The Evaluation of Timberland Assets – Drivers of Under-Performance

Background

Timberland assets are different. Investors considering the acquisition of a timberland property face the unique challenge of valuing a non-uniform, organic asset that naturally evolves over time. In its simplest form, a timberland asset might mirror an apartment building that not only creates new apartment units each year, but constantly improves the quality of existing apartments with little additional investment. These characteristics are well-known to foresters and timberland investment groups of course, and are built into valuations, but even these experts must navigate a multitude of economic and biological variables when evaluating timberland investment properties. Mistakes can be made, and are probably the largest single cause of under-performance of assets in the sector. In the due diligence process, particular attention needs to be paid to certain biological, legal, and market factors as they are often the difference between above, or below, pro-forma investment performance.

Biology

The biological metrics used to value a timberland asset are constantly being improved but are far from standardized. Investors will recognize that the boundaries of a timberland asset can be checked with great accuracy, but that volume due diligence remains a variable as it is verified through sampling methods (a sampling of trees are measured and the result extrapolated to the entire asset). Estimates of volume, and value, can vary depending on the sampling methodology employed. The greatest opportunity for error, however, is in the growth and yield models that are used to predict how the forest will age and respond to silvicultural treatments such as fertilization, thinning, harvest activities, or improved growing stock (such as clonal seedlings). An overly optimistic growth and yield forecast results in a harvest schedule (cash flow projections) that may be unattainable on a sustained basis, and likely over-investment in the asset.        

Legal

In many investment geographies, legal attributes such as land titles, easements, and environmental restrictions and set-asides for a timberland asset are recognized and well documented. However, several jurisdictions (including parts of the US) have enacted restrictions on foreign ownership of agricultural lands, and such restrictions can prohibit, or increase the costs of investment. The 2010 AGU opinion in Brazil against foreign investment in agricultural lands (which included plantation forests by default) for example, clearly depressed the market for timberland properties by reducing the number of potential buyers willing to structure investments around the new restrictions.

Investors may also attempt to structure investments to maximize tax efficiency through the use of thin-capitalization laws and tax-efficient LLC domiciles. However, these can be over-engineered as the total costs of operating multiple layered investment structures can sometimes overwhelm the savings. It may look good on paper, but at the end of the day, may not be accretive to the investment.

Markets

Timber and timberland market due diligence is a target-rich environment for investment mis-calculations. Investors need to understand not only the breath of the regional roundwood market (are there markets for all the roundwood products harvested from the property?), but also the depth (multiple buyers for each product?), and viability of those buyers. A great timberland property being sold by a large sawmill operator going out of business should give pause to a potential buyer. While a single product investment (e.g. a fast-growing eucalyptus pulpwood asset) may be an excellent investment opportunity, it represents a higher market risk than a multi-product investment. Mis-calculation of market breath, depth or viability often results in missed cash flows, and asset under-performance.

Market due diligence of a timberland investment inevitably leads to a DCF model price forecast. As has been documented by ForestEdge LLC and elsewhere, real price increases in roundwood timber products over the last 20 years have been the exception, rather than the rule. In a balanced timber supply-demand scenario, prices tend to increase in step with, or slightly below local inflation. There are exceptions of course, such as when prices are significantly below trend-line levels, or far below freight equalized levels due to short term regional market imbalances or economic conditions. However, an aggressive price forecast for an extended period of time can dramatically alter pro-forma return expectations, lead to investment under-performance, and should be a red flag to investors.         

The valuation of timberland properties has greatly improved over the past 30 years. Buyers and sellers have better information, yet timberland asset acquisition values continue to vary widely. Professional timberland investment Fund managers such as most TIMO and REIT groups have well established protocols, but of course must forecast using the same clouded crystal ball as other investors. The growing number of direct investors have the option of hiring in evaluation expertise as needed. For such direct investors, or investors who participate in discretionary accounts, this could be money well spent as enhanced due diligence by an experienced, 3rd party transaction professional might improve investment outcomes.  

R. Hagler
July 2017

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