Use of Land Lease Rights as a Collateral for Bank Loans: Current State and Prospects

August 1, 2016

Pavlo Kulynych, Denys Nizalov and Oleg Nivievskyi

Executive Summary

1. The current land legislation of Ukraine has virtually no legal provisions for turnover of the lease rights for agricultural land. However, the possibility to use lease rights as a collateral depends directly on the possibility for turnover of these rights. Therefore, since the legislation does not provide tenants of agricultural land with the right to alienate the land lease rights on the basis of civil agreements – purchase/sale, exchange, gift, etc., the tenants have no right to use the lease right for agricultural land as a collateral to obtain loans from banks.
2. Currently, the turnover of the lease right for agricultural land takes place in shadow – via alienation of corporate rights of farming companies as tenants or via changing the party (tenant) in the rental agreement, which makes the market for rental rights non-transparent and not attractive for the banking sector.
3. From the economic point of view, the moratorium for land sale leads to a lower rate of land rent payments and redistributes economic return from use of agricultural land in favor of land tenants. Such state of land governance contributes to a highvalue of land lease rights. When the moratorium is lifted, it is expected that the rate of rent payments will increase and the value of land lease rights will decrease. Therefore, the value of the collateral will disappear.
4. Ukrainian banks are skeptical about the possibility of providing loans to agricultural enterprises secured by the right to lease agricultural land due to the low liquidity and no practice for valuation of such right. The National Bank of Ukraine (Resolution #351, 30 June 2016) does not consider the right to lease land as an acceptable collateral for repayment of loans issued by banks and does not determine a liquidity coefficient for the lease right.
5. So, in the short-term, the lease right will not be used as a collateral for bank loans. It is unlikely that banks will use the lease rights as a collateral in the longer-term either
   because the land lease rights depreciate proportionally to the decrease in the remaining duration of the rental period, and because after the lifting of moratorium the value of rental rights will likely to disappear. Therefore, the use of land lease right as collateral has no prospects.

The state of legal regulation for turnover of lease rights for agricultural land and use of such rights as a collateral in Ukraine

In Ukraine, dominant is the practice of using agricultural land, owned by villagers after land sharing, via leasing land parcels to agricultural producers on the basis of land rental agreements. The lease right for land is, first of all, a legal institution designed to unite and concord the interests of the land owner and the user of a certain land parcel, which are stated in the land rental agreement as contractual obligations of two parties – the land owner and the tenant. Secondly, the lease right for land has an additional legal characteristic – turnover capability, which means that one person (the lessee) may transfer the land lease right to another person. Lease right for land can serve as a collateral for obtaining bank loans only on condition of having turnover capability. However, the current land legislation actually makes it impossible to alienate lease rights for agricultural land. Even though Part 5 of Article 93 in the Land Code of Ukraine states that lease rights for a land parcel may be alienated, as well as sold via land auctions, used as a collateral, transferred by inheritance, or contributed to the authorized capital by the land parcel owner – for the period of up to 50 years, except the cases stipulated by law, in fact, the above-mentioned Article means a different type of right – the right to lease land.

“Land lease right” and “right to lease land”. The content of the land lease right is defined in Part 1, Article 93 of the Land Code of Ukraine. In accordance with Article 93 of the Code, the right to lease a land parcel is the agreement-based term-bound and paid ownership and use of a land parcel, needed by the tenant for conducting business and other activities. Thus, this norm leads to the definite conclusion that the land lease right arises on the basis of an agreement, i.e., only after the landlord and the tenant sign such an agreement with all the essential conditions included and the State Registrar of Rights  registers the land lease right in the State Registry of Rights.

However, Part 5 of the same Article provides a fundamentally different norm. It declares that only the land owner, i.e. the landlord, not a tenant, may alienate the land lease right. However, if the owner of the land parcel is its landlord, it means that the other person – the tenant – has acquired the land lease right. If so, the owner may not alienate the land lease right which does not belong to him/her, but to another person – the lessee.

So, Chapter 5, Article 93 of the Land Code of Ukraine is not about the existing land lease right, but about the right to lease land which (the right) will arise in the future; that is, the right to lease land.

The question arises: what does the land owner alienate when he or she alienates the right to lease land? According to Article 78 of the Land Code of Ukraine, the ownership right for land is a set of rights to possess, use and dispose of land parcels. That is why the land owner has the rights (authorities) regarding possession, use and disposal of the land parcel. Before leasing it out, the land owner can put on sale or alienate in a different way two of his/her three authorities, namely regarding possession of and use of the land parcel. Accordingly, the person who buys such authorities obtains the right to rent a land parcel with subsequent registration of the rental agreement and state registration of the lease right for the land parcel.

Thus, putting on sale (or another alienation) one’s authorities for possession and use of the land parcel, the owner alienates not the land lease right, but the right to lease the land, i.e., the future right to lease the land parcel.

And what opportunities to alienate the lease right for private land or its use as a collateral does the current land legislation of Ukraine provide? An analysis of the Law “On the Lease of Land” gives grounds to conclude that such opportunities are very limited. On the one hand, it regulates the alienation of both the land lease right and the right to lease the land. However, under this Law, the possibility to alienate land lease rights is very limited, and the alienation of the right to lease agricultural land is not allowed by the land legislation of Ukraine at all (For more detail see: “The Turnover of the Right to Lease Agricultural Land in Ukraine: Current Practices and the Ways to Improve It”, published on the project web-site on August 1, 2016. Access via: http://www.kse.org.ua/uk/research-policy/land/analytical/? newsid = 1713).

It should be noted that the possibility to use the land lease right as a collateral is stipulated not only by the land legislation, but also by special law on mortgage. According to Article 5 of the Law of Ukraine “On Mortgage”, the subject of the mortgage may be the rental right or the right to use real estate, which entitles the tenant or the user with the right to build, own and alienate an object of immovable property. Since it is permitted to develop buildings and constructions for industrial purposes (in particular, facilities for agricultural production infrastructure, including wholesale markets for agricultural products) on agricultural lands, in some cases the rental right for agricultural land can be used as a collateral to obtain bank loans.

Thus, it can be stated that current land legislation of Ukraine allows no alienation of agricultural land parcels on the basis of most civil agreements (purchase-sale, gift, exchange, etc) and no use as a collateral either. Therefore, the use of lease rights for agricultural land parcels as a collateral to obtain bank loans is impossible.

The practices of using shadow ways to alienate lease rights for agricultural land cannot be extended onto using lease rights for such lands as a collateral to obtain bank loans.

The valuation of the lease rights for agricultural land as objects of market turnover and collateral

The value of the lease right is factually determined as a margin between the profit that such right yields to the tenant and the costs of maintaining such right. The first component of the value of such lease right is the land rent payment received by the tenant for using a land parcel or field. The second component is the rental payment paid by the tenant to the landlord according to the rental agreement.

To illustrate the estimations of potential value of lease rights for agricultural land, the data from the article “The Economic Return of Agricultural Lands and its Distribution” can be used (http://voxukraine.org/2016/04/13/economic-return-to-farmland-in-ukraine-and-its-incidence-ua/). The authors show that the economic returns from the land (as a resource), or land rent payment, was estimated as USD 455.00 per ha in 2014. Certainly, that is an average indicator, and it could be higher or lower in certain regions of Ukraine. On the other hand, the rental payment was only USD 37.00 per ha on average. In other words, the value of the lease right in 2014 would have been about USD 418.00 per ha. Such valuation is very close to non-official data being operated when doing the valuation of the lease right for agricultural land – about USD 400-500 per ha.

Furthermore, economic theory proves that the value of lease rights for agricultural land as a margin between land rent and factual rental payment appears as a result of drawbacks in land market functioning (for example, caused by a monopoly or excessive regulation of land market) and other land-related markets, for instance, banking area. On competitive markets, the maximum possible returns of land should be equal to the maximum land-related expenses. That is, under such conditions, the lease value has to come close to the land rent.

Yet, as it was already stated in many articles^[1], the imperfections of the land lease market in Ukraine (minimum rental payments, 7-year minimum rental period, local monopolist position of tenants, etc.) and of the purchase/sale of agricultural lands (primarily, the moratorium on alienating agricultural land parcels) allow for keeping the rental costs of agricultural lands at a rather low level. It is obvious, though, that after the market of purchase/sale of agricultural land is open and the regulatory pressure is lowered for both lease and purchase/sale of land, the lease prices will be rising and approximating the level of land rent. That, in turn, will be reducing the value of land lease rights and, accordingly, the value of such right as a collateral object.

Therefore, considering the economic realities of agricultural land use on the market and the functioning features of Ukrainian market, it can be stated that:

1)
since in Ukraine there is quite a big margin between the amount of land rent, caused by the existing distortions of the land market, the value of such right can be high. In other words, the moratorium on alienation of agricultural lands creates economic preconditions for considering the land lease right as a valuable and liquid resource and contributes to its attraction for market;

2)
lifting the moratorium on alienation of agricultural lands will promote redistribution of land rent in favor of land owners (landlords) and thus cause an increase of rental payments with simultaneous reduction of cost (value) of the lease rights for such lands. It is quite obvious that when the moratorium is lifted, the market attractiveness of lease rights for agricultural lands will decrease substantially. This is what explains the fact that in countries with free or liberally regulated market of agricultural land the lease rights are seldom used as an object of market transactions or as a collateral to obtain bank loans.

What are the prospects for the legislation on agricultural land turnover and collateral to improve?

As it is known, nearly 27 million hectares out of 41 million hectares of agricultural land were divided into small plots measuring an average of 3.6 hectares and transferred into farmers’ ownership by sharing. The size of the land share ranges from 1.5 to 15 hectares. That is why in Ukraine each field with privately owned land consists of a large number of small land parcels (shares) which are leased by villagers and other owners to agricultural producers of various legal types: from farmers to agricultural holdings. It is the fragmentation of agricultural land funds of the country that significantly complicates the turnover capability of the lease rights for agricultural lands. And the latter creates risks for using land lease rights as a collateral to obtain bank loans.

The attitudes of the banking sector of Ukraine to the possibility of granting loans secured by lease rights for agricultural land

When identifying the attitudes of banks to their possibility to give loans secured by lease rights for agricultural lands, the positions of the following banks were analyzed: Raiffeisen Bank Aval, Credit Agricole, Credit Dnipro, Alfa Bank, and JSC Piraeus Bank ICB. In general, their positions were identical and can be summarized as follows:

Firstly, banks will not provide loans secured by the lease right if the latter is non-liquid. The non-liquid nature of available lease rights for agricultural land is evident to banks.

Secondly, the businesses on the leased land, not the pure right to use such land as a collateral, should be the source of repayment of bank loans.

Thirdly, even if amendments to legislation that would enable the turnover of land lease rights are made, the use of existing lease rights for fragmented land parcels (land shares) will increase transaction costs for registering and realizing (if necessary) a collateral. However, under the current conditions of banking activities in Ukraine, banks will not endure the increased transaction costs.

Fourth, if the government prolongs the moratorium on sale of agricultural land for a long period, banks would try to use the lease right for state agricultural land as a collateral for loans because such lands can be leased as whole fields (arrays).

In addition, there is the official position of the National Bank of Ukraine (NBU) regarding the use of lease rights as a collateral for bank lending stated in the resolution of the NBU’s Board and in its response to the inquiry from the project “Capacity Development for Evidence-Based Land and Agricultural Policy Making”. According to Resolution #351, adopted by the Board of the National Bank of Ukraine on June 30, 2016, “On Approval of the Provisions for Estimating Credit Risk Value for Active Banking Operations”, using lease rights for land as a collateral in banks to secure repayment of loans is unacceptable due to high credit risks. In fact, the NBU imposed a ban on using land lease rights as a collateral by banks. A similar response is given in Letter № 22-0003 / 60394, dated July 20, 2016, from the National Bank of Ukraine.

Thus, it can be said that Ukrainian banking sector has negative attitudes towards a possibility of using lease rights for agricultural land parcels as a collateral to secure repayment of
bank loans.

So, in the short-term, the lease right will not be used as a collateral for bank loans. It is unlikely that banks will use the lease rights as a collateral in the longer-term either because the land lease rights depreciate proportionally to the decrease in the remaining duration of the rental period, and because after the lifting of moratorium the value of rental rights will likely to disappear. Therefore, the use of land lease right as collateral has no prospects.