With the recent run-up in row-crop farmland prices, savvy investors should be looking to similar investments that offer many of the same benefits of crop land ownership, without the hefty price tag. Timberland is just such an asset. In fact, timber is a crop. It just has a much longer production cycle. And here’s a secret…when you look at the asset classes held by the ultra-wealthy, almost without fail, you will see a heavy timberland flavor. Institutional investors, and high net worth individuals have already begun to take advantage of this opportunity. If you have not recognized this opportunity until now, it’s time to educate yourself on the benefits of timberland ownership.

Now I’ve mentioned the wealthy a couple of times here, but that does not mean you need 10 million dollars socked away to buy into a timberland asset. Those wealthy individuals had to start somewhere, and for the most part, they did not start out with millions to invest either. They started by making smart investments in assets that appreciated in value, or brought them income in some manner. Timberland will do both. It will work for the guy that can buy 40 acres, just like it will work for the investment group that owns 400 thousand acres. YOU have to start somewhere. As investors begin to substitute away from the higher priced good (Crop Land), the substitute good (Timberland) will appreciate in value. There’s no magic formula or fuzzy math here, it’s straightforward, basic level economics. When the value of a good goes up, so does the value of substitute goods. Timberland is a good substitute for crop land.

Why Timberland and Why Now?

Real Estate is a tale of two markets right now. Everyone knows that the larger real estate market, like our total economy, is not doing well. However, farmland seems to be breaking new record highs on an almost daily basis. Many factors contribute to that. Some of it is scarcity, some of it is commodity prices, some of it is advancement in the productive capacity of good farmland, some of it is capital from non-farm sources flowing into the ag land economy, and some of it is pure speculation.

Let’s focus on the last two, as these are the factors that are driving prices the most in the current market. Speculation. There’s a bad word, isn’t it? I beg to differ. Speculation brings liquidity to markets the world over. Unless you can predict the future 100% correct all the time, every decision you make is a speculative one. Without this speculation many of our markets would swing more wildly than they already do. Speculation will help put a bottom sagging markets. Speculation in the commodities markets helps farmers plan their crops, and protect their investments. Speculation has a purpose in a free-market economy. Speculation can propagate itself to unsustainable levels, as we have witnessed in so many “bubbles” in the last decade. Speculation that is based on provable numbers, and time-tested data is a better bet than speculation in a market because everyone else is doing it. The cropland market has a fair amount of speculative value built into it right now. Yesterday is when you should have invested it cropland. If you are going to profit from the appreciation in an asset based on the forward momentum of speculation, the time to do that is before it’s all the rage. Timberland is positioned well to take advantage of this right now. As the cropland numbers push higher, more people will see the value in substituting timberland for cropland. More people will grow uneasy with the run-up in cropland values and substitute away from it. Get into timberland now, and benefit from this economic law.

There’s also much more capital in the agricultural economy today than is traditionally present. People that would not know which end of a cow to feed, or that peanuts grow in the ground now are owners of farmland. Many of these people have invested in the land factor of production because they are substituting away from investments in the stock market that they have deemed more risky. They simply hold the property for the rental income, appreciation, and hedging ability of the asset. They rely on a traditional farmer to actually produce from the land. Until recently, this was a very uneasy partnership between the big money, city-slicker and the farmer. With the maturation of our ag markets, and the sheer volume of capital available from urban investors, they have grown to appreciate each other a bit more than in the past. Many of these same dynamics are at play in the timberland market. More investors are realizing the income, appreciation, and hedging properties of the timberland investment. This market will soon develop in much the same fashion as the cropland market has in the past couple of years. Plus timberland can be more easily managed by someone who has not been a farmer all of their life, or even someone who lives in a downtown loft apartment. It’s a bit more forgiving to the newbie than is cropland and you have the opportunity to time your harvest to highs in the wood fiber markets instead of taking the going price at the end of the growing season. This puts the investor in the position of profiting from the production aspect of timberland…not just sitting back and collecting rents from someone else trying to work out a profit using the land too.

Why is Timberland a Good Investment Substitute for Cropland?

Timberland has all of the qualities that today’s investors are paying premiums to obtain in the cropland market (income, appreciation, hedging). Timberland has a lower capital requirement per unit of production than cropland. Timberland has not experienced the recent run-up in prices that cropland has. Timberland can be more easily managed, in a hands-on manner, by the novice than can cropland. You can do all of this with timberland and still obtain rents on the timberland from outdoorsmen who wish to hunt on the property…while you are growing your timber crop. The numbers you need to make speculative investment decisions are available, proven, and time-tested. No fuzzy math. Just good solid investment sense. Get yours before it’s all the rage. Then profit from a timberland investment once everybody’s doing it. Get ahead of the curve instead of behind it. Buy Low. Sell High.

How might wood bioefuel projects affect wood demand and timber markets for timberland investors in the United States? After all, wood biofuel projects attract strong private and public investment, and advance federal energy policy objectives such as the Renewable Fuel Standard which requires that 8% of all fuel used in the US come from renewable sources in 2011. Forisk and the Schiamberg Group recently completed a study that details the 36 projects in the United States that convert wood to fuels.

What is the context for the wood biofuels market? In 2010, foreign and domestic producers supplied nearly 7 billion barrels of petroleum products, including 3.3 billion barrels of motor gasoline, to US markets. The barrels of motor gasoline translate into 379 million gallons of gas used per day in the United States. Fuel ethanol, an alcohol fuel made from corn and other renewable sources of biomass, represented another 36 million gallons per day (9.5%) to US markets. Fuel ethanol accounts for a small but growing source of “renewable” transport fuel for US consumers.

In evaluating the 36 projects in the United States, we identified 12 technologies in use and under development for the conversion of wood to transportation fuels including ethanol, butanol, diesel, gasoline, and jet fuel. For each technology, we evaluated and ranked the level of technical risk, estimated a commercialization timeline, and estimated the expected yields at commercial scale. Our results indicate that major technical hurdles need to be solved and will delay or disrupt commercialization for most of the technologies under development across the 36 projects.

What are implications for timber markets and timberland investors? The overall, potential impacts from this sector appear modest, though specific local markets could benefit within the next ten years. On a national scale, demonstration and commercial projects could use up to 8.8 million dry tons of wood per year by 2030. According to project announcements, this total wood demand would occur by 2018. A commercialization scenario projects 8.8 million dry tons of wood per year 11 years later in 2029. In other words, we estimate an 11 year lag between when the projects expect to operate and when our technology analysis indicates the technology could overcome hurdles and be viable at commercial scale.

The study models and graphs data for all US regions: the US South dominates the potential incremental wood use from the transportation fuel projects evaluated. At the most basic unit of analysis, the local wood basket circling each liquid fuel project, the population of timberland owners and investors with significant exposure to potential increases in raw material demand from announced projects would include those with timberland investments in markets that include lower risk, higher potential projects. These markets include Alabama; California; Michigan; Mississippi; and Tennessee.

Projects producing drop-in fuels have superior potential for investors. However, wood-based biofuels will fail to contribute substantively to EPA’s Renewable Fuel Standard targets in 2011 or 2022, as firms continue to struggle with applying technologies at commercial scale with competitive yields.

About the study
For more information about the study, Transportation Fuels from Wood: Investment and Market Implications of Current Projects and Technologies, visit www.foriskstore.com and click “Bioenergy.”

If you have ever been involved in the marketing of timberland with mature timber on the property, you have probably faced the dilemma of deciding if you would be better off to cut the timber and then sell, or sell with the value of the timber built in. The solution to this dilemma will vary by property, location, species of timber, timing, goals, your tax situation, and many other variables. For example, in a market that shows strong recreational value in timberland properties, you are usually better off selling the property with the trees still standing up. However, this is not always true. It might be that the stand is so thick that one cannot easily navigate through it, and the recreational component of the property would benefit from a thinning. Lots of variables and several options could leave your head spinning and ultimately lead to inaction or a bad decision. It’s fair to say that this is a problem where two heads are better than one. Maybe three or four. I would suggest you and your agent work together on this decision. If the tract is large enough to warrant the expense, the services of a consulting forester will be extremely helpful in this process. You may also need the help of your accountant to help you sort out the tax consequences of your decisions.

Below, I will discuss some of the things you need to know in order to make the best choice financially, and then show you a mathematical approach to this decision.

1. What are your options for timber harvest? Treatments available might include: Clear-cut, thinning, partial-cut, or no-cut.
2. What is your financial timing? Timber harvest can bring in quick cash, but will probably delay final liquidation of the asset. Not cutting the property allows you immediate access to the real estate market, but sure does not guarantee a sale within a given time period.
3. What is the value of the timber that you will realize if you clear-cut, partial-cut or thin the timber? How much you thin the stand can have a big effect on this number. Any fees you will have to pay as a result of your decision to harvest the timber should be subtracted from your projected gross sales before application of the formula below.
4. If you cut any timber, how much will it cost you to make the property marketable again? Road repair, disposing of forest waste (limb piles), replanting, burning…etc. Many times the timber contract you negotiate can make the timber buyer responsible for these costs.
5. What is the tax liability incurred from the sale of the timber? This publication from Purdue Extension might be helpful in helping you calculate your taxable income from the sale.
6. What is your projected market value of the property after the elected treatment? What is your projected value of the property with no treatment (no-cut)? This is where an experienced agent will be helpful to you.
7. What is your projected tax liabilities for the sale of the property with and without the treatments? You might find this link on the IRS website helpful in determining this.

If you have decided that your financial timing could include timber harvest, below is a formula to help you break it down to a mathematical decision. You might need to run this calculation for any acceptable cutting treatment and then compare the results.

Projected Value of the property if you do not cut it
—
Projected taxes resulting from the sale of the asset at the projected value for not cutting
(If you are experiencing a loss on your investment at the projected market value, plug in the projected tax write-off here as a negative number)
—
Projected Value of the property after the elected treatment
+
Projected taxes resulting from the sale of the asset at the projected value after the elected treatment
(If you are experiencing a loss on your investment at the projected market value, plug in the projected tax write-off here as a negative number)
—
Projected net Income from timber sales
+
Cost to make the property marketable again
+
Taxes incurred from the sale of the timber
=
Positive Answer = Don’t Cut; Negative Answer = Cut
(A positive answer means that you are better off not applying the treatment in comparison to not cutting at all. A negative answer means that you are better off to apply the treatment in comparison to not cutting at all.)

Again, there are many variables that you have to account for along each step of the way. I hope this helps you to break down the process into a series of smaller, more logical decisions that add up to a better financial decision for you. This process is purely financial. Many other factors may play a role in your decision. Remember, lean on your agent for market advice that is specific to your property, a good forester for timber advice, and your accountant to help you understand your particular financial situation.

• To review the updated and revised Wood Demand Report, click here.
• For information on Forisk’s US-wide mill database and shapefiles, click here.

Timber REITs: Forisk Equity Research just completed a comparative analysis of timber REIT forest harvesting activities to address the question, “Who wins as the housing markets return?” The firms include Potlatch (PCH), Plum Creek (PCL), Rayonier (RYN) and Weyerhaeuser (WY). In assessing the future operating performance of public timber REITs, this Technical Note analyzes potential revenue implications from (1) direct exposure to housing markets; (2) the capacity to increase harvest volumes; and (3) the ability to improve harvest mix. While timber REITs emphasize the centrality of timberlands and forest products to their businesses, less than 50% – in cases, much less – of firm revenues derive from timber sales.  Rather, direct exposure to housing – as measured by revenues from Timber, Wood Products and Homebuilding segments – exceeds 60% of revenues for three of four REITs.

• To access the complete Technical Note (January 2011), click here.

The 8^th IQPC Timberland Investment World Summit in New York at the end of October was more pessimistic about the mid-term future for forest products and timberland prices than the two predecessors I’ve attended. Rosie Scenario did not show up.

The most optimistic sense of the future came from Remsoft, a software-development company in New Brunswick that works with natural resource industries, particularly timber. Their take on the next 10 years was that things would “revert to the trend,” which is price appreciation in products, broadly speaking.

Peter Barynin, principal timber economist at RISI, the global timber information company, was less optimistic. He described the outlook for forest-product demand as “anemic,” with price gains “difficult.” He suggested that the near-term future might be considered an “unstable recovery,” with something like 2.5 to 3 percent annual U.S. GDP growth on average to 2024.

Within that outlook, he saw housing starts (single-family and multifamily combined) at an average annual 1.7 million compared with an annualized rate in 2010 of about 600,000 (about 450,000 single-family and about 160,000 multi-family starts).

Barynin believes that the U.S. is “emerging as the timber basket to the world.” The very fact of unused milling capacity and excess timber supply in this country should, however, keep timber prices flat for the next couple of years.

He considers the market for U.S. forest products to exist in a “high-risk” environment related to 1) “unprecedented” developments in the U.S. housing cycle, 2) questions about stability in both the U.S. and Europe, 3) currency questions and 4) whether Russia’s vast supply of stumpage will start filling a significant space in global demand.

(Gunnar Balsvik, CEO of Kapan Pensioner, a large Swedish pension manager, said that he would not invest in U.S. timberland because he thought it was “too scary.” This struck me as a common attitude when facing a choice between domestic and foreign investments—“better the devil you know than the devil you don’t.” The unfamiliar always looks scarier than the familiar, and, of course, often is.)

A cold-water perspective came from Joel Shapiro, head of Atlanta-based Timbervest, LLC, which manages about 825,000 acres in the U.S. He said that he saw timberland prices coming down, with “some [bare] dirt values dropping in half over the last few months.” He believes that few harvests are profitable today, and the REIT structure of some timberland managers are “forcing these companies to cut in a bad [market] environment.”

Still, Shapiro described U.S. timberland as “the best place to be” among global timber regions, because it has provided over time “nice returns,” low risk and low volatility. He pointed to “operating problems” in South America as a reason why investors are “not making money” there, and he was somewhat amused at the TIMO interest in South American projects “that won’t make money.”

He suggested that the next big wave of buyers for U.S. timberland during the next 10 years would be European and Scandinavian utilities looking for boiler fuel and integrated oil companies looking for wood-based biofuel capacity. Both uses are driven by government requirements for renewable energy.

Jeff Wikle, principal in TerraSource Valuation, LLC in Waxhaw, N.C. and Blacksburg, Va., gave an insightful presentation on timberland appraisal. He may make this available in pdf to those who request it.

In sum, my sense is that timberland prices have lagged the downward trends in housing starts, stumpage values and product prices. The recent sale to Molpus Woodlands Group of about 125,000 acres for $1,362/acre, down from the $1,700-$1900/acre prices of several years ago for plantation property, may be a bottom, but I don’t think so.

While pulp and chips may show a bit of price appreciation related to new markets for fuel and energy, both softwood and hardwood sawtimber prices (and the land that produces them) is mostly driven by housing starts. I think that a lot of the past’s hoped for and imputed HBU value in timberland is washing out.

I think defensible arguments are at hand to suggest that an average of 1 to 1.3 million (combined single family and multifamily) starts a year over the next 15 years might be a realistic guess. That’s a tangible market, but it’s half of where we where several years ago.

When 2007 timberland bought at $2,500/acre is reset at $1,200-$1,400/acre, the market will move again. I’m not sure timberland sellers will do better tomorrow than they can do today. And if the glut of foreclosed homes keeps growing and depressing starts, they may do even worse.

Everybody that I know wants an answer to that question.  Nobody that I know has a firm grasp on anything that can totally predict it.  There are simply too many variables for that to be a “known.”  But, that does not stop us from giving it a go.  Those of us that consider ourselves land professionals like to think we can predict the market.  I’ve got a feeling that those people we dispense our knowledge upon look at it with slightly more doubt than the prognostications they hear from their local meteorologist during the evening news. However, as professionals do, we push onward.

Beginning in the Spring of this year, LandThink.com conducted an online survey of buyers and sellers of land.  Among the questions posed to the respondents was, “Where do the you think we are in the current land real estate market?”.  The answer from the 860+ respondents was a collective, “I have no idea.”  Just over 21% of those polled think we are currently at the bottom.  Almost 17% thought that the bottom has already passed.  43% think we will find the bottom within the next year, and 18% said that we were not within site of the bottom.  I think this is very similar to the collective of what I hear from customers day in, day out.  It’s not uncommon for me to spend 15 minutes on the phone with someone that is completely convinced we are headed for a deep, deep depression.  I think some of this is gamesmanship in trying to get a better deal though.  I also spend a great deal of time talking with those that think the worst is behind us and are thinking of dipping their toes back in the water of real estate investment.  Ironically, uncertainty about the market keeps driving the uncertainty of the market.  It makes one think that knowing for certain the market is still headed down might somehow give us a better map out of the entire mess.  Indeed, I know another land broker that, about a year ago, told me, “I’m ready for the market to go ahead and fall off the cliff.  Then we can sort it out.”  I’m not so Gung-Ho on his notion, but I can almost see the logic.

Yesterday, at the LandThink Summit, Mr. Barry Gittleman of John Wieland Homes and Neighborhoods, dissected the Atlanta metro area residential market to us.  Using data from the MLS there and in-house sources he presented the numbers in such a fashion that would lead you to believe that the low point in that market is in sight, but not past, and that Spring 2011 should see some improvement…however slight.  In that the land market has tended to lag behind the residential markets and has been infinitely less volatile, I think that it is logical to conclude that those land markets that are so heavily influenced by those living in the Atlanta area are going to continue to be remarkably flat.  Once there is significant improvement in the residential market there, look for the land market to improve marginally within a few months.  I would imagine this to be true for the influence on land prices around any major metropolitan area.  Indeed out West, where some of the first severe corrections occurred in the residential market, and have since began a rebound, you can see an uptick in the land market as well.

Specific to my area here in East Central Alabama, we have a great deal of influence from Atlanta and Birmingham.  Birmingham did not quite reach the highs that Atlanta did during the boom and has not seen the same kind of lows that Atlanta is now suffering.  That has served to temper the market here in rural East Central Alabama in comparison to what it would have been had Atlanta been our only metro-area influence.

Timberland and timber markets were also discussed heavily at the LandThink Summit.  Unlike some of our other discussions, the general thoughts on timber markets were more positive and had less uncertainty.  This leads to a more predictable timberland market.  One of the most notable pieces of information that I gleaned from the discussion yesterday was that paper companies were back into the land market…as buyers.  This definitely signals that there has been enough of a price correction on timberland properties to make the managers and economists with those companies think owning land for growing trees might be profitable again.  Private investors should take note of this.  With the more specific management a private investor can provide on a property, he should be able to squeeze out a profit, even when the institutional investors cannot.  This represents opportunity.

The timber markets are being strengthened from the bottom.  The more uses there are for a particular commodity, the more demand there should be for it.  Biomass and biofuels are beginning to put a bottom-certain in the pulp markets.  While both biomass and biofuels can use forest refuse in production, it may be more cost effective to use pulp as an input that is currently easier to transport and more consistent.  In the future I see both pulp and forest waste being substituted for one another in these production processes.  This gives the timberland owner the opportunity to extract some value from forest waste that has traditionally gone unused and has even been a net cost to the owner due to clean-up.  This, in turn, helps the value of timberland.  There were several other ideas presented that indicated a favorable outlook in the timber markets.  I will leave that to someone more qualified than I to present.

The general notion that I took from the discussions was favorable for timberland investments.  The low cost of money right now figures heavily into this.  For private investors, the Farm Credit lending cooperatives are offering fairly good financing terms and ultra-low rates on good timberland properties.  They are also in tune with the production cycle of timberland and are willing to work with those cycles in your repayment plans.

So, here we go.  The answer to the million dollar question.  Maybe.  Timberland is a buy.  If you have some holding power, transitional lands (land that is moving from one use to another due to market forces)  purchased at current markets will look like great investments in 5-10 years.  If you are someone looking to buy 40-100 acres in the country that you will use for a retirement homesite or getaway place, and have the funds for a 20% down payment, I think now is a good time to make that investment.  I do not foresee a significant drop in prices on the horizon.  I see the general market staying flat for a couple years…but not interest rates.  Fortunes are made by those who buy low and sell high.  Today represents an opportunity to buy low with cheap funds.  Can you buy lower tomorrow?  Maybe…but not alot.  Will you be able to borrow money tomorrow as cheaply as today?  Not likely.   If you have been waiting for someone to tell you it’s time…It’s time.

In a year from now, you will know if you can look back at me as someone who is “Land Smart” or not!  Until then, it’s just an educated guess.  Just like the weatherman.

It used to be a lot easier to make money in timberland investments than it is today. The old days were better…at least for that.

Back then — say at least 30 years ago — most timberland was usually priced in one of two ways. Either it was sold for a bit more than the value of the merchantable timber with the “dirt” thrown in for free, or, if the merchantable timber was insignificant, it might be priced at the value of the bare dirt.

Timberland was cheap, because it was assumed that it wasn’t valued for much else except growing trees. Higher-and-better-use (HBU) valuation did not run with most timberland, which was used almost exclusively for producing timber and recreation. The land in timberland — usually referred to as “the dirt” — was rarely valued at very much.

It wasn’t that hard to find tracts — both big and small — whose timber could either  pay for the purchase outright or in substantial part. The buyer needed to perform his due diligence to confirm acreage and check title, among other things, but the main pre-purchase financial analysis was limited to determining the value of the merchantable timber.

Buyers often cut the merchantable timber immediately after acquisition, or after a year (for capital-gains treatment). Net sale revenue was used to pay down the mortgage, or retire it altogether. This remains a sensible strategy.

To the extent that the net timber sale revenue matched the allocated timber basis at the time of purchase, no taxable event occurred. If revenue exceeded allocated timber basis, only the excess was subject to tax at the time of the harvest, either at the ordinary-income rate or capital-gains rate. This, too, remains true.

The imputation of HBU value to all timberland has inflated timberland prices during the last 10 to 15 years. My guess is that if a true national average could be calculated, timberland acreage became overvalued by a factor of two or even three in the bubble years. Timberland prices remain too high for land devoted to timber production, given stumpage prices and the factors that shape those prices. But I’ve seen timberland prices ease off during the last year or so.

Still, timberland today often appears to be priced with, perhaps, 75 percent of property value presumed to be in the dirt (a large portion of which is thought to be HBU value) and the remainder is the timber value. (This is a generalization that is illustrating an argument; it’s not true everywhere all the time.) Or put another way, if the seller thinks the merchantable timber is worth $200/acre, he might price his property for sale at $800/acre. I have seen numerous timber tracts offered for sale where the merchantable timber is no more than 20 to 40 percent of the asking price.

From a buyer’s point of view, I try to follow the 60-percent or more rule with timberland purchases. If the buyer’s consulting forester finds 60 percent of the asking price in merchantable timber (that is, stumpage that the local market will pay for), a buyer should feel comfortable moving forward. The buyer’s consulting forester must cruise the seller’s tract using the same scale, definition of merchantability and procedures that local timber buyers will apply.

The estimate of merchantable timber value that the consulting forester gives to a buyer prior to the buyer submitting an offer represents the forester’s estimate of the seller’s merchantable timber volumes (or weights) and the prices gathered from local mills and timber buyers when the forester was preparing his report for the buyer. Buyers should understand that prices for sawlogs, veneer, pulp/chips and chip-and-saw change with market conditions, as do prices for each species. So the forester’s estimate of merchantable value should hold for three to six months from the date on which he submits his report to his client, the buyer.

The forester’s cruise and valuation also provides the evidence for the timber basis the buyer’s accountant uses in allocating the buyer’s purchase costs for federal tax purposes among the property’s various assets, such as timber basis, land basis and improvement basis. The forester’s work can also be used to establish a state-approved forest management plan that can bring property-tax relief for managed timberland.

I’ve found that a properly done cruise by a consulting forester whose work a lender knows is seen as representing a “hard” asset when the buyer indicates that he plans a prompt timber sale and pay down of a loan. Lenders prefer to see a pay down of a timberland loan within a year or two of purchase when the property is the only collateral and the borrower is short of cash. A 60-percent deal and a quick pay down may produce a 100 percent loan. The buyer then has to figure out how to repay the remainder of the loan. This might come from other sources of income or selling a portion of the land after timbering.

When merchantable value is in the 20 to 40 percent range of asking price, buyers should be hesitant about purchasing, unless some other asset factor is present. The buyer may be able to sell an unwanted asset, such as a house or a piece of the land. Merchantable timber value plus the sale of one or more severable assets might amount to 60 percent or more of the asking price.

When merchantable timber value is 50 percent of asking price, the buyer is in an “it-depends” situation. Whether this purchase will work for this particular buyer depends on the investment’s objectives, timeframe, plans for the property, financing and local land-appreciation trends.

Other ways are available for buyers to value timberland. Large acreages purchased by owners who need annual cash flow from future timber sales used a discounted cash flow (DCF) analysis. A buyer interested in land that’s just been clearcut or pasture that he plans to plant in trees can’t use a 60-percent rule, so a DCF analysis might be applied or just some old-fashioned haggling over the value of bare dirt.

I always try to think of ways that a timberland investment can pay for itself. Many factors figure into this type of calculation. And each property presents its own set of assets, values and prospects.

Nonetheless, with tracts that have merchantable timber, I start by looking for 60 percent or more of the asking price in merch value. That simple rule of thumb protects buyers against many common mistakes.

Since the late 1980s, rural land — pasture, cropland and timberland — has been a safer, less volatile and more profitable investment than stocks. Is this past predictive of future returns for these investments?

From 1990 to 2009, the annual compounded return for the S&P 500 index was 7.32 percent.

I have no idea how to forecast stock returns over the next decade. (I’m tempted to say that no one else does either, but I won’t.) Over many decades, stocks returned about 9 percent before fees and taxes.

Given the American economy’s uncertainties, would a 3 percent annual return in the S&P 500 over the next 10 years be reasonable to all concerned? To add perspective, I will point out that the S&P 500 was down 11 percent for 2008-2009. Three percent stock return (before fees and taxes) would roughly approximate the forecasted annual rate of growth in U.S. gross domestic product for the next some number of years. Two to 10 years, take your pick.

The National Council of Real Estate Investment Fiduciaries (NCREIF) gathers information from tax-exempt investors, primarily pension funds, with which it develops individual indices for farmland and timberland returns. These are large holdings. Quarterly rates are multiplied to get an annual rate of return, and it is assumed that returns from early quarters are reinvested.

For the 1990-2009 period, the annual compounded return for these NCREIF  timberland transactions was 11.75 percent before fees and without a tax hit. Cash yield comprised 45 percent of that return. Other timberland return indices are in the same ballpark.

If you were to add in fees and taxes on big holdings and not assume constant and complete reinvestment, the average annual net return might have been more in the 5-7 percent range. But that’s just a rough guess on my part.

My sense is that small timberland investments typically show higher rates of return than those in the NCREIF samples. But data are not available to prove or disprove this opinion.

Small timberland holdings are not set up or managed to throw off much cash annually in the way pension funds or money managers require. Small holders get most of their return as occasional lump sums from the sale of timber or some or all of the land itself. Predictable, rather than episodic, annual (taxable) income might come from hunting leases, firewood sales, mineral royalties and the like.

I have not been able to find proof that small timberland investments outperform larger ones, but that’s been my experience. It’s difficult to find large-apples-to-small-apples data for a number of reasons, including the lack of basic tracking information on small holdings that would include factors like leverage, structure of ownership, net for tax liabilities and benefits, disposition of the property (sale, exchange, or allocated to the tax-free portion of the estate, for example), conservation easements and so on.

If you try to track return for a significant number of small timberland investments, I think you would end with what epidemiologists call a “survivor population.” These are the individuals that are still being followed when the study ends. The ones who vanish or drop out of the study are not counted in the final calculations of mortality rates.

If you drop out of a small timberland study all the properties that have acquired one or more confounding factors that squirrel up (that’s the technical term) the integrity of their information, the analysis will be limited to the properties that were easiest to track over a long period of time. The survivors in a timberland study are not likely to be the best earners. I encourage return research on large v. small timberland holdings.

So for the purpose of arguing with myself, I’ll say on my own say so that the average small timberland holding will do at least 15 percent annual return before taxes and expenses if held for at least 10 years and one sale of merchantable timber is included. The amount of merch timber at the point of acquisition, degree of leverage and other factors obviously affect this return number.

Everything was down in 2009. The S&P 500 was negative. The NCREIF farmland index for 2009 showed an annual return of only 4.15 percent; the timberland index for last year showed a loss of 1.04 percent.

Two extension economists at Iowa State University (ISU), William Edwards and Don Hofstrand, calculated returns to farmland owners per year per acre for 1970 to 2009.

Total farmland return combines annual cash returns and change in market value for the land. The data for both measures come from the USDA’s Economic Research Service. Cash return is taken to be the cash rental return, a gross number that does not reflect deductions for property tax and expenses.

In dollars unadjusted for inflation, farm cash rents rose from $33/acre in 1970 to $167/acre in 2009 while land value rose from $392/acre to $3,650/acre. For this period, total farmland return averaged 13.6 percent a year, and 16.1 percent for the 2004-2009 period. The only down period was 1982-1987, which the authors characterized as the “farm crisis,” when annual return averaged -5.6 percent.

Mr. Hofstrand, co-director of Agricultural Marketing Resource Center at ISU, said that corn-based ethanol demand drove farmland returns after 2003-2004. The 1.8 percent total farmland return calculated for 2009 reflects weakness in the supply-demand-price relationship for corn used in ethanol last year.

About one-third of the U.S. corn crop is currently devoted to ethanol, which will amount to about 12.5 billion gallons in 2010. Ethanol production has been driven by the 2007 Energy Security and Independence Act that required the use of 36 billion gallons of biofuels annually by 2022.

Future farmland return, he believes will be tied to ethanol. If federal policy does not raise the 10 percent ethanol cap in gasoline to 12 or 15 percent, future total farmland returns will trend down inasmuch as the capacity to grow corn for ethanol exceeds demand. He does not foresee growth in corn exports or in its primary market, livestock feed. At the moment, overcapacity probably exists in both corn-growing land devoted to ethanol and ethanol-production capacity.

Mr. Hofstrand sees corn yield productivity increasing into the 300 bu/acre range on prime Iowaland, which will weaken future corn price if demand does not increase proportionately.

He finds that climate change is affecting the geographic locus of crop production. Corn land has been moving north as temperatures rise. Mr. Hofstrand suggests that long-term warming will increase the variability of precipitation and planting cycles—an early frost might, for example, come with a warmer growing season. If atmospheric carbon buildup were to stop today, he says, we still face a 25-year warming span resulting from the current carbon overload.

One bright spot on the horizon is the potential for biochar (charcoal or black carbon from biomass, such as agricultural and forest wastes, crop residues, urban bio-waste and mill wastes) to be incorporated into farm soils to improve fertility, increase soil productivity and sequester a lot of carbon. Biochar carbon sequestration is measurable and since it lasts for many years would have annual cash value as a credit.

Corn-based ethanol has its critics. It decreases mileage. Ethanol refineries receive a tax credit of $.45/g, which is supposed to expire at the end of this year. At a richer-than-10-percent blend, it can corrode engines. It involves major water-pollution issues, because corn requires much more fertilizer and pesticides than other biofuel feedstocks and substitute crops. Both corn and ethanol require large amounts of water. One 2009 study estimated that were corn-based ethanol to displace 25 percent of U.S. gasoline consumption, it would require 51 percent of U.S. cropland and about 180 gallons of water per gallon of fuel. (Erica Gies, “As Ethanol Booms, Critics Warn of Environmental Effect,” New York Times, June 24, 2010.)

Going forward, I’d look at the not-very-systematic information above and project return for stocks, farmland and timberland down from their previous 20-year averages. If you give me 3 percent for stocks over the next decade, give me 5-6 percent for the NCREIF timberland samples as NCREIF calculates them, at least 10 percent for small timberland investments and 5-7 percent for farmland.

I can’t prove this — I can’t prove any of these opinions — but I think bought-right land in terms of its assets, liabilities and price will be a safer, less volatile and more profitable investment going forward than any of the stock or bond alternatives. But I don’t think land returns will be as saucy as before.

The general consensus at the 7th Annual Timberland Investment Summit held in Vancouver, BC, at the end of June was that new single-family housing starts would recover to about 900,000 units a year within the next two to four years. That’s about half of the 2006 high, but it’s about twice 2010’s current annualized new-start rate. Nine hundred thousand new housing starts, not 1.5 or 2 million, might be considered the mid-term future’s expected norm.

No one forecast second-home starts and timberland sales.

Home construction is projected to boost lumber and timber prices, which, in turn, would strengthen timberland prices. But whether the turnaround comes in two years, four, or six is anybody’s jump ball.

Put differently, timberland prices should gain last in line, lagging stumpage prices, which will lag lumber prices, which will lag improved housing prices. On the other hand, timberland prices have not fallen as much as housing prices, so less loss has to be made up.

Housing starts are not correlated with timber (stumpage) prices, observed Jack Lutz, a long-time market analyst with the Forest Research Group. Timber prices lag housing starts by 12 to 24 months, and they tend to regress to their mean over time, he said.

Clark Binkley, managing director of International Forestry Investment Advisors, added that “real timber prices can’t go up over time.” Nominal prices, unadjusted for inflation, will, however.

Lutz believes that timber prices won’t pick up for two years, because trees have been stored on the stump for the last three years rather than sold into a down market. This will make for a price-suppressing supply situation when demand does pick up.

Timberland prices have not been correlated with timber prices or housing starts historically. Timberland prices have correlated with stumpage (timber) prices over the very long term, not the short-term.

Recent timberland prices have been driven higher and then supported by imputed Higher-and-Better-Use values associated with second homes and recreation even as both housing starts and stumpage prices fell. One question is whether or not HBU valuation fundamentally and perpetually shifts timberland prices up going forward, or, alternatively, whether HBU is more of a bubble.

From an investor’s point of view, HBU “value” is a much trickier (and softer) asset than merchantable timber. Thirty years ago, it was not that hard to find timberland priced with 70 percent of more of the acquisition cost found in the merch. Today, 70 percent of timberland cost is typically purported to be in the bare dirt, and, perhaps half of that, in inferred HBU value. Buying a 70:30, land-to-timber tract increases investment risk and makes 10 to 20 percent down-payment financing hard to arrange.

The market for timberland is somewhat distorted in my opinion. It’s not reacting in price terms to supply-and-demand factors, because much of it is owned or controlled by investors like pension funds, endowments, hedge funds and private-equity firms that can wait out a down market and not lower their price to get a sale.

Many individual timberland owners also appear to have the ability to carry their investments for the next few years, rather than sell at a 2000 price.

The new-start housing forecasters see a huge pent up demand for stick-built homes. They argue, maybe assume, that higher employment rates will drive these sales.

I’m moderately skeptical of the link between employment and new-start housing in our current times.

People buy housing when their current income and long-term prospects are sufficient to afford it; we’ve seen what happens when they can’t afford it. Employment rates can rise without income capability rising. Income, not employment, will drive new housing. A fully-employed Nation of low-wage McFlippers will not be buying houses.

It’s plausible to me that our economy has permanently been reset by the irretrievable loss of much of our high-wage manufacturing base overseas. In turn, that loss will reduce high-wage public-service employment sooner or later. This will leave a smaller and poorer middle class. America’s economy will continue to grow, but at a slower rate than in the past. Our expected economic-growth norms will be lower, even as our population grows.

A housing-start recovery might occur in the shape of a hockey stick, but it’s just as arguable that the mid-term future looks like protracted 7-9 percent unemployment (with real unemployment at 15 percent of more) and real income stagnating or declining in the middle-income and blue-collar sectors.

Demand for timber will grow moderately whether you’re an optimist or a skeptic as population grows. Timberland investments should work over a long term, i.e., more than 10 years, if bought properly.

But timberland investors should no longer expect annual returns in the 9-to-15 percent range as long as unemployment is high, income is chancy and our economy is establishing new norms that are lower than those they’re replacing.

The consensus now seems to have been reset at 6-to-7 percent nominal annual returns on large timberland investments, held for a number of years.

If return expectations are cut in half, what change might we expect in timberland prices?

The next timberland investment summit will be held in New York City, October 27-October 29, 2010. LandThink is a media sponsor of this event.

Bill Calton, Plum Creek’s Senior Director for Real Estate and Land Management, is cautiously optimistic about the prospects for timberland investors and rural land sales.

Plum Creek, a real-estate investment trust (REIT), is a NYSE-listed company that is the Nation’s largest private timberland owner with 7 million acres. Calton oversees Plum Creek’s non-strategic land dispositions in 18 states along with its recreational lease-management program. He’s based in Atlanta.

Calton is a scheduled speaker at the first LandThink Summit to be held at the Gwinnett Center in Duluth, Ga., on September 30, 2010. He also spent 20+ years in the residential and commercial real estate industry with both Jones Lang LaSalle and Trammell Crow Company.

His unedited answers to my questions appear below:

1. If you were investing your personal money in land for a 10-15 year horizon, what type of land would you buy? Do you prefer some locations to others? Why would you choose this type of land and location over alternatives?
Obviously, we at Plum Creek continue to believe that timberland is a good, long-term, stable investment. And compared to other market indices, timberland historically has proved to be a good inflation hedge. Our strategy as a REIT has certainly been to be geographically diverse. For an individual land investor, opportunities exist in almost every state to buy and invest in land as a diversification play from traditional Wall Street asset classes.

2. Do you think farmland and timberland are currently priced above, at or below market in terms of their intrinsic values (defined however you want), and why? What’s driving current valuations? Do you see a change in valuation drivers in the future?
Most timberland investors today are not placing as much of a premium (if at all) on potential HBU qualities of a parcel like they were in 2004-2007; rather, they are looking more specifically at just the inherent timber characteristics of a tract. Combine that fact with the fall in housing starts (which has negatively impacted stumpage prices), and it’s no surprise that recreational timberland has experienced a decline in prices in the past two years in some of our markets. With that said, as the economy rebounds and housing starts climb back to more stable levels, we expect to see improvement in both timber values and recreational land in general.

3. Do you use or recommend a general valuation formula for determining which investments to make, such as x% of farmland price in current or projected net cash annual income, or x% of acquisition cost in merchantable timber, or projected 10-year pay off of acquisition cost? When using DCF analysis, what minimum target do you recommend? Do you have non-revenue hurdles against which you measure land investment performance?
We look to maximize the value of every acre we own, and while the timber component of land is obviously a major part of our underwriting and valuation, other future uses like conservation, real estate, energy, minerals, mitigation, etc. come into play as we make investment decisions. In other words, each piece of land has its own risks and opportunities, and we evaluate each potential purchase through a “value optimization model” which utilizes many factors and variables that consider our potential Hold period and those risks/opportunities tied to that piece of land. In contrast, for an individual land investor, his/her motivation for buying land may not be purely financial. Many investors, while certainly considering the financial implications of an acquisition, also place an intangible value on raw land purchasing decisions (i.e., they can use it for recreation, hunting, building, etc).

4. Do you anticipate any significant shifts in the market (either positive or negative) for agricultural products and timber fiber/logs during the next 15 years? Do you anticipate any technology change, shift in end uses, environmental issues, trade restrictions/expansion etc. that would positively or negatively affect current production trends and markets for agricultural and timber products?
We expect to see a slow and gradual increase in housing starts. Most economists expect housing starts to recover to about 900,000 in 2011. And, we see some structural shifts in the market.

1. There’s going to be a significant decline in Canadian timber supply due to harvesting restrictions related to the Mountain Pine Beetle

• Canadians report they believe that there will be about a 50% reduction by mid-decade in British Columbia harvest from this beetle kill phenomenon that’ll last for 60 years, a significant change in supply.
• There will also be some supply reductions that have already started occurring in Eastern Canada – about a 20% reduction there. So Canada is a big factor.

1. Demand growth for wood fiber as a renewable energy source will increase competition for wood fiber. As more power is required from renewable energies, biomass will be a part of the baseload energy regeneration.
2. There are also potential value opportunities should carbon markets develop.

5. How have general macro-economic conditions affected the market for HBU land sales in your experience during the last five years? Are you anticipating stronger land sales during the next five years? If so, on what basis?
HBU lands, which are historically higher priced, have taken a back seat over the past year to pure timberland, especially in markets that experienced a very high uplift in HBU prices several years ago (i.e., Florida, Montana). Markets are very “local”, though, and our geographic diversity has allowed us to shift our HBU dispositions to markets that have continued to show some strength and resilience (Gulf South and Lake States).

6. How would a sharp “crash” in commercial real estate and/or loan resets in 2011 affect the market for land sales?
It will not drastically affect real estate dispositions, as 80% of our buyers are cash buyers; however, if the pending commercial loan issue creates a larger macro-economic problem which prolongs the country’s recession, then lower consumer sentiment could certainly have an impact on land sales, which are typically discretionary purchases. On the other hand, we have seen that many of our buyers are, in fact, choosing to buy land as an alternative investment to other traditional Wall Street choices. So if the broader stock markets continue to be unpredictable, land is a dependable, safe investment that investors can feel, use, and touch over their lifetime.

7. To what extent do you think your buyers are affected by interest rates and credit availability?
Only to the extent that rising interest rates and tight credit is affecting their other investments. If those other investments decline in value, then those factors certainly could cause some investors to sit on cash on the “sidelines”.

8. What are the three most important policy changes (including tax) that the federal government could enact that would improve the climate for investing in land?
There are two areas of federal legislation that we are watching carefully. One is the renewable portfolio standard, and the other is greenhouse gas emissions. Right now those policies are joined and in Congress, but we’re not seeing a lot of activity. But at some point, we’ll see Federal policy that addresses both of these issues. From there, we’ll see a move toward lower-based carbon energy. That should benefit our biomass ownership.

LandThink.com is proud to host the first ever LandThink Summit! This groundbreaking event will cover a variety of topics impacting the land industry, including market conditions and trends, recent legislation, conservation, creative financing, land market from a broker’s perspective, the timberland market and more. The Summit brings together industry experts, potential investors, and individuals and companies who own, sell, and invest in land. Summit attendees will gain access to some of the greatest and most valuable resources and thought leaders.

Join us September 30th at the Gwinnett Center in Atlanta, Georgia for a full day of industry education, information and networking with land industry experts and keynote speaker Coach Bobby Bowden. More information on the LandThink Summit can be found at GetLandSmart.com.