| comment (1) in Forest Finance & Economics, Timber REITs, Timberlands

Timberland Obfuscation: How Equity Analysts Muddy the Inflation/Deflation Story

Another incomplete timberland investment thesis resurfaced: timberland as a deflation hedge. Chip Dillon of Vertical Research Partners dusted off this idea during a conference presentation in March. (We have had issues with timberland investment analysis from Mr. Dillon’s team in the past.) My inbox pinged and phone rang before the planes returning home had landed. I summarize the questions asked as, “does this make sense? How should we think about this?”

To set the table, let’s define our terms. Deflation is how we describe a general decline of prices in the economy. It is the opposite of inflation. For investors, deflation generally means falling prices for commodities, real estate and other hard assets. So they often find solace in bonds and cash, which gains value when prices fall (crazy, right?).

Mr. Dillon’s argument relies on a simple ratio of cash flow to discount rates. Lower rates imply higher values; higher rates imply lower values. This is really the dividend discount model in action:

  • If a stock pays $1.00 in dividends per year, and you expect a 10% return on your investment, you’d be willing to pay $10 per share: $1/0.10 = $10
  • If a 5% return meets your need, you’d be willing to pay $20 for said stock: $1/0.05 = $20


In this story, inflation is bad for timberland values, while deflation is good. Higher inflation (and interest rates) lead to higher borrowing (mortgage) costs, lower housing demand and, ultimately, weaker timber prices, timber cash flows and timberland values. Alternately, lower inflation (and interest rates) leads to lower discount rates and, ultimately, higher timberland values. Therefore, timberland does not hedge inflation, but it does hedge deflation through higher values.

The argument is incomplete and overstated. In practice, timberland values don’t change much or quickly as interest rates (or inflation) change. Timberland values tend to hold regardless the timber prices and cash flows because of strong demand for the asset class. This story reinforces why the deflation argument fails. Investors want in. Per the evidence to date, the link between timber prices and inflation and timberland valuations is more tenuous.

Understanding that high interest rates increase borrowing costs is simply one element of evaluating value and relevance for timberland investments. Timber satisfies a need for safety. As we have reported previously, timberland protects against unexpected inflation, and may serve different functions in low inflationary environments and, yes, deflationary environments, as well. What distinguishes timber from other commodities is the pairing of continuous, positive growth along with the ability to store volume and wealth over time as markets cycle.

We don’t live in an absolute returns world; we live in a relative returns world. Timberland remains attractive to institutional investors because it provides protectionary diversification during all types of markets and financial stress. A stronger argument with respect to alternate inflation scenarios recognizes land and timber as stores of wealth. In real terms, timberland investments stabilize portfolios.

Comments (1)

  1. A Riving Home / Reply

    Interesting contradiction going on here. In Mr. Dillon’s 2011 report, he states that evidence for a correlation between log prices and housing starts is lacking (which of course, you refuted, with statistical evidence). And yet this thesis relies on the presumption of a positive correlation between log prices and housing starts to make the narrative work. Though still incorrect (or at least incomplete), I suppose this is progress?

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