Timberland Valuation.

Private timberland investment is a unique form of investment that emerged from a shift in ownership from private forest product companies in the United States to tax-exempt pensions and other investors seeking portfolio diversification. The value of timberland, similar to other real estate, is derived from its current and future economic use. The use of timberland involves the biological growth and harvest of timber for use in various industries such as construction and paper manufacturing. The value of unharvested timber appreciates over time due to growth and the potential for a higher proportion of older trees to be sold as sawtimber, which is used for making furniture, flooring, and other high-value products.

Timberland Investment Characteristics

Timberland Valuation

Timberland is usually evaluated based on a long-term investment horizon that combines income and capital appreciation. Timberland valuation is approached differently from other real estate assets by solving for the land expectation value (LEV), which is the value of an acre of bare land in perpetual timberland production. It can be calculated as
$$​LEV = \frac{NFV}{(1+r)^n -1}$$
where

• \(NFV\) is Net future value of a single timber rotation
• \(r\) is required rate of return
• \(n\) is length of timber rotation in years

Example

GreenPine Investments, a firm specializing in sustainable forest management in the northern United States, plans to invest in a new timberland project with the following expected cash flows and investments:

• Initial Site Preparation and Planting Costs: USD500 per acre, paid today (year 0).
• Pest Management and Fertilization Costs: USD120 per acre, incurred at the end of year 2.
• First Thinning Revenue: USD600 per acre in year 10.
• Second Thinning Revenue: USD800 per acre in year 20.
• Final Harvest Revenue: USD9,000 per acre in year 30.
• Annual Management Fee: USD4 per acre, from year 1 through year 30.

The project targets a 7% annual return. To evaluate its financial viability, we calculate the Land Expectation Value (LEV) based on all future cash flows adjusted to their present value (PV) as of Year 30.

To calculate the LEV, we first need to determine the NFV by calculating the present value of all cash flows at year 30. The PV of a future cash flow is its worth in today’s dollars. It is calculated using the formula:

$$PV = CF \times (1 + r)^{-(n-t)}$$

• CF: The cash flow in future dollars.
• r: The annual return rate (7% for this project).
• t: The year the cash flow occurs.

Calculations for each cash flow are as follows:

Initial Investment PV (Year 0): As this cost is incurred at year 0, no discounting is needed. Therefore, the PV is directly -USD 500.

Pest Management Investment PV (Year 2):

$$PV = 120 \times (1 + 0.07)^{-(30-2)} = 120 \times (1.07)^{-28}=18.048$$

First Thinning Revenue PV (Year 10):

$$PV = 600 \times (1 + 0.07)^{-(30-10)} = 600 \times (1.07)^{-20}=155.05$$

Second Thinning Revenue PV (Year 20):

$$PV = 800 \times (1 + 0.07)^{-(30-20)} = 800 \times (1.07)^{-10}=406.67$$

Final Harvest Revenue PV (Year 30): As this revenue is received at year 30, no discounting is needed. Therefore, the PV is USD 9,000.

Annual Management Fees PV: For the Annual Management Fees, we are dealing with a series of identical cash outflows of USD 4 per acre, occurring annually from Year 1 to Year 30. The correct way to calculate the present value of these outflows is to use the formula for the present value of an annuity because these payments are equal and occur at regular intervals. The present value of each annual management fee is:
$$ PV_{\text{annual fee}} = \sum_{i=1}^{30} \frac{4}{(1 + 0.07)^{i}} = 49.63$$

Adding these values gives us the Net Future Value (NFV) of the project: about $8,994.05. This figure represents all expected incomes and costs, adjusted to today’s value as of Year 30.

By applying the NFV in the Land Expectation Value (LEV) formula, considering a 7% required rate of return and a 30-year rotation period, the LEV per acre is calculated to be approximately USD 1,360.21.

This LEV signifies the current value of an acre of bare land dedicated to continuous timberland production under the specific conditions and cash flows of GreenPine Investments, demonstrating the economic viability of the project.

Characteristics of Timberland Investments

In practice, additional factors such as potential alternative land use or premiums paid by investors to capture carbon credits can significantly affect timberland prices. For instance, a piece of timberland may be more valuable if it can be converted into a residential or commercial property. Therefore, the discounted cash flow approach is often complemented by sales comparisons when similar recent transactions exist.

Timberland investments have unique characteristics due to their biological features. Cash flows derived from the harvest and sale of real assets used as inputs in basic industries offer inflation-hedging potential and tend to have low correlations with other asset classes. Forest management techniques can be employed to optimize the age distribution of trees, the stocking of species, and the acceleration or deferral of harvests in response to market price changes at little or no cost.

Risks and Returns of Timberland Investments

Timberland owners face biophysical risks from drought, wildfires, pests, and disease. Despite these risks, timberland has attractive risk and return features and has seen increased investor interest due to its environmental, social, and governance-related characteristics. A secondary source of timberland returns is the purchase of forests or carbon credits from forest owners as a form of carbon offset .

Illiquidity of Timberland Investments

Timberland investors face a high degree of illiquidity and must therefore consider these investments as components of a long-term portfolio. The length of the timber growth and harvest cycle and the processing and delivery cycle used to convert raw timber into pulp, paper, and lumber dampen the effect of short-term market fluctuations for finished products.

Farmland Investment Characteristics

Investing in farmland presents a unique opportunity for investors to diversify their portfolios and tap into the steady demand for food and other plant- and animal-based raw materials. This guide will delve into the characteristics of farmland investments, including ownership and size, land suitability and crop usage, investment approaches, financial returns, reasons for investment, government intervention, environmental considerations, and additional benefits.

Ownership and Size

Ownership of farmland varies significantly across different regions. For example, in the United States, farmland is typically owned by smaller, family-owned farms. In contrast, countries like Brazil have larger-scale, concentrated agricultural land ownership. In developing countries in Africa and Southeast Asia, the state often owns the land.

The size of farmland investments can also vary, ranging from tens to a few hundred acres or hectares. To put this into perspective, 98% of US farmland is owned by families, excluding corporations, cooperatives, and external managers.

Land Suitability and Crop Usage

In agricultural production, the suitability of land is determined by several factors, including temperature, soil type, rainfall, and available irrigation sources. For instance, the fertile plains of the Midwest in the United States are ideal for growing corn and soybeans due to their rich soil and ample rainfall.

Crops serve various purposes, either directly as a raw material in food production or as an intermediate good when feed crops, such as grains, are cultivated for use in raising livestock. For example, corn is used both as a food product and as feed for livestock.

Investment Approaches

There are two primary approaches to farmland investment: the own–operate approach and the own–lease approach.

The own-operate model involves owning land, buildings, equipment, and other assets and operating an agricultural business. This is similar to owning and operating a private company. Owner-operated farms and agricultural businesses have cash flow features and risk-return characteristics similar to those of private companies. For instance, they generate revenue from the sale of crops and livestock and face risks such as fluctuating commodity prices and weather-related disruptions.

The own-lease model, more common among financial investors, involves receiving fixed rental payments for undeveloped tillable acreage under a multiyear lease agreement from a farm operator lessee who assumes all other business risks. This model is similar to owning a rental property and collecting rent from tenants. Own-lease farmland investments earn periodic rent, which offsets property tax, with no other significant income or expenses. As a result, financial returns on own-lease farmland are primarily in the form of capital appreciation instead of income.

Reasons for Investment

Investors are attracted to farmland for several reasons, including portfolio diversification, long-term capital appreciation, an inflation hedge, and a relative lack of correlation with the economic cycle. For example, during the 2008 financial crisis, farmland values remained relatively stable compared to other asset classes.

Steady and growing demand for food and other plant- and animal-based raw materials combined with government policies ensure stable demand for agricultural land use. For instance, the global population growth and rising middle class in developing countries are driving increased demand for food and agricultural products.

Government intervention in agriculture includes production supports, subsidies, and other programs under the Common Agricultural Policy of the European Union, as well as US Renewable Fuel Standards mandating and subsidizing the production of biofuels from corn and other plants. These policies can significantly impact the profitability of farmland investments.

Environmental Considerations

While farmland generally lacks the degree of carbon capture available from timberland, opportunities to reduce carbon emissions include environmental protection via expanded conservation areas, sustainable farming practices, such as reduced tillage, and soil and water protection. For example, farmers can adopt practices like cover cropping and rotational grazing to improve soil health and sequester carbon.

Additional Benefits

Unlike other vacant land, farmland generates positive cash flow in the form of land leases less taxes with no capital improvements necessary, while also granting an owner a perpetual option to develop the property for an alternative economic use in the future. For instance, a farmland owner could potentially convert the land into a residential or commercial development if the opportunity arises.

In addition to the inflation-hedging properties of tillable land whose economic use is based on the value of real assets, such as crops, the option to rezone and repurpose a property may be particularly valuable if land prices are volatile or the property is subject to increasing urban density or greater proximity to transportation infrastructure.

Practice Questions

Question 1: Timberland investment has emerged as a popular choice among tax-exempt pensions and other investors seeking portfolio diversification. Which of the following statements is true?

1. Timberland investments have high correlations with other asset classes and offer no potential for inflation hedging.
2. Timberland investments are highly liquid and are not affected by short-term market fluctuations for finished products.
3. Timberland investments have unique characteristics due to their biological features and offer inflation-hedging potential with low correlations with other asset classes.

Answer: Choice C is correct.

Timberland investments indeed have unique characteristics due to their biological features and offer inflation-hedging potential with low correlations with other asset classes. The biological growth of timber provides a natural, intrinsic value that is not directly tied to the economic cycle, making it a unique asset class. This biological growth, coupled with the fact that timber can be harvested at different times based on market conditions, provides a natural hedge against inflation. Furthermore, timberland investments have historically shown low correlations with other traditional asset classes, such as stocks and bonds, making them an effective tool for portfolio diversification. The value of timberland is derived from its current and future economic use, including the biological growth and harvest of timber, which is influenced by a variety of factors including timber prices, land values, and management practices.

Choice A is incorrect. Timberland investments do not have high correlations with other asset classes. In fact, they have low correlations, which makes them an effective tool for portfolio diversification. Additionally, timberland investments do offer potential for inflation hedging due to the biological growth of timber and the ability to time harvests based on market conditions.

Choice B is incorrect. Timberland investments are not highly liquid. The process of selling timberland can be lengthy and complex, and the market for timberland is not as liquid as markets for more traditional asset classes. Furthermore, timberland investments are indeed affected by short-term market fluctuations for finished products. The prices of timber and timberland can be influenced by a variety of factors, including changes in demand for timber products, changes in land values, and changes in management practices.

Question 2: The valuation of timberland is a complex process that involves a long-term investment horizon combining income and capital appreciation. Which of the following statements correctly describes the land expectation value (LEV) in timberland valuation?

1. The LEV is the value of an acre of bare land in perpetual timberland production.
2. The LEV is the value of an acre of land with fully grown timber ready for harvest.
3. The LEV is the value of an acre of land without considering its potential for timberland production.

Answer: Choice A is correct.

The Land Expectation Value (LEV) in timberland valuation is indeed the value of an acre of bare land in perpetual timberland production. The LEV is a fundamental concept in forestry economics and is used to determine the value of a piece of land based on the net present value of the future income streams that can be generated from the timber grown on it. The LEV takes into account the costs of planting and maintaining the trees, the income from selling the timber, and the time value of money. It assumes that the same cycle of planting, growing, and harvesting will be repeated indefinitely into the future. Therefore, the LEV represents the value of the land under the assumption of perpetual timberland production. It is a key input in the valuation of timberland and is crucial for investors to understand the potential returns and risks associated with this type of investment.

Choice B is incorrect. The LEV is not the value of an acre of land with fully grown timber ready for harvest. This would be the stumpage value, which is the market price for standing trees or “stumpage.” It does not take into account the future income streams from timberland production, which is what the LEV represents.

Choice C is incorrect. The LEV is not the value of an acre of land without considering its potential for timberland production. This would be the bare land value, which is the value of the land without any trees or improvements. The LEV, on the other hand, specifically takes into account the potential income from timberland production.

Glossary

• Own–operate approach: An investment strategy that involves owning land, buildings, equipment, and other assets and operating an agricultural business.
• Own–lease approach: An investment strategy that involves receiving fixed rental payments for undeveloped tillable acreage under a multiyear lease agreement from a farm operator lessee who assumes all other business risks.
• Common Agricultural Policy: A set of legislation and practices adopted by the European Union to provide a common, unified policy framework for agriculture.
• US Renewable Fuel Standards: A program in the United States that requires transportation fuel sold in the U.S. to contain a minimum volume of renewable fuels.
• Net Future Value (NFV): The value of a cash flow or series of cash flows at a specified future date.
• Land Expectation Value (LEV): The present value of an infinite series of net revenues from a perpetual series of timber rotations, less reforestation costs.
• Discounted Cash Flow: A valuation method used to estimate the value of an investment based on its expected future cash flows.
• Carbon Credits: A permit that allows the holder to emit a certain amount of carbon dioxide or other greenhouse gases.
• Illiquidity: The state of a security or other asset that cannot easily be sold or exchanged for cash without a substantial loss in value.

Private Markets Pathway Volume 2: Learning Module 6: Private Real Estate Investments; LOS 6(d): Discuss the distinctive investment characteristics of timberland and farmland