Buying Land

Timber Investing and Discount Rates: Forest Ownership is Not a Charitable Enterprise

Timber Investing and Discount Rates: Forest Ownership is Not a Charitable Enterprise

Behavioral finance teaches us that we are prone to both emotional error and brilliant insight, and sometimes we confuse the two. For this reason, when evaluating investments, we value clear benchmarks (objectives) and strong decision-making processes. By accepting and acknowledging our limitations as emotive, thinking machines, we can then focus our energies on learning, practicing and applying helpful tools and frameworks.

Investing in Timberland

When it comes to timberland investing, this can start with clarifying what we want and confirming that the expectation is operable and reasonable. In his 1909 book on forest finance, based on lectures he delivered at the Biltmore Forest School, Carl Schenck wrote:

“With the private owner of forests, the financial outcome of his investments is the first and last consideration. The private owner cannot be expected to supply this country with forest products unless forestry is as remunerative an investment as agriculture…”

Dr. Schenck reminds us that forest ownership, like any capital investment, is not a charitable enterprise. The asset must pay its way, especially when compared to alternatives of comparable risk, return and liquidity. When tracking these investments in the Forisk Market Bulletin, we note how this requires an understanding of how forest investments perform as they transact and mature. For investors, a forest reaches financial maturity when its annual growth rate in value equals the target rate of return.

Discount Rates

When walking through case studies in Applied Forest Finance to evaluate investments, I talk to how it remains appropriate to use a discount rate that reflects the marginal cost of capital of the firm. In business school, I learned the importance of a company’s weighted average cost of capital and, to this day, find it intuitive, relevant, operable and important as a source of information for discount rates. Beating the cost of capital creates value for the firm and trailing the cost of capital destroys wealth. If firm A raises capital at 6% and firm B finances projects at 8%, firm A has the advantage, seven days a week. They have a lower “hurdle” to jump.

The weighted average cost of capital is analogous to a credit score. If the market believes you’re a credit risk, it will charge you more to borrow money. Different firms have different risk profiles which dictate their ability to access money to invest. And different assets (or projects) have different risk profiles which necessitate different “discount” rates to account for the uncertainty associated with future cash flows.

Trouble begins with the fact that many firms or investors have an asset-specific discount rate in mind – their expected rate of return – rather than accounting for their cost of capital. In isolation, this does not matter much if your firm is well-capitalized and a good credit risk. But “backing into” a discount rate prioritizes the deal over the risk of the asset or the capability of the firm.

When firms apply a risk-adjusted, weighted average cost of capital for timberland investments, they contemplate the fact that any financing would occur at the cost of capital of the firm. This subjects the timberland asset to the same test any other asset would be expected to pass: does it generate returns competitive to any other project or investment contemplated by the firm that has a similar risk profile?

This content may not be used or reproduced in any manner whatsoever, in part or in whole, without written permission of LANDTHINK. Use of this content without permission is a violation of federal copyright law. The articles, posts, comments, opinions and information provided by LANDTHINK are for informational and research purposes only and DOES NOT substitute or coincide with the advice of an attorney, accountant, real estate broker or any other licensed real estate professional. LANDTHINK strongly advises visitors and readers to seek their own professional guidance and advice related to buying, investing in or selling real estate.

About the author

Brooks Mendell, Ph.D.

Brooks Mendell, Ph.D. is President and Founder of Forisk Consulting, a forest industry, timber REIT, bioenergy and timber market research firm. Dr. Mendell has over fifteen years of operating, research, and consulting experience in forest business and finance. Mendell has published over sixty articles and two books on topics related to timber and timberland REITs and markets, forest business management and operations, and communication skills.

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