Buying Land

When Might We Overvalue Our (Timberland) Investments?

When Might We Overvalue Our (Timberland) Investments?

With rising interest rates and stubborn timber prices, investors in timberland and timber REITs are asking about the durability of current timberland values. Their questions probe the assumptions related to the estimates of future cash flows generated by forest assets. The ‘phrasing’ and nature of these questions vary between those who identified timberland as a candidate for investment from those who bought a forest-related investment in the past and still have it in their portfolio.

How Investors Think

In 1990, Nobel Prize-winning economist Daniel Kahneman and two colleagues published a study in The Journal of Political Economy documenting how we can “overvalue” things we already own (Kahneman, Knetsch and Thaler, “Experimental Tests of the Endowment Effect and the Coase Theorem”). This “endowment effect” applies to investors who may hold on to assets beyond their strategic relevance, failing to account for true opportunity costs, and missing out on opportunities to reallocate that capital to investments that better meet the needs of the portfolio.

Recent reporting in The Economist magazine also highlights the powerful incentives investors have to stand behind the original return assumptions for their investments (“Interest Rates and Investment Returns,” March 2, 2017). When we consider investments in forestry (or other sectors), we must look forward. This may require us to adjust our thinking for probable nominal returns. When evaluating timberland holdings, revisit key questions, such as:

  1. Do my reasons (my investment thesis) for holding the asset still apply? If the investment helpfully diversifies my portfolio and generates cash as needed relative to other opportunities, then ignore the noise and focus on other issues. Your timberlands are doing what they are supposed to do.
  2. Have my timberlands reached financial maturity? This is when the owner’s cost of keeping an asset exceeds expected returns. Timber complicates this thinking because a tree is both the “product” and the “factory,” which continues to appreciate over time through adding volume and value. Harvesting trees resets the production process. So we approximate financial maturity in forestry by comparing the annual increase in forest value with the investor’s expected rate of return from other investments of similar risk and duration. If we can do better elsewhere, we should feel compelled to do so. If we cannot, then we should grab a beer, sit on the porch and enjoy the view while we can.
  3. How do I evaluate short-term opportunities to enhance the performance of this forest asset? Financial analysis often supports the “investment decision” by helping investors rank investment options, evaluate risk, and assess the impact of a given project on the forest. For example, marginal analysis helps assess forest management and intermediate harvest decisions for existing stands. It answers questions of “when to harvest?” and “when does forest management pay?” and “should I accept this ‘woods run’ offer to bring all logs to the pulp mill?” Incremental differences in costs and benefits “on the margin” clarify decision making by focusing on the effects of a specific treatment or harvest decision, not on the entire portfolio or investment.

In forestry, we often struggle with “sunk costs.” When evaluating the current value of our timberland investment against new investment opportunities, we must do so with ice in our veins and clear financial analysis on hand. We, first, ignore sunk costs and, second, evaluate forest investments based on their ability to generate income and returns moving forward. The only time we have complete control over our portfolio is today.

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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