Testing the rent review system: report

Chapter 6: Productive Capacity

6.1 Interpretation of the Act

6.1.1 Productive capacity is referred to in the Act as one of the factors the Land Court 'must have regard to' when assessing the fair rent for a holding. The Scottish Government has further defined the Productive Capacity as follows:

Table 3: Productive Capacity

“The ‘productive capacity of the agricultural holding’ means the sustainable yield of agricultural products that would reasonably be expected from the agricultural holding under a system of farming suitable to it when farmed by:

• a competent, efficient and experienced tenant farmer;
• with adequate resources for that system;
• with such assessment being made as at the effective date; and
• taking account of any factors that might reasonably be thought to vary it before the next rent review.

Determination of the productive capacity: The productive capacity of the agricultural holding is to be determined:

• taking account of the physical character of the agricultural holding relevant to its use for agriculture as a trade or business, including but not limited to those factors detailed in the non-exhaustive list (see below);
• having disregarded the presence of fixed equipment and any tenant farmer’s improvement so far as;

(i) it has been provided wholly or partly at the expense of the tenant farmer (whether or not that expense has been or will be reimbursed by any grant) without equivalent allowance or benefit having been made by the landlord in consideration of its provision; and

(ii) it has not been provided under an obligation imposed on the tenant farmer by the terms of the lease unless it was an item that the landlord was obliged to provide when the lease commenced in the circumstances on the agricultural holding at that date;

• taking account of the fixed equipment provided by the landlord;
• allowing for any land and fixed equipment provided by the landlord that is accepted as being used for a purpose that is not an agricultural purpose relevant to paragraph 7(4) of Schedule 1A;
• having disregarded any dilapidation to or deterioration of or damage to fixed equipment or land caused or permitted by the tenant farmer;
• taking account of the extent to which the agricultural holding may reasonably be farmed with other land or to the extent an agricultural holding may be farmed with contractors providing machinery services in place of the overhead costs of owning machinery;
• taking account of the terms of the lease by which the agricultural holding is let to the tenant farmer;
• taking account of the terms of any other legally enforceable agreement or restriction affecting the use of the agricultural holding; and
• using the yields that would reasonably be expected from the agricultural holding for that system of farming conducted by such a tenant farmer”.

Source: Invitation To Tender

6.1.2 Through discussions with Hamish Lean we have confirmed that the following points can be derived from the above definition in order to base our working models on:

• Productive capacity is linked to the output, which can be produced from a farm. ;

• reference to a 'competent, efficient and experienced tenant farmer' gives the potential to use a standard percentage of output for costs. This is an appraisal methodology commonly used by banks;.
• the inclusion of the assumption that a 'competent, efficient, experienced tenant farmer' would have 'adequate resources for that system' means that where it would be expected the availability of subsidy is relevant in calculating the productive capacity. In rare circumstances where these would not be taken into account the Land Court could consider this in terms of 'taking account of all the circumstances'.;
• section 1 (2) of the Agricultural Holdings (Scotland) Act 1991 states "agricultural land" means land used for agriculture for the purposes of a trade or business. We can, therefore, assume that 'a hypothetical competent tenant' would not continue a business in the long term if it was not profitable over the medium term.;
• the 'hypothetical tenant farmer' would be expected to make the best use out of the farm's productive capacity. There is an assumption that a tenant would seek to utilise the potential opportunities the farm provides.;
• generally a black patch approach should be adopted for significant tenant's improvements.;
• improvements which need to be included in order to determine a realistic farming system such as fencing, water troughs, access and electricity can be considered as it is reasonable to assume a competent, efficient and experienced tenant would take the opportunities the lease gives him and extract the potential from the farm. A deduction can therefore be made to account for these where it can be proven that they have not been supplied by the landlord. For such improvements this will mean the landlord's renewal obligations have not been fulfilled as most leases state that holdings are accepted at the beginning of the lease to be in a full state of repair and renewal. ;

• Grants:
  • where the tenant has completed works with grant aid and no landlord contribution has been made, this must be regarded as a tenant's improvement and disregarded from the rent assessment.;
  • where the landlord and tenant make a contribution to works, then both the tenant's contribution and the full amount of grant aid should be disregarded in the rent assessment. i.e. if a building was put up with 40% grant, 30% tenant contribution and 30% landlord contribution, then 30% of that building can be considered in the analysis of rent.
• further regulation may be needed to account for grants where contributions have been made from the landlord. In terms of assessing the fair rent, being unable to include any element of these in the rent assessment does result in disadvantaging the landlord and fully advantaging the tenant in an unproportionate way. It should also be clarified that this is only applicable to improvements therefore allowing grant funded capital to be taken into account when it represents a renewal of fixed equipment.;
• fixed equipment used for non-agricultural activities is rentalised using market value not productive capacity. Fixed equipment used for non-agricultural activities which have not been notified under the 2003 Act or consented to as by the landlord should be considered under productive capacity rather than market value, as once rented as non-agricultural activity the landlord's consent will be implied.;
• contractor costs may be used. Recognising that they only reflect labour and machinery costs. Although these costs include profit and overheads, many farmers do use them due to the advantages of scale and modernity.;
• if a farm is let for a specific purpose this must be considered when defining the farming system.;
• a post-lease agreement or unusual lease conditions must be considered in terms of placing a higher cost burden on the tenant which will impact profitability.

6.2 Learning From Other Systems

6.2.1 Agricultural Holdings Act 1986 ( AHA)

6.2.1.1 Prior to looking into the various approaches available to calculate the productive capacity of a holding it was considered relevant to look at the pros and cons of the English model which already calculates rents under a similar legislative framework. In England, Agricultural Holdings Act 1986 tenancies, which are similar to that of 1991 Act tenancies in Scotland, rent reviews tend to be approached from two different directions in order to come up with a justified rent. The two procedures used in tandem are comparable evidence and productive capacity via a budgetary approach. The comparables are almost always only drawn from other AHA sitting tenancies, and the values may be adjusted to reflect the terms of the tenancy, and differences in the physical characteristics of the holdings. The budgets are derived from what the hypothetical tenant would be likely to do on the holding, which includes income from sub-let housing, and subsidy receipts. In most cases a valuer would prepare an analysis of comparables and a budget, which ought to produce a similar rental figure in theory and in practice mostly does according to our English counterparts.

6.2.1.2 The legislative basis of the 1986 Act as to how rent is calculated is not dissimilar from how our legislation is now worded under the 2016 Act. Paragraph 1 (1) of Schedule 2 of the 1986 Act defines the rent properly payable in respect of a holding to be:

"the rent at which the holding might reasonably be expected to be let by a prudent and willing landlord to a prudent and willing tenant, taking into account (subject to sub-paragraph (3) and paragraphs 2 and 3 below) all relevant factors, including (in every case) the terms of the tenancy (including those relating to rent), the character and situation of the holding (including the locality in which it is situated), the productive capacity of the holding and its related earning capacity, and the current level of rents for comparable lettings"

6.2.1.3 In practice this system still disregards the tenant's occupation, scarcity, marriage value, tenant's improvements, grant-aided landlord's improvements, dilapidations and high farming.

6.2.1.4 As a contrast to this the Land Reform (Scotland) Act 2016 Part 10, Chapter 5, section 7, sub-section 4 states:

"In determining the fair rent for the holding, the Land Court must have regard, in particular, to—

(a) the productive capacity of the holding,

(b) the open market rent of any surplus residential accommodation on the holding provided by the landlord, and

(c) the open market rent of—

(i) any fixed equipment on the holding provided by the landlord, ; or

(ii) any land forming part of the holding, used for a purpose that is not an agricultural purpose."

6.2.1.5 Through the inclusion of the reference 'in particular' it would be possible to undertake a rent review using a similar process to what has been adopted in England for reviewing AHA 1986 tenancies. This would allow comparable rents taken from similar 1991 Act tenancies to be used as a sense check for the productive capacity model. In practice this provides the landlord and tenant with two figures to give them parameters for negotiations. However since the comparable figures would have no relevance to the open market and would be based on sitting tenant rents which are agreed between parties and may have hidden considerations, its application would only be recommended as a sense check provided adjustments were made accordingly. It would also be relevant to add that this sense check should only reference rents agreed or set within the previous 3 year cycle.

6.2.1.6 In practice these rent reviews are done by dealing with the following factors in order:

1. the The terms of the tenancy (including those relating to rent); this involves the analysis of terms relating to the repairs, user, subsidy, interest, prohibition of sub-letting and improvement obligations.

2. the The character and situation of the holding (including the locality in which it is situated); this involves the consideration of size, soil type, aspect, climate, access, topography, layout, drainage, fixed equipment, access to additional land, markets, public access and available subsidy schemes.

3. the The productive capacity of the holding and its related earning capacity; this involves the assessment of the holding as it stands subject to both landlord's and tenant's fixed equipment. The related earning capacity, essentially an assessment of profitability, may be assessed by first undertaking a gross margin budget for each enterprise in the identified system of farming in the circumstances of the subject holding. Having arrived at a total gross margin, the overhead costs (excluding rent) for the holding should then be deducted to establish the surplus before rent – from which a rent needs to be deducted to arrive at the statutorily identified measure of profit. The disregarded rental value of tenant's improvements is commonly deducted from the landlord's portion of the surplus and the remainder of that portion is left as rent for the purposes of this one relevant factor. Alternative approaches may involve different divisions of the present surplus between the parties.

4. the The current level of rents for comparable lettings; this involves considering any available evidence of rents determined by arbitration under the 1986 Act.

6.2.1.7 The following contentious factors are apparent within the English model according to the CAAV & RICS guidance on AHA Rent Reviews. Generally these factors have resolved themselves in practice:

• Managerial costs – whilst a very large or intensive unit may require the appointment of a manager, it may be more conventional to regard this as a proper function of profit from the farmer's enterprise.;
• typical return on tenant's capital – this requires a capital account to be prepared, including machinery, livestock and working capital but may again often be seen as a use of profit.;
• the tenant's own working labour – conventionally the self-employed make profit as a return on their labour as well as their capital. Inclusion of any of these items in calculating the pre-rent surplus may influence the division of that surplus.;
• presence of tenant's improvements - The two main approaches considered by valuers to deal with this are: the "black patch" approach and valuing the holding with and without the improvement, assessing the difference, and trying to establish an annual value for the improvement directly, perhaps by writing it down over a period of years. The black patch approach is often criticised for its inability to reflect the latent value provided by the farm in providing the opportunity to implement such an improvement. Writing down on the other hand often means the value of the improvement is overstated as it relates to the cost and the economic write down period rather than the improvements value to the holding.

6.2.1.8 No direct priority is given to earnings-based evidence or market-based evidence. It would seem that generally the practice is to agree a rent somewhere between the two with the preference being towards whichever method relied on the most applicable data i.e. were the comparables fully applicable? Was the costing and output data fully up to date? It therefore provides for the two systems to have their limitations as they are used as a cross check against each other to come to a sensible figure.

6.2.1.9 From the analysis of the English model it is clear that there are a number of workability issues in both determining the productive capacity and excluding or deducting tenant's improvements. In terms of comparable evidence it is also clear that the availability of comparables and the dark art of making adjustments will always prove a limitation when using this method. A sense check to the productive capacity approach seems sensible especially as it would provide a range for debate.

6.3 Calculating the Productive Capacity of a Holding

6.3.1 Working Models

6.3.1.1 The following models have been derived from an analysis of the legislation as being possible methods for considering the productive capacity of the holding:

Model 1: Individual Enterprise Gross Margin Approach ( SAC Handbook)

Model 2: Standard Data Approach (Whole Farm Data)

Model 3: Gross Output Approach

Model 4: Alternative Approach 1: Capital Value Approach

Model 5: Alternative Approach 2: Land Use Classification Approach

Model 6: Full Farm Budget

6.3.1.2 Each model has been used to assess the rent on the sample farms inspected with the advantages and disadvantages of the results they produce discussed. The following non-exhaustive list of additional factors should be considered (taken from the Scottish Government's Invitation to Tender) and be taken into account when considering the most appropriate farming system for the holding:

• locality (including proximity to or remoteness from markets and other factors based on general location);
• topography (including altitude, aspect, inland, coastal, exposed, sheltered, etc.);
• geology and soil types, depth and nature (acid, alkaline, stony, heavy clay, organic content, light sand, free or slow draining, etc.);
• climate;
• vulnerability of land to flood, drought, wind blow or erosion;
• presence of contamination, disease infestation, pollution and other limiting factors;
• quality, quantity and compliance with standards of landlord's fixed equipment – not only buildings but also including drainage, fencing, field water supplies, reservoirs and other items;
• services and permissions benefiting the agricultural holding;
• quality and suitability of land parcels and their relative mix;
• Macaulay land classification of the agricultural holding;
• layout of the agricultural holding;
• field sizes, slopes and shapes, sizes of headlands and margins, ease of working, neighbouring woodland;
• access to agricultural holding and fields;
• damage risk by rabbits, game and other animals;
• field drainage and ditches;
• water supply to the agricultural holding, including private water supplies, abstraction licences on the land;
• designations including SPAs, SACs, SSSIs, NNRs, National Parks, Scheduled Monuments, Listed Buildings, Battlefields and items listed on the Inventory of Gardens and Designed Landscapes;
• site specific statutory regulations ( e.g. NVZs);
• servitudes and wayleaves affecting the agricultural holding (including pylons, poles, cables, mobile phone masts and pipes);
• core paths and rights of way affecting the farm;
• existing uses of the agricultural holding for non-agricultural purposes;
• any long term use established on the land that could limit choice or offer opportunities;
• the terms of the agricultural tenancy arrangement;
• past, current and available future prices of inputs and agricultural products relevant to the agricultural holding;
• availability of labour for the agricultural holding.

6.3.1.3 Regardless of the model adopted, it will be necessary for the landlord and tenant to agree on certain factors prior to assessing the productive capacity otherwise dispute will be inevitable. The main aspects to be agreed are the farming system most appropriate for the holding, what expected production is likely to be from that system ( i.e. yields for crops, stocking densities for livestock) and the status of the fixed equipment present on the holding.

6.3.2 Model 1: Individual Enterprise Gross Margin Approach

6.3.2.1 The gross margin based model begins with the determination of the farming system as all models do. This can be defined through reference to lease documentation, local farming practices, land type, field sizes, fixed equipment provided by the landlord and latent value as well as all the other factors outlined in the list produced by the Scottish Government. A system should be considered by the landlord and tenant as one in which a competent, efficient and experienced tenant would be expected to carry out in order to derive the best, sustainable performance possible.

6.3.2.2 This approach involves both parties working out the productive capacity using gross margins derived from the SAC crop enterprise data and Farm Business Survey Enterprise Data. It assumes a competent tenant would be in receipt of any basic payment, LFASS or other standard subsidy available to them. Following the deduction of all costs the model assumes a 50/50 split of the divisible surplus as is the industry standard. The dataset provides high level information and it is difficult to drill down and analyse. All data would be averaged over a 3 year period in an attempt to account for unstable market conditions. Fixed costs can be obtained from the FBS Cost Centre Analysis Tables. A more detailed extract of this data was provided to the Team by the Scottish Government's Rural and Environmental Science and Analytical Services ( RESAS) team to enable costs to be allocated on an area rather than per farm basis.

The sequence is shown below:

6.3.2.3 Advantages

• External data could be seen to be more objective and less arguable.
• In-keeping with the hypothetical tenant farmer.
• Reflects how businesses would make profit projections and plan their accounts.
• Although they would be unlikely to use standard data for this.

6.3.2.4 Disadvantages

• Open to debate between parties with every figure open to scrutiny and the potential for output data and cost data to be analysed in different ways.;
• reliance on standardised data which is past data rather than accounting for the current or likely future prices and costs.;
• FBS data will include a wide range of data with no ability to check whether the sample only includes competent farmers.;
• the lack of consistency within the model could lead to misleading profit/loss figures depending on the angle taken by each party. ;
• different Scottish Government data sets are difficult to reconcile and ensure all costs are accounted for or make sure there has been no double counting. ;
• does not achieve the aim of the productive capacity model to decrease conflict in the industry.

6.3.2.5 Although there are obvious benefits to using a definitive standard data source, the overall issue is that the data is already out of date before it is published and therefore does not reflect markets accurately. With a lack of general detail in terms of what is included within the fixed costs and an inability to account for actual prices and costs, the model lacks accountability and would therefore not be recommended.

6.3.3 Model 2: Standard Data Approach

6.3.3.1 The standard data based model begins with the determination of the farming system based on the standard farm types from the Scottish Farm Business Income ( FBI) publication RESAS online publication – Detailed Tables http://www.gov.scot/Topics/Statistics/Browse/Agriculture-Fisheries/Publications/FASdata. The selection of the most relevant farm type to the holding from the list of Specialist Sheep ( LFA), Specialist Beef ( LFA), Cattle and Sheep ( LFA), Cereals, General cropping, Dairy, lowland cattle and sheep and mixed should be agreed between the landlord and tenant on the farm inspection as well as agreeing the likely best possible production from the land.

6.3.3.2 This approach involves both parties working out the productive capacity using the FBS farm scale data. This differs from model 1 as the information for each enterprise comes from one of eight farm types. It assumes a competent tenant would be in receipt of any basic payment, LFASS or other standard subsidy available to them. It again bases fixed costs on those expected of that farm type and assumes a 50/50 split of the divisible surplus as is the industry standard. The dataset provides high level information and it is difficult to drill down and analyse.

The sequence is shown below:

6.3.3.3 Advantages

• Provides for a higher level of consistency within datasets via fixed farm types. ;
• fixes input and cost data, by defining the data source, leaving less opportunity for dispute.

6.3.3.4 Disadvantages

• Limited to only 8 farm types which is unrealistic in practice.;
• leads to trying to make the holding match the model rather than matching the model to the holding.;
• could be seen as a way of starting with the answer and working back to the farm.;
• limited in some respects due to missing data for some farm types.;
• variability of the cost data. ;
• lack of information available in terms of what is included in fixed cost calculations could lead to double counting or missing important elements. ;
• the concept of a simplified model in which standard data is used appeals as it limits the opportunity for dispute. However in this model the lack of transparency would prove difficult in terms of parties being able to fully justify where rent has come from.

6.3.3.5 Again, although there is an appeal to this model in terms of providing a simplistic means of calculating the productive capacity, it again lacks accountability due to its inability to react to market circumstances, its restrictive nature in terms of farm type and the fact the data is out of date before it is published.

6.3.3.6 It should also be noted that when analysing results from models 1 and 2 there was potential for huge variance depending on which model was used.

6.3.4 Model 3: Gross Output Approach

6.3.4.1 The Gross Output based model begins with an analysis of the farm and the determination of the farming policy. This farming policy is informed by the local farming practices, the landlord's fixed equipment and the physical characteristics of the farm.

6.3.4.2 The farming system is then analysed into arable and grassland based enterprises and a rotation prepared. Data can be gathered from reliable data sources for past, current and future prices available to the parties and should reflect a 3 year average to ensure stability. Ideally one year past, one year current and one year future data should be used where possible with the source for the data remaining as consistent as possible.

6.3.4.3 This approach involves both parties working out the productive capacity based purely on the likely output of the agreed farming system. This removes the need to agree on variable cost and fixed cost data.

6.3.4.4 The following percentage was found through reference to the whole farm review data and then discussed with accountants and banks to determine what percentage of output a farmer would be expected to make in profit. It is considered by banks to be a realistic profit figure and has been used for over 20 years to analyse business performance:

• Profit before Rent & Interest & Personal Drawings (30%).

6.3.4.5 As such it was agreed with three banks that the above percentage is currently used to analyse whether a business is viable or not. There are rules of thumb which the banks use to assess farm businesses. Rent could then be calculated at approximately 12-18% of gross output i.e. 50% of the gross profit (surplus split 50/50). Evidence from banks suggests competent farm rents sit somewhere between 10 and 18% of gross output. When queried on the relevance of these percentages to all farm types, the banks were clear that adjustments were rarely made except where a particularly specialised or intensive farm was analysed. In these cases variable costs would likely be at the higher end of the 30-40% range. It was clear that banks considered businesses with a gross profit below 30% as struggling.

Following the Stakeholders meeting we were guided to consider 'The John Nix Pocketbook'. It notes a number of common ratios, using normalised output prices ( i.e. those in an average year) which it states can be used as guidelines:

Table 4: John Nix Output Table

% of Gross Output	Arable	Dairy	Mixed	Upland	Intensive Stock
Labour inc drawings	12	15	21	17	12
Rent & Interest	12	13	9	8	4
Profit (to cover tax, capital repayments, reinvestment	14	5	14	19	2

(Source: John Nix Pocketbook 2018)

The John Nix Pocketbook also looks at farm survey ratios in England. The analysis looks at rent as a percentage of gross output. It notes that rent as a percentage of gross output on surveyed farms in 2014 and 2015 was 15% and 16% respectively.

6.3.4.6 DEFRA has also published documentation on expected percentages of farming businesses in their paper 'Figures for a Farming Future' (2004). The table below shows the expected percentages for variable costs, fixed costs and Rent and Finance which would leave a likely gross profit of approximately 30%. Once again these are defined as 'expected' percentages not 'target' percentages so it would seem fair to make 30% the base rate for ranges to start from depending on the specific circumstances of the holding.

Table 5: DEFRA Output Table

6.3.4.7 Although a useful cross reference, it should be noted that data sets such as John Nix and DEFRA are based on farms in England which limits the relevance of its application. However, in principal the data does provide for interesting comparisons and shows that it may be relevant to adjust the 30% profit figure to account for certain aspects of the holding. For example the following would perhaps be relevant when setting the profit percentage:

• The existence or lack of non-surplus residential accommodation.;
• the ability to benefit from economies of scale.;
• remoteness of markets (although this should be mainly adjusted through prices achieved).);
• higher or lower fixed costs.;
• the presence of restrictive lease clauses or farm types.

6.3.4.8 Based on the above, 30% as an average could be adjusted up or down depending on the specifics of the holding. In order to ensure relevant ranges are adopted we would recommend further research is undertaken to define what 'a fair' profit expectation would look like and what would be 'fair' in terms of appropriate ranges at either end of this figure to account for varying factors within a holding.

The sequence is shown below:

6.3.4.9 Advantages

• This model allows the specific farming system to be appraised. ;
• it is considered, alongside a full budget, to be the best means of producing an accurate assessment of the output for the holding.;
• by only dealing with output it significantly reduces the potential areas of dispute. ;
• in working directly with gross output it allows both fixed costs and marriage value to be bypassed.;
• removes the potential for calculations to conclude a nil or de-minimus rent.;
• ensures the farm is considered as a business with account to the actual profit the farm is capable of, rather than reference to cost which is generally business specific and often includes an element of individual preference and reference to actual circumstances. For example, a full budget is used by a business to account for their actual circumstances with cost data often altered from the beginning to account for an individual's preferences rather than the most efficient means of running the business in order to ensure profit is maximised.

6.3.4.10 Disadvantages

• Over simplifies the assessment of costs which means it is less able to react to changes in the economy/market.;
• still has the difficulties involved in agreeing a farming system, stocking densities, yields etc.

6.3.4.11 Although this model still has restrictions and limitations, it is considered to be a means of simplifying the calculation of the productive capacity of a holding. We appreciate that research is required in order to set relevant profit percentage ranges and a sense check would be relevant in order to prevent the potential for 'unfair' results. However the output model is potentially the most robust option available.

6.3.5 Model 4: Alternative Approach 1: Capital Value Approach

6.3.5.1 Model 4 was investigated as an alternative way of calculating the productive capacity rather than dealing with the divisible surplus as per the conventional 50/50 split. It derives a 'fair rent' from the established theory of economic activity being made up of the four factors of production being:

• Land
• Labour
• Capital
• Management

6.3.5.2 The economic return to each is shown below:

Table 6: Economic Return

Factor of Production	Component
Land	Rent
Labour	Wages and Salaries
Capital	Interest Payment
Management	Consultancy and wages

6.3.5.3 Rent, from a landlord's perspective, is simply a return on the capital tied up in the holding, and to the tenant it is the cost of acquiring the use of that capital asset. In a system based on the economics of a hypothetical farmer where a "divisible surplus" is to be shared between the parties, that surplus must represent the same thing to both landlord and tenant. To achieve that from a conventional accounting or budgeting perspective, you must take the output (production) and deduct from it all the cost of achieving it except the one you are trying to "Divide".

6.3.5.4 We should therefore deduct from output all variable costs ( i.e. seed, feed, fertiliser), all fixed costs ( i.e. labour, machinery, insurance) to account for working tenant's. The fixed costs must include the tenant's own labour and a component for management but exclude any interest costs. On the landlord's side, we must also deduct landlord's insurance and admin costs (landlord's management) leaving a figure which represents the return on capital of both Landlord and Tenant.

6.3.5.5 To be "fair", we should then divide that "surplus" between the parties in the ratio of the capital they have each contributed to the economic system. For example, the landlord's capital would be the value of the holding subject to tenancy whilst the tenant's capital would be the working capital, stock, machinery and the value of any tenant's improvements.

The sequence is shown below:

6.3.5.6 In theory this represents a "fair" way of determining the rent. However, if you apply that system in practice by accounting for all the costs involved in a farming system, it almost always leaves a negative margin and therefore in theory no surplus to be divided.

6.3.5.7 Watson Bell believes that in agriculture you can afford to pay the market value of only two of the four factors of production. If you are an owner occupier and the farm is fully paid up you can borrow money for stock and machinery and employ paid labour but you are not paying the market price for land or able to employ management.

6.3.5.8 For a tenant paying rent and paying interest they must receive less than the market price for labour and management. This scenario is reflected in reality where many working farmers will receive less per hour for their labour and management than even the minimum wage.

6.3.5.9 The divisible surplus must represent labour and management and any return on tenant's capital for the Tenant and Ownership costs and return on capital for the landlord. There is no way of reconciling this division or providing a "fair" split in which case it is difficult to envisage an alternative to the accepted "norm" of 50%-50%.

6.3.6 Model 5: Alternative Approach 2: Land Use Classification Approach

6.3.6.1 Although not a budgetary approach, the Macaulay considers the land use capability not its current use and therefore takes its potential into account and excludes reference to the actual tenant, meaning it could be used as a means of calculating the productive capacity of a holding. Used as a main model or a sense check annual pre-determined ranges of rent would need to be produced for each Macaulay land use class or agreed land type. These could be produced through stakeholder agreement and published annually. For example Grade 2 land could be set at £X- £Y/acre, grade 3 at £A-£B/acre etc. The variance within the range would take into account different levels of fixed equipment supplied by the landlord and any limitations within a particular holding in terms of the 'additional factors to be considered' which were outlined previously. It is important to note that agreement between the landlord and tenant onsite as to the class of the land would be required as there are obvious restrictions to the accuracy of the Macaulay data in certain parts of holdings. For example a particularly wet area of grade 3 land could be agreed to be classified as grade 4 or 5 in reality provided its condition was not due to a lack of maintenance.

The sequence is shown below:

6.3.6.2 There would of course still need to be adjustments for region, landlord's provision of fixed equipment and tenant's improvements, but it would root the final outcome within a sensible framework and could be used to provide a useful cross check to a budget based approach to allow for reasoned negotiation. This would need to be annually updated to reflect a rolling average of economic conditions, regional and local rental patterns and changing agricultural regulations.

6.3.6.3 Advantages

• Offers a useful sense check to a budgetary approach.;
• is based entirely on the productive capacity of the land. ;
• completely black patches tenant's improvements.;
• is simple in its application so less open to debate between parties.

6.3.6.4 Disadvantages

• Considered to be over simplistic in its ability to cope with differences in location, fixed equipment, current price data, likely costs, infrastructure and investment in the holding from either party.;
• adjustments would need to be made for the specifics of the holding, without a structure for such adjustments debate could occur.;
• relies on the stakeholders being able to agree on ranges with a methodology in place to determine such ranges. Likely to relate to sitting tenant rents which leads us to believe that the ability to use relevant sitting tenant rents in terms of comparables as a sense check would be a better option.

6.3.7 Model 6: Full Farm Budget

6.3.7.1 Models 1 & 2 utilise financial data from either FBS or the SAC Handbook. Both information sources gather farm account data from sample farms across farm types.

6.3.7.2 There are a number of challenges associated with using this survey information which have been discussed. However having identified these challenges and in response to feedback from the stakeholders meeting, it was important to consider a further option, a farm budget, which would get round the issues of using historic data recorded in a rigid format. The farm budget could describe either the actual farming system or the hypothetical farming system. The legislation guides us to the latter after disregarding tenant's improvements.

6.3.7.3 The process is therefore straightforward and does not require a detailed description other than to layout principles. The budget could look at the current agricultural conditions and look forward with a realistic approach to commodity prices, yields and variable costs based on the hypothetical farming system.

6.3.7.4 The budget also has the ability to consider fixed costs in detail. The equipment present on the farm today reflects the tenant's actual farming system, represents the choices the tenant has made and may relate to a wider farming business or contracting enterprise. The budget will therefore need to build up a register of fixed equipment which facilitates the hypothetical farming system. The equipment required would be appropriate in size and value to the holding. In some cases ownership of a machine would not be proportionate. So just as the output and variable costs need to be justified, so must the fixed costs.

6.3.7.5 The presence of a post-lease agreement or unusual lease conditions could be reflected within the annualised costs before the divisible surplus is then split 50-50 as with the other models.

6.3.7.6 Although favoured by some of the stakeholders, there are a significant number of difficulties in arriving at what can be agreed between the parties. In a whole farm budget even for a simple all cereal farming system, there are up to 30 component figures for each gross margin, potentially four or five gross margins and a further 20 costs to agree in order to arrive at total fixed costs. In total between 120 and 150 physical estimates and prices have to be determined in order to arrive at even a simple budget. Where more complex livestock or mixed farming systems are involved the numbers increase significantly.

6.3.7.7 What must be remembered is that even with the best will in the world these figures are only estimates based on the parties respective professional judgements or based on external experts professional advice. There is no "sense check" within the figures and each side will seek to vigorously defend their own position.

6.3.7.8 The use of "standard" gross margin figures as seen in Model 1 could reduce, to an extent, the areas for disagreement, but "standard" figures are precisely that and need to be adjusted for regional, local and individual farm circumstances. It is within the fixed costs particularly that there is scope for significant debate about what is and is not appropriate for a hypothetical farming system. When to hire a tractor or buy, to contract an operation or not are some of the other variables for debate.

6.3.7.9 Whilst variable costs are precisely what they say, fixed costs in general do not fluctuate as much with price or output nor do they follow a linear pattern based on scale. Thus, a 100 acre farm does not have half the fixed costs of a 200 acre farm even where the farming system itself is identical. There is little reliable published data analysed to farming system and scale and therefore widely varying opinions about what should and should not be included. At one extreme it can be argued that where economies of scale are not achievable due to the small scale of, for example arable enterprises, then contractor's rates should be used in place of machinery costs. The recently published report by Savills 2016 Arable benchmarking illustrates the difficulties with this showing a difference of over £100/Ha in costs comparing in hand farming with contract farming.

6.3.7.10 It has already been pointed out in Model 4 that a model which tries to fully budget a proposed farming system including the tenant's labour, capital and management doesn't work. In many cases this leads to a negative divisible surplus. To get meaningful results therefore these costs need to be excluded from the budgeted figures in order to arrive at a positive surplus. The split of the divisible surplus is therefore further open to argument and cannot be objectively defined in terms of "fairness".

6.3.7.11 Advantages

• It is the most accurate way of looking at costs and prices through finding the most relevant data source for each and not being restricted to standard data sources.;
• ability to look at past, present and future price data reflects how businesses would make profit projections and plan their accounts.;
• assures a reactive model which can adapt comfortably to changing circumstances like the loss of farm subsidy or significant rises in variable costs.;
• all employment costs can be identified in the budget. This means that the accommodation of the farm can be reflected in the divisible surplus.

6.3.7.12 Disadvantages

• Allows for a huge number of variables which can be altered slightly and have a huge impact on the final figures. Although the number of factors allows this model to adapt easily to market changes it also increases the ability for varying results.;
• greater scope for partisan behaviour with both sides favouring circumstances which support their position of either increasing or decreasing output or cost. ;
• with such a wide range of data sources available, the two parties involved can use completely different data sources and come to completely different answers with no means to justify which data source is correct.;
• fixed costs required are extremely open to debate with the amount of machinery, labour and housing required being business specific. Standard labour units can be used but if they are not mirrored in practice then the question of 'fairness' is raised.;
• housing requirements are also subjective and the treatment of housing costs can be difficult. Is it fair to apply all the costs involved in housing an employee without accounting for the benefit the house provides? If there is no housing provided should costs be put in to reflect renting in from elsewhere or greater travel expenses?;
• assumptions on interest and ownership of machinery are also widely open for debate.;
• costs of running a business have the ability to be widely inflated or deflated depending on which party is arguing. ;
• although not as contentious, output and prices alone can be difficult to agree on with yield capability and carrying capacity in terms of livestock also open to debate. ;
• the ability to account for the tenant's own labour is also an area of contention.;
• this model becomes generally very personal and encourages conflict within the tenant farming sector generally.

6.4 Adjustments to be made for Tenants Improvements

6.4.1 As discussed previously, the primary method for dealing with tenants improvements is to black patch them wherever this is possible. There are difficulties in "black patching" tenants' improvements where in their absence there would be no viable farming system on which to determine productive capacity. An example would be an upland livestock unit on which the tenant has provided all the fencing including march fencing, the water and the internal road system. Without such items it becomes very difficult to adopt a viable farming system. There are therefore certain items which it must be assumed are present to determine the productive capacity but it is recommended that these are limited to land improvements such as fencing, water troughs, electricity supplies and access.

6.4.2 Due to the fact that these improvements are often situation specific, we do not propose implementing a stringent method by which to deal with them but instead have provided a number of ways by which they could be dealt with depending on the situation that presents itself. This should provide parties with a framework under which to form a reasonable basis for a deduction to account for non black patched improvements.

6.4.3 The methods account for these improvements through either an analysis of their likely impact on the rent a competent tenant would pay for the holding or the annual cost, of the improvement spread over its lifetime, deducted from the landlord's share of divisible surplus. Treatment of improvements may vary depending on whether they are considered to be permanent improvements such as installation of an electricity supply or depreciating improvements such as fencing.

6.4.4 A permanent improvement where, once undertaken, there is no further input from the tenant such as stone removal or reclamation of land from scrub to arable or where with regular maintenance the improvement could be considered to last in perpetuity such as drainage or dyke building does not depreciate and therefore if not black patched could be accounted for by crediting the tenant with an annual return on the capital expended. In practice it should be possible to black patch these improvements.

6.4.5 One of the improvements without which it would be virtually impossible to operate a viable farming system is the provision to the farm of an electricity supply. Most supplies were provided in the 1950s and in many cases the cost of this provision was met by the tenant. Once connected, the maintenance and replacement costs of this infrastructure are met by the electricity companies themselves. It can therefore be considered as a one-off improvement which lasts in perpetuity and the tenant could be credited with a return of 10% on the initial cost of the improvement NOT the current cost of the provision to account for this. This would equate to approximately £50 being deducted in most cases in perpetuity. It should be noted that in most cases a new lease will have been granted either compensating the previous tenant at waygoing or having written off the improvement under the old lease. Improvements done under previous leases (unless carried forward into a new lease) should be considered as the landlord's fixed equipment going forward.

6.4.6 With depreciating assets, which have not been black patched, it could be argued that the tenant would carry them out only if they envisaged a return on the capital expended and that capital to be repaid over the lifetime of the asset. Improvements would only be considered in this way if they are likely to form part of the landlord's fixed equipment obligation or are intrinsic to the definition of the farming system. The challenge with this assessment is that in some instances the land without the improvement would have very little rental value. For example, steep grassland without fencing would have little value but once fenced it can be grazed and thus has an enhanced rental value. In this analysis the potential value of the land is not considered if the improvement is black patched. Thus, in such circumstances, it would be more appropriate for the rent to be based on the value with the improvement in place and a relevant deduction made in order to disregard the improvement. A number of depreciation options have been considered as follows:

1) Depreciation and interest at historic cost;.

2) Depreciation and interest at current replacement cost;.

3) Depreciation and interest at current value to an incoming tenant.

6.4.7 The example tables show the effect of each option on a hypothetical 1000 metres of fencing depreciated over a 20-year period.

Table 7: Historic Cost / Depreciated

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Year 11	Year 12	Year 13	Year 14	Year 15	Year 16	Year 17	Year 18	Year 19	Year 20
Fence Cost /metre	4.50	4.60	4.70	4.80	4.90	5.00	5.10	5.20	5.30	5.40	5.50	5.60	5.70	5.80	5.90	6.00	6.10	6.20	6.30	6.40
Rent Review	Year 1			Year 4			Year 7			Year 10			Year 13			Year 16			Year 19		Total
Value	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500	£4,500
Depreciation	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£225	£4,500
Interest at 3%	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£135	£2,700
Deductable (Dep + Int)	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£360	£7,200
Deductable /Metre	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36	£0.36

6.4.8 As the capital is being repaid over time, then the outstanding amount will start at 100% and gradually reduce to 0% over the estimated lifespan of the fixed equipment. In line with the non-depreciating assets, long term interest rates appropriate to the deemed life of the investment should be used to determine the fair opportunity cost of not having the ability to invest capital elsewhere. In the case of the above fencing example we have used 3%. This means the cost of the improvement is fully paid off over its lifespan so accurate record keeping at rent reviews would be vital to ensure this approach was feasible.

6.4.9 The obvious advantage of this approach is that it attempts to put the tenant in the position he would have been in had the landlord made the initial investment through making an equal deduction to the rent over the estimated lifespan of the fixed equipment plus a sum for interest.

6.4.10 The disadvantage of this approach is that it is inconsistent with the 2003 Act which made write off agreements void. If at the end of the 20 years there is still value in the fence and this continues to be accounted for using this method then the tenant begins to make a profit from the investment. When assessing the rent, a tenant's improvements should be disregarded which means their presence should neither benefit or disadvantage either party. As such without the ability to write off an improvement at the end of its financial lifespan we believe this model has fundamental flaws.

Table 8: Current Cost

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Year 11	Year 12	Year 13	Year 14	Year 15	Year 16	Year 17	Year 18	Year 19	Year 20
Fence Cost /metre	4.50	4.60	4.70	4.80	4.90	5.00	5.10	5.20	5.30	5.40	5.50	5.60	5.70	5.80	5.90	6.00	6.10	6.20	6.30	6.40
Rent Review	Year 1			Year 4			Year 7			Year 10			Year 13			Year 16			Year 19		Total
Value	£4,500	£4,500	£4,500	£4,800	£4,800	£4,800	£5,100	£5,100	£5,100	£5,400	£5,400	£5,400	£5,700	£5,700	£5,700	£6,000	£6,000	£6,000	£6,300	£6,300
Depreciation	£225	£225	£225	£240	£240	£240	£255	£255	£255	£270	£270	£270	£285	£285	£285	£300	£300	£300	£315	£315	£5,355
Interest at 3%	£135	£135	£135	£144	£144	£144	£153	£153	£153	£162	£162	£162	£171	£171	£171	£180	£180	£180	£189	£189	£3,213
Deductable (Dep + Int)	£360	£360	£360	£384	£384	£384	£408	£408	£408	£432	£432	£432	£456	£456	£456	£480	£480	£480	£504	£504	£8,568
Deductable /Metre	£0.36	£0.36	£0.36	£0.38	£0.38	£0.38	£0.41	£0.41	£0.41	£0.43	£0.43	£0.43	£0.46	£0.46	£0.46	£0.48	£0.48	£0.48	£0.50	£0.50

6.4.11 The current cost approach considers the improvement based on current costs at each rent review and like the previous model compensates the tenant via a reduction of rent over the estimated lifespan of the improvement. Again depreciation and interest are based on a percentage of the cost but in this case because the cost is increasing so are these rates over the lifespan of the fixed equipment.

6.4.12 This method is practical in its application as current costs are always available and do not rely on a record of when the improvement was put in place as the previous model does.

6.4.13 The current cost approach, does however, provide an inflated return on the tenant's investment and is considered to disadvantage the landlord and benefit the tenant with the result likely to be a profit at the end of the estimated lifespan and then an additional profit if the improvement is still functional beyond the estimated lifespan.

Table 9: Value to Incoming Tenant

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Year 11	Year 12	Year 13	Year 14	Year 15	Year 16	Year 17	Year 18	Year 19	Year 20
Fence Cost /metre	4.50	4.60	4.70	4.80	4.90	5.00	5.10	5.20	5.30	5.40	5.50	5.60	5.70	5.80	5.90	6.00	6.10	6.20	6.30	6.40
Rent Review	Year 1			Year 4			Year 7			Year 10			Year 13			Year 16			Year 19		Total
Value	£4,500	£4,500	£4,500	£4,080	£4,080	£4,080	£3,570	£3,570	£3,570	£2,970	£2,970	£2,970	£2,280	£2,280	£2,280	£1,500	£1,500	£1,500	£1,500	£1,500
Depreciation	£225	£225	£225	£204	£204	£204	£179	£179	£179	£149	£149	£149	£114	£114	£114	£75	£75	£75	£75	£75	£2,985
Interest at 3%	£135	£135	£135	£115	£115	£115	£96	£96	£96	£80	£80	£80	£67	£67	£67	£57	£57	£57	£57	£57	£1,750
Deductable (Dep + Int)	£360	£360	£360	£319	£319	£319	£275	£275	£275	£229	£229	£229	£181	£181	£181	£132	£132	£132	£132	£132	£4,735
Deductable /Metre	£0.36	£0.36	£0.36	£0.31	£0.31	£0.31	£0.27	£0.27	£0.27	£0.22	£0.22	£0.22	£0.18	£0.18	£0.18	£0.13	£0.13	£0.13	£0.13	£0.13

6.4.14 The value to an incoming tenant approach considers the improvement based on the current cost depreciated to reflect its current value to an incoming tenant. This would involve a revaluation of the fixed equipment at each rent review and compensates the tenant for the improvement via a reduction in rent for so long as the improvement is functional and considered to provide value. Depreciation and interest are based on a percentage of the value. The principal of this approach is therefore to compensate the tenant for the value to the holding the improvement provides rather than attempt to fully repay the cost of it.

6.4.15 This approach has the obvious benefits of being practical as it is already used as a means of valuation at waygoing, so we know it can be applied by practitioners robustly. It is therefore more easily deductable than a pure cost analysis which has write off implications.

6.4.16 The difficulty with this approach is that it does not result in the tenant fully recovering the investment made in the improvement over the estimated lifespan. Although it values out the improvement unless the cost is completely recovered over the lifespan of the fixed equipment it is difficult to conclude that it has been fully disregarded as it would be if completely black patched. Although this appears to be the fairest approach as it can be consistently applied throughout the period that the fixed equipment provides value to the holding, we do appreciate that it may still have weaknesses in terms of reaching a fair rent.

6.4.17 The value to an incoming tenant approach does not allow the tenant to recover their costs (£4.12/metre) over the 20 year term modelled. However costs will be recovered at waygoing and the deduction will continue to be made beyond the anticipated lifespan of the improvement if the fence remains stockproof and serviceable. Obviously the deduction is based on the value to an incoming tenant at the time of assessment, so the poorer the quality, the less deduction relevant. For these reasons the value to an incoming tenant approach is probably the most fair means of accounting for non black patched improvements.

6.4.18 The difficulties in adopting a cost and deduction method for disregarding tenant's improvements (as outlined in depreciation tables 1 & 2) relate to the ability to under or over account for them. The following factors put the fairness of these approaches into question:

1. Proportion of improvement which has been grant funded. Although the 2016 Act points to grant funded improvements being undertaken by the tenant being disregarded, it would seem unfair to use a cost basis to deduct these from the rent if neither the landlord nor tenant has financially contributed to them.

2. Likelihood of a hypothetical tenant relying on borrowings in order to undertake the improvement and the relevance of this to the likely interest rate to be included in the deduction or whether it is relevant to include an interest rate at all. The inclusion of an interest rate could be seen to benefit the tenant for undertaking the improvement especially where it is not written off when the cost has been re-couped. On the other hand there is undoubtedly an opportunity cost which is relevant when disregarding the improvement.

3. Double counting: many of the improvements would be compensated at waygo at which point the tenant's investment will be recouped. Making an annual rental deduction reflects the tenant's investment and provides a return on it but also must reflect the fact that should the tenancy end, the remainder of the value of the improvement is available to the tenant through their waygo valuation. This valuation is on the basis of the value to an incoming tenant therefore a reduction in the rent using this methodology allows the procedures to remain consistent and avoid the opportunity for double counting.

4. There is often ambiguity over the fixed equipment provided at the commencement of the tenancy. Records of condition, detailing the landlord's fixed equipment, are seldom available. Therefore what is and what is not a tenant's improvement may be difficult to establish in many cases.

6.4.19 It can be concluded that tenants' improvements must be black patched wherever possible to avoid the complexities and inevitable subjectivity of discounting them from the rent. Where, in order to facilitate the hypothetical farming system, the improvement needs to be taken into account it must be deducted from the landlord's surplus.

6.4.20 We consider deducting non black patched improvements to be a complicated process with the creation of an exact methodology proving to be difficult in practice. Due to the diversity of tenant's improvements it is not sensible to provide a prescriptive methodology for the valuation of the improvement. It must reflect the value to an incoming tenant but also account for the land's potential or latent value. We consider this to be an aspect of the legislation which needs to rely on both parties being transparent, reasonable and fair to enable agreement on the rental value of the non-black patched improvement. This may be facilitated by guidance notes from the Tenant Farming Commissioner.

6.4.21 In terms of adjustments made for post-lease agreements or unusual lease conditions which place a higher level of obligation on the tenant, the following differences exist from how we have considered improvements:

1. Post lease agreements or unusual lease terms are case specific and all place differing obligations on the tenant so should be considered on a case by case basis. In some cases the obligations placed on the tenant will be the same as are contained in a standard 1991 Act tenancy and no adjustments will be relevant. It is common for post lease agreements to place landlord renewing obligations on the tenant and these do need to be considered on the basis of an increased cost obligation.

2. Where a renewal of landlord's fixed equipment is placed on the tenant, this fixed equipment should be considered when assessing the farm type and therefore adjustments cannot be made through black patching as would most commonly be the case when dealing with tenants improvements.

3. The value to an incoming tenant cost and deduction method would also not be appropriate because it is not the value to an incoming tenant which needs to be assessed, it is the cost of 'the increased obligation' to 'a tenant' which needs to be accounted for.

6.4.22 Therefore where a landlord's obligation to renew has been placed on the tenant via a post lease agreement or unusual lease terms, we believe this is best dealt with by deducting the annualised current cost of the renewal where it is evident that it has been undertaken. It would only be where the tenant has gone beyond the renewal obligations of a post lease agreement/lease terms by providing an element of betterment that it might be necessary to black patch the betterment element. An example might be erecting a modern steel portal framed building to replace a traditional U-shaped steading.

6.5 Consideration of other factors

6.5.1 The 2016 Act states that the Land Court should determine the fair rent 'taking account of all the circumstances' and having regard 'in particular' to productive capacity, surplus residential accommodation and land/buildings used for a purpose that is not an agricultural purpose. This leaves the Land Court with the capacity to consider other areas which they feel may be relevant to the 'fair rent'. From the work undertaken we consider that the following fall outwith the main three areas being considered and perhaps could be included separately in order to set the 'fair rent'.

1. Sitting tenant rents – there would generally be an acceptance that when considering 'fairness' it would be reasonable to conclude that similar holdings should have similar rents. A sense check using existing farm rents would seem to be a reasonable consideration.

2. Residential accommodation – the productive capacity model as it sits does not account for residential accommodation 'on farm'. It is based around business systems and output generated rather than the advantages available if accommodation is located on the farm. This would result in a farm with accommodation for the farmer and his staff being rented at the same level as a farm which does not provide such accommodation. An obviously unfair outcome.

6.5.2 In terms of the use of sitting tenant rents agreed or set in the previous three years, we believe this would be a useful sense check and should be defined as such in further regulations as a relevant factor within 'all circumstances'.

6.5.3 With residential accommodation which is not considered to be surplus to the requirements of the holding, the ability to account for this is unclear and possibly needs further research depending on the method used for calculating productive capacity.

6.5.4 In England this is accounted for through dealing with all the costs involved in the non surplus residential accommodation within the budget (council tax, property repairs, etc) then separately an amount is added per annum to reflect the benefit the residential accommodation provides. Figures used are a fraction of residential letting rents and have been derived from successful agreement rather than having any standard methodology to them. Evidence provided by the CAAV showed broadly that farmhouses achieve rents of £3-4,000 with variations reflecting condition and cottages typically achieve £1,250-1,500.

6.5.5 It is unclear whether the issue of non surplus residential accommodation can be dealt with within the productive capacity calculation or not. One means of dealing with it could be to consider the increased cost involved in being based 'off farm' to being based 'on farm' for example higher fuel costs and potentially higher wages if a house is not supplied as part of the employment contract. This could be dealt with through varying the expected gross profit percentage within the gross output model i.e. a fully equipped unit would perhaps be expected to make 30% of Gross Profit while a unit with higher costs would make less. Again more research into a realistic range of percentages would be required to ensure fairness to both parties. Fairness should ensure that residential accommodation which is not surplus to the requirements of the holding is accounted for.

6.6 Worked Examples

6.6.1 The below table summarises the results of the ten sample farms using the gross output model and the farm budget model. Appendix 4 gives a further breakdown of the ten sample farms and shows the results of models 1 and 2. These models were considered to be unworkable in practice due to a reliance on out of date datasets, the potential for huge variance in results and a general lack of flexibility to allow for changing market conditions.

Table 10: Worked Examples of Model 3 & Model 6

FARM	SYSTEM	COMPARABLES (£/ac)	MODEL 3: GROSS OUTPUT 2013 to 2015 30% £Range (Avg. Rent)	MODEL 3: GROSS OUTPUT 2015-2017 Type £Range (Avg. Rent)	MODEL 6: FARM BUDGET (£/ac)	DEDUCTIONS FOR IMPROVEMENTS (not been made to figures in model 3 & 6)
A	General Cropping with Potatoes	32 - 67	£176k - £194k (Avg £99/ac)	£174k - £194k (Avg £92/ac)	33	10 acres of reduced production reflecting 50/50 share of drainage improvement over 20 acres
B	Upland Cattle + Sheep	43 - 59	£161k - £191k (Avg £59/ac)	£145k - £191k (Avg £54/ac)	53	Water pipe and troughs - £659 Fencing (6km) - £1,440
C	Cereal Non- LFA	80 - 120	£365-£400k (Avg £74/ac)	£365K - £415k (Avg £76/ac)	18
D	Lowland Cattle and Sheep	42 - 71	£35k - £42k (Avg £65/ac)	£33k - £42k (Avg £60/ac)	49
E	Lowland Cattle	35 - 59	£58k - £64k (Avg £66/ac)	£49k - £57k (Avg £56/ac)	39	60 acres of drainage assessed as: 30 acres improved grass and 30 acres of rough grazings. Fencing (3km) - £600 Water - £443 Electricity - £50
F	Mixed, non- LFA, Beef Finishing	77 - 121	£535k - £630k (Avg £81/ac)	£491k - £579k (Avg £75/ac)	50	Fencing (10 km) - £2,400
G	Lowland Cattle & Sheep LFA	38 - 77	£40k - £47k (Avg £48/ac)	£33k - £42k (Avg £39/ac)	47	Fencing (2.5km) - £600
H	Lowland Sheep, Non- LFA	39 - 52	£14k - £19k (Avg £42/ac)	£14k - £19k (Avg £40/ac)	31	See comment V below
I	Dairy	39 - 73	£185k - £244k (Avg £114/ac)	£185k - £245k (Avg £110/ac)	71	Water troughs - £63
J	Hill Sheep	4 - 25	£98k - £120k (Avg £5.2/ac or £13/ewe)	£88k - £117k (Avg £5/ac or £11/ewe)	3	Adjusted stocking density to reflect bracken spraying, liming and hill reseeding

Notes:

I. Gross output uses 3 historic years.

II. Gross output 2015 FAS, 2016 SAC handbook and 2017 represents current yields and prices.

III. Farm budget is made up from current prices, SAC variable cost figures (2016/2017) and fixed costs derived from the Scottish Government Farm Account Survey 2016 ( Appendix 5).

IV. Fencing, water and electricity deduction, based on the value to incoming tenant model.

V. The rent in Farm H was influenced significantly by high machinery fixed costs, relative to the holding, its size and its hypothetical machinery register. As a result this was amended from Scottish Government FAS survey figures.

6.7 Common Issues arising from the samples

6.7.1 Issues with Gross Output Model

6.7.1.1 The Gross Output system has the advantage of simplifying the calculation of productive capacity by focusing on the output of the farm. Within the Statement of Facts (as discussed in the previous chapter) a rationale for the farming system, yields, prices and livestock productivity will be explicit with the combination of all of these factors determining the gross output. In order to normalise agricultural markets a 3 year average for each enterprise would be used. We believe that the average should comprise the previous year, the current year and an estimate of what the next year may bring. The main issue with this model is that it simplifies the assessment of costs and may potentially disadvantage one farm type over another. For this reason further research into a fair range for expected profit percentages should be undertaken to validate the use of this model. Research should involve approaching a range of banks to produce ranges from the farm accounts they keep so that these can be analysed to identify averages, ensuring at all times that the research is based on a competent farmer.

6.7.1.2 The challenge of assessing fixed and variable costs would be avoided by the use of well established banking principles which consider a competent farm business would generate a profit before rent, interest and drawings of 30%. Therefore 30% of the gross output could be split 50:50 before deductions are made for land based tenant's improvements which have not been black patched.

6.7.2 Issues with the Budget Model

6.7.2.1 The budget model's main issue relates to the amount of variables it contains which could be argued over. For example, even published data produces information with huge variation. The below table outlines the differences between the labour hours per enterprise per HA per annum published in the SAC Handbook and the John Nix handbook:

Table 11: Standard Labour Hour Data Comparison

Enterprise	SAC (hrs)	John Nix (hrs)
Cereals	18	9.2
Grassland	3.1	3.2
Rough Grazing	1.5	1.6
Beef cows (lowground)	26	10.8
Beef Cows (upland)	26	13.44
Other cattle	12	12
Sheep lowground (Ewes)	5.2	4
Sheep upland (Ewes)	3.7	3.6
Sheep (upland)	3.1	4
Sheep (hill)	3.1	3.2
Dairy Cows	35	32

6.7.2.2 The table below shows how the above data variations effect the rents for the 10 sample farms:

Table 12: Standard Labour Hour Data Comparison Per Farm

	SAC SLR	JN SLR			Labour (inc.T)
Farm	inc. T	inc. T	SAC Rent	JN Rent	Modelled	Rent
A	1.11	0.57	33	36	1.11	33
B	2.89	2.26	22	36	1.5	53
C	2.91	1.49	9	24	2	18
D	0.63	0.5	49	49	0.63	49
E	1.16	0.76	39	48	1.16	39
F	4.76	3.69	37	45	3	50
G	0.68	0.53	47	47	0.68	47
H	0.34	0.29	65	65	0.34	65
I	2.11	1.96	71	75	2	74
J	4.06	3.37	1	3	1	6

6.7.2.3 It is difficult to promote a model which can vary so much based on published data variances - never mind variances which will also take account of varying price and cost data from varying years with varying assumptions based on varying preferences.

6.7.2.4 It can be assumed that through the use of a 'statement of facts' agreements can be made on the productive capacity of the holding i.e. what yields would be expected, what carrying capacity would be expected and what the fixed equipment provided by the landlord could be used for. Such aspects can then easily be converted into gross output using pricing evidence. However costs are not as easy to agree on and can be easily inflated or missed depending on a party's motives. Aspects of fixed costs such as labour, machinery and interest can also be personal to the business and although it can be argued that we are considering the 'hypothetical tenant' it is fair to say that implying a hypothetical tenant could do something more cost effectively would be controversial. As far as costs are concerned it is therefore very difficult to avoid these becoming personal.

6.7.2.5 The potential for significant variations within the huge variety of cost and price information used means that the rental figure can also vary significantly. With such potential variance we would suggest that this model could only work if a relevant sense check or checks were put in place. For example it could be that the creation of a budget was the primary means of calculating the rent with two sense checks in the shape of the output model and the comparable sitting tenant model to ensure the rent set is fair.

6.7.2.6 The down side to recommending that a full budget, a gross output assessment and a comparable evidence assessment is done would be the likely time and cost of this. It is unlikely that landlords and tenants would choose to undertake such work themselves which would mean that professional advice would be sought and such an onerous assessment would end up expensive.

6.7.2.7 Another alternative we considered was that agreed figures be produced annually for rent review budgeting purposes to provide variable and fixed cost guidelines for the main enterprises and farm types. However given the difficulties the above models have shown when dealing with standard data we believe such a data source would become out of date too quickly and therefore become inaccurate and inappropriate in practice. For this reason we do not recommend a standard dataset produced for rent reviews is taken forward.

6.7.3 Issues with accounting for non black patched improvements

6.7.3.1 From working through the sample farms, the main tenant improvements which were difficult to black patch when considering the productive capacity were land improvements such as fencing, water supplies and access. The main difficulty found with such improvements involves the lack of a record of condition and the uncertainty of splitting the improvements between the landlord and tenant. For example in terms of fencing there are often occasions where there has been shared investment in the fencing or the tenant claims to own all the fencing but is unsure what level of fencing was supplied at the outset of the lease.

6.7.3.2 In terms of drainage, further difficulties were experienced where a tenant had re-drained an entire area but since the work had been done the landlord had supplied the materials for the renewal of sections as and when required. It is also common practice generally for the tenant to pay for the labour and the landlord to provide materials for drainage repairs and renewal works.

6.7.3.3 For water supplies, most tenancies would not have supplied water troughs at the outset, instead water would have been deemed to be available via waterings. Changes in SEPA regulations have meant many tenants have fenced off waterings and provided water troughs, often via grant funding. It is difficult to account for such improvements where the landlord has supplied the holding in the order it should be supplied and is under no obligation to update this standard due to changing regulations.

6.7.3.4 As previously discussed the question of potential or latent value needs to be addressed and valued. From the sample farms, fencing and drainage were the most obvious examples. On one of the livestock stock farms the tenant identified most of the fencing to be his own. If this were valued on the basis of value to an incoming tenant and an annual sum deducted from the rent to reflect the tenant's capital tied up in the fencing then this could be annualised as follows: assuming 6 km of fencing was split equally between 4 valuation categories of £1.5, £2.5, £3.5 and £4.5/metre. At the rent review, the value of the fencing would be £18,000, taking account of interest on tenant's capital at 3% (£540) and depreciating the fence over 20 years (£900) the total deduction to the landlord's share of the divisible surplus would be £1,440.

6.7.3.5 A further example relates to a farm on which the tenant had drained approximately one third of it. The landlord had contributed by providing the materials and the tenant provided / paid for the labour. Thus the tenant's capital had resulted in the farm being broadly classified as ploughable grass which before the improvements would have had significant areas of less productive permanent pasture and rushes. The farm was approximately 150 acres of which 60 acres had been improved. Following our recommendation on the treatment of drainage, we would classify 30 acres of grass as ploughable and the other 30 as permanent pasture with rushes. This classification therefore accounts for the joint improvement of the land.

6.7.3.6 The concept of dealing with such improvements via the amount a tenant would pay more in terms of rent for their inclusion has been agreed by the Team. How this is accounted for in terms of value will need to be decided on by both parties in order to use the method which best represents the situation. In order to avoid future dispute and uncertainty it is considered relevant for parties to use the tenant's amnesty to document all tenants' improvements so that they can be identified easily at rent review with their relevance to the holding agreed by both parties. Such a process would simplify all future rent negotiations and minimise the opportunity for conflict.

6.8 Recommendations

• Clarity is required to ensure that the productive capacity can be calculated using the Gross Output model proposed. Further research into what percentage of Gross Output would reflect the expected Gross Profit of a competent farmer, how this may vary and what factors would allow it to be varied is required.;
• a black patch approach to tenant's improvements should be adhered to except where the improvement is required to be considered in order to derive a sensible farming system for the holding. ;
• non black patched improvements should be accounted for and deducted in terms of the additional rent a tenant would pay for them. This may be done using a relevant cost and deduction method agreed to be reasonable by both parties.;
• where an improvement is undertaken using grant aid, the amount that represents the landlord's contribution should be taken into account in the rental assessment. The amount which represents the tenant's contribution should be disregarded from the rental assessment. This approach would be considered as fair to both parties but different to what has been done in the past and what is outlined in the Rent Review Tender document.;
• as standard it is recommended that the divisible surplus is split 50/50 before deductions for improvements and additions for surplus residential accommodation and non-agricultural use. Adjustments to the 50/50 split will only be justified where the result of this is considered to be 'unfair'.;
• the inclusion of adequate residential accommodation for the holding can either be accounted for by varying the gross profit percentage used in the gross output model or by considering this in terms of 'all of the circumstances' outwith the three statutory considerations of the Act. Further research is required to ensure a fair means of accounting for non surplus residential accommodation.;
• use of comparable sitting tenant rents agreed or set in the previous three years should be allowed as a reasonable sense check for productive capacity. ;
• guidance should encourage parties to complete a 'Statement of Facts' and record all tenant's improvements and tenant's fixtures within the timeframe of the Tenant's amnesty.