Aunt Fanny sighed loudly and kicked the dirt. A pinecone ricocheted off a nearby white oak before landing in a mound of dirt and leaves. Two dogs barked in the distance.
“Nephew, I have a few thoughts regarding the value of land.”
“Yes?” I asked.
“When I worked at the bank, we liked giving loans for investments in buildings because these generated cash and provided reliable collateral,” said Aunt Fanny, recalling her days as a regional vice president for a community bank.
“Yes, real assets produce,” I said.
“Exactly,” said Aunt Fanny. “So a building, for example, had some value no matter who owned it.” And then she paused and raised her finger to make a point. “But the building had more value if managed well. It required less maintenance, earned higher rents and stayed occupied more consistently with tenants.”
I waited while Aunt Fanny caught her breath and toed the dirt again. The dogs had stopped barking, perhaps to listen.
“Nephew, how does this work with land?” she asked. “How do we value the land?”
“Well, what you said for the building holds, in a way, for forestland,” I said. “A well managed forest creates more income.”
“Tell me more,” said Aunt Fanny. “From an investment point of view.”
“Okay,” I said. “The value of the forestland relates to the income it generates from, mostly, growing trees. Basically, if one piece of land with a good management plan can grow more merchantable trees than another piece of land, the first has more value as an investment.”
“You figure this out yourself?” asked Aunt Fanny.
“A German forester named Martin Faustmann figured it out in 1849.”
“Who is this Martin fellow?” she asked. “I love history.”
“He was a forester and an appraiser. One day he read an article about forest valuation that made him scratch his head,” I said. “The article said that forestland is worth the income you earn from a single rotation.”
“Well that doesn’t make sense,” said Aunt Fanny. “It’s like saying a building is worth the income from the first lease.”
“Sort of,” I said. “If the first lease was for 20 or 30 years. Faustmann’s insight was that after you harvest, you will replant and grow a second forest and then a third forest and so on. Each of those forests have value that should be reflected in the current price.”
“But those trees probably won’t generate cash for me,” said Aunt Fanny. “They would happen in 50 years!”
“That’s true, but they still have value, even if just a few percent of the total in today’s dollars,” I said. “It’s an opportunity cost associated with owning the land.”
“Faustmann wrote up and published a different technique for valuing bare forestland, or ‘dirt,’ for tax purposes,” I said. “And to this day, Faustmann’s formula – referred to as ‘bare land value’ or ‘BLV’ or land expectation value – remains a standard model for estimating the optimal timber rotation age and maximizing forest value in short and long-term analysis.”
“Nephew, that was too much lecture and not enough entertainment,” said Aunt Fanny.
“Well what did the monkey say when he caught his tail in the lawnmower?”
“What?” ask Aunt Fanny.
“Won’t be long now,” I said, matter of fact.
“Oh, Nephew,” groaned Aunt Fanny. “No soup for you!”
“Sorry,” I said. “Anyway, Faustmann’s formula helped shape forest economics as we know it.”
“My experience with formulas and models is that they are usually wrong,” said Aunt Fanny, raising an eyebrow at me Spock-like.
“Yes, that’s true,” I said. “So we use ‘bare land value’ with caution. BLV serves us best as a guide. It takes our best information and assumptions, and lets us make comparisons between forest management plans or different properties.”
“It’s tool in the toolbox. I get it,” said Aunt Fanny.
“That’s right,” I said. “And some say that Faustmann, with this analysis, was one of the first to correctly use compound interest rates in discounted cash flow analysis. As a forester, I’m proud that another forester was a pioneer in analyzing real estate investments.”
“I can see why,” said Aunt Fanny. “He figured out the value of dirt.”