In graduate school, forest economist Dr. David Newman taught us that “timberland is a residual land use.” When he said that, I wrote it down and nodded my head like it made sense, but it took time for the idea to click in my head. Then I learned more about risk and return and opportunity costs in forestry.
Professor Newman, in citing “use,” meant land values often depend on the highest available use. For example, the term HBU, or “higher and better use,” reflects this concept in action with forests that get converted for agriculture or real estate. Forest carbon projects, through deferred harvests or set-asides, also offer options for landowners to essentially rent out or sell the land or its services into higher yielding markets. In the U.S., forests sometimes serve as a final “residual use” for landowners, when other options remain unavailable or uninviting as investments.
How Can Discount Rates Get Misapplied in Forestry?
Misapplied means to “use (something) for the wrong purpose or in the wrong way.” Examples include using a butterknife as a screwdriver or opening a beer bottle with a ballpoint pen. (I’m guilty of both). In forest finance, we use discount rates to adjust for the risk in future timberland-related cash flows when conducting discounted cash flow (DCF) analysis.
At times, analysts tweak discount rates for things like the size of a project or the quality and experience of management. While convenient, loading up the discount rate with additional criteria and obligations abuses any process focused on transparency and standardization. It reflects a misapplication. Why?
DCF analysis provides a systematic way to organize available data and current analysis when evaluating the variability of estimated cash flows for a going concern. In other words, the analysis does not really contemplate failure; it simply tests whether the project hits the desired financial performance target given the discount rate and portfolio objectives. NYU finance professor Aswath Damodaran addressed the proper use of discount rates in a November 2016 blog on valuation:
…the discount rate exerts a pull on analysts, inviting them to use it as a receptacle for their hopes and fears. Doing so will expose you to double counting both the good stuff… and the bad…The discount rate… is meant to carry the weight of measuring going-concern risks…That is task enough…!
DCF and Discount Rate Considerations
As analysts, we seek to match discount rates to the specific risk of the project assuming it falls within a firm or portfolio of assets. This point highlights practices that can weaken the rigor of a given valuation based on discounted cash flows.
For example, understand the implications of applying discount rates to cash flows that presume perfect forest operations or optimal harvest model results. While I understand the desire to be optimistic or forward-leaning in acquisition models, I caution against the use of both “perfect” cash flows and “aggressive” discount rates because, as noted by Professor Damodaran, you end up “double counting” the effects and assumptions.
Also, discount rate selection enters treacherous waters when investors focus on what they “need” to pay to make a timberland deal happen and then back into the discount rate, price forecast, or harvest model that plugs the valuation hole. For both optimistic models and derived discount rates, sensitivity and scenario analyses provide helpful tools for testing key assumptions and clarifying the tradeoffs.
Timberland investment decisions get made at the margin. Forest lands located in the path of population growth feed hungry developers looking for tracts to build homes, schools, and office parks. Forest lands located in less active areas, those with fewer people or alternate uses, provide attractive opportunities for forest carbon projects. In both cases, the math of forest finance and the appropriate application of discount rates reinforce, from a financial standpoint, how intensive silviculture and active forest management help preserve the income potential of a given plot of land and forest ownership for the long-term.
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