This post is the first in a series related to the Q1 2022 Forisk Research Quarterly (FRQ). It includes topics that will also be addressed in the (virtual) Applied Forest Finance course on May 19th, 2022.
Years ago, a forest industry executive told me, “You only get to cut a tree once.” He made the point that, “our trees are in the ground already. So, how do we maximize the value of the forests we have?” That conversation, nearly 20 years ago, has a different flavor today as timberland investors consider new forest carbon opportunities, supply chain disruptions and macroeconomic uncertainties.
With that in mind, recent discussions with institutional investors and industry executives have touched on common themes and concerns that remain relevant. These include:
Discount Rates
One timberland CFO said, “when people start talking about ‘real discount rates’, the number they share often conveys less information than the speaker or hearer intends.” This issue, whether a function of communication or analytics, aggravates appraisers and investment committees alike. Even if all parties in the room agree, “let’s apply a real discount rate of X%”, the ensuing application requires further confirmation with respect to cost assumptions, timber price appreciation rates and land values over time.
That said, what have we observed with real discounts applied to timberland investments over the past twenty years? Beginning in the early 2000’s, real discount rates declined from around 7% in 2000-2001 to around 6% in 2005-2006 before stepping down to 4-5% in 2007-2008. Following the Great Recession of 2007-2009, rates stepped up to and above 6% by 2010. More recently, over the past several years, real rates in the U.S. returned to 4-5%.
Risk Management
In our work with clients, we’ve seen a shift from talking about risk in financial terms to managing risk as an operational imperative. The basic struggle to get “rubber under the wood” and deliver needed logs to hungry mills during hot lumber markets increased investor implications and exposure to short term supply chain disruptions. Analytically and for annual budgeting, these can overwhelm the timber market fundamentals associated with forest supplies and wood demand.
Supply chain stresses have (1) highlighted the importance of locating in good local markets and (2) increased the appreciation for operational competence. For the first and from a traditional risk management perspective, securing timberland assets with good proximity to diverse, well-capitalized wood-using markets is akin setting up a natural, risk mitigating hedge, as timber assets in poor wood markets suffer disproportionately during recessions.
For the second, my view is that managing risk means being one of the best in your business. Someone always makes money, regardless the sector or geography or economic cycle. Investors that partner with strong operators that are good at what they do with solid business relationships and a clear understanding of costs and value are well-positioned to prosper. Managing risk means constantly revisiting the question, “Are we maximizing value – making the best investment decisions we can – of the timber assets we have given the current situation and available information?”
Thanks for this, Brooks. I’m interested in your observation above that real discount rates stepped up by 100-200 BP following the Great Recession. In my 2010 White Paper, “US Timberland Post Recession, Is It the Same Asset”, I predicted similar behavior, but in the years following I concluded that I got it wrong and the up-tick never materialized. Are you saying that I actually got it right? Hey, I’ll buy that! You also note that it has since returned to 4-5%. What do you suppose happened to the market perception of risk to cause it to go down again? Is that the “carbon effect?”
Jim: appreciate your faithful reading and comments! Yes, I remember your paper and am always respectful of having time pass to offer helpful perspective and context. Looking back validates your intuition. On the current situation, a few observations seem relevant (but we may need time to better understand which one “drives” the valuation models): one is that capital allocation to timberland remains strong, robust and persistent. So the demand is there from tradition buys. Two is that one motivate centers on securing assets in the “winning” markets (e.g. the ones with all of the new mills). And, three, yes, hits your final question: we have new investors with new ESG investment theses entering the fray (and giving traditional timberland appraisers a lot of heartburn). We’ll compare notes in a few years… – Brooks
Dr. Brooks is good at predicting the timber market. Thanks for this observation. I actually thought it was the other way round. Although, it is entirely different in Nigeria. Timber rates continue to increase every year