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Timberland Investing - A Good Deal At The Right Price For The Right Reason

Investors in timberland have been banking substantial risk adjusted returns in this asset class for the last century. Their secret was to hold it for a long time. The trees grew, increasing the volume of valuable timber. The trees mature from small-diameters to saw timber diameters, and when this “in-growth” threshold was crossed it compounded a tree’s value many times over. You could harvest your timberlands on a rotation based on age and current market conditions providing cash flow. And the dirt itself continued to appreciate as our population grew.
 
The strategy of holding timberland was based on the assumption that the U.S. economy would continue to grow over the long-term, that cyclical ups and downs would trend up over decades, that people would need to build wood-intensive houses and that wood products would continue to benefit from growing global demand.
 
Most investors who bought and held did just fine, because the underlying economic forces performed as expected and the trees grew.
 
In recent decades, institutional investors and their Timber Investment Management Organizations (TIMO) have shortened the holding period. “Flipping” made both small speculators and TIMOs a lot of money. Buying a large tract at a wholesale price (timberland price), parting it out (cut some timber, divide the property and sell it for higher and better use (NYSEARCA:HBU) and, maybe, putting a conservation easement on it for the tax benefits–this became a common investor strategy. Flipping shortens the holding period as much as possible.
 
You can, however, play the flipping game only so many times within a few years. The last flipper in line gets stuck, much like the last guy in a chain letter.
 
I have been looking at a lot of land over the last two years and it feels like I may be the last guy in the chain letter. Some of these TIMO sellers have been attempting to auction small investor tracts, less than 1,000 acres at prices significantly higher than the same type of tract in a 10,000 acre offering. I understand the “wholesale” trading game as well as anyone but the economics must also work for the small individual investor. Most of the “odd lot” TIMO offered tracts simply do not make economic sense based on their current offering prices.  
 
Most small timberland investors don’t apply sophisticated analytical tools to their decisions. They look at the purchase price in relation to comparable values. Or they value the assets in light of the purchase price; if the parts exceed the cost of the property as a whole, they buy. Or they estimate the value of selling some of the land’s assets, earning annual income from others and then selling the remainder at some future date for more than they have in it.
 
Another way of approaching a purchase is discounted cash-flow (DCF) analysis. This method values an investment by estimating its future cash production and then discounting that number by the time value of the money invested and the risk involved. DCF can be adapted to a single cash event (i.e., buy 1000 acres for $1,000,000 and then sell it for $1,750,000 five years later, leaving $750,000 in gross cash) or multiple cash events (i.e., a big tract of timberland that is managed to produce timber-sale and hunting-lease income each year, along with sometime sales of pieces of the land base). If the rate of return on the investment is zero or negative after all the costs over time are counted and all the discounts are applied, it’s not a good deal. DCF analysis must incorporate assumptions about interest rates, risk and other factors that may be little more than a guess. An investment decision based solely on DCF analysis may or may not work out.
 
After our recent economic calamity in 2008 and resulting deep recession, I think things have changed and we can’t estimate the future in the ways we’ve done in the past. A higher embedded risk may be our future. This would be the long-term impact of the continuing mortgage melt down, all the efforts to address it and all the needed changes that don’t seem to be on the national agenda.
 
I continue to think that land and timberland will be better investments than stocks, bonds and commercial real estate in the future. Land values will rise because of population growth if nothing else. As a finite resource, more people mean continued demand and appreciating prices, even if the middle-class shrinks some as the consequence of structural changes in the economy. Timber markets, I think, will change, but the net shake out is likely to be something more diverse—traditional markets, plus biomass energy of different types and carbon credit markets. Faster growing species will bring down the cost of lumber and its products, increasing demand overall.
 
I’d look at timberland investments over a three-to-five year period or over a very long time, say 20 plus years. It’s the period in-between that poses the most risk.
 
For the individual timberland investor I suggest this basic formula: If the amount of merchantable timber on a property represents at least 50 percent of the purchase price, you’re likely to make money either short-term or long-term. If it does not, the investment needs to be for reasons other than financial. That’s OK as it is hard to put a monetary value on the serenity factor of owning timberland for recreational and personal enjoyment. Just make sure of your objectives before making the decision to invest.
 
Let me know what you think.