As noted in Part I of this series, cash-on-cash return (COCR) provides one way for real estate investors to quickly compare the profitability of different income-producing properties or investments. However, it has limits for measuring returns or wealth creation over time. This makes cash-on-cash returns a problematic performance metric for timberland investments.
Specifically, COCR does not account for the time value of money. Cash-on-cash return must be restricted to simply measuring a residential income property’s first year cash flow and not its future year’s cash flows. Why? The first year’s COCR estimate will be the most accurate; each successive year becomes increasingly speculative.
Also, COCR does not account for appreciation. Lower COCR today may lead to a greater opportunity for appreciation than acquiring a property with steady COCR and little or no appreciation. For timberlands in particular, a meaningful analysis should account for the facts that rates of timber growth differ by age, investment objectives differ by timber portfolio, and the pace of increased values vary as forests grow and move through higher product classes in changing markets over time.
For example, buying and owning a juvenile 8-year old forest for ten years may generate minimal cash flows while appreciating in value through biological and product growth. Alternately, buying and owning a mature 30-year old plantation may generate tremendous cash flows in the first year while appreciating minimally. While the juvenile forest may have a low COCR, it may in fact prove a superior value creating investment when evaluated using discounted cash flow (DCF) measures such as net present value (NPV) and internal rate of return (IRR).
The next post will compare COCR to internal rate of return (IRR) and return on investment (ROI) for evaluating timber investments. Click here to register for “Applied Forest Finance” on February 7th in Atlanta. The course details necessary skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments.