control of the Applicant (eg. acts of God, random acts of an elected Government, or Minister of the Crown, collapse of the market, etc.), then a loan may need to be taken-out by the Purchaser to pay-out the balance; unless by agreement between the parties for payments to continue (which will not be unreasonably withheld).

All monies paid to the vendor, at all times remain the property of the vendor.

If the sale does not complete, the vendor may buy-back the Stock and Plant at a substantial discount to their book value; or a Put Option may be in place.

I commend the concept of ‘Rent, Buy; or Both?’ to the market, and the future retirees, for their consideration.

It is also my fervent hope that there may develop in Australia a liquid market in leased rural land, as a part of the above process. Stock and Station Agents should find a niche here, as it is their natural bailiwick, and they already have the relationship with the client, for the sale of produce.

I welcome feedback, and am open for comment.
 

 

 

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