Thinking about forestland ownership?
Land ownership and private property rights are fundamental American values, God-given rights so important that our Founding Fathers specifically listed their protection in the Bill of Rights in the U.S. Constitution.
For many people, owning a piece of land, especially a tract of forestland, is the ultimate fulfillment of their American dream.
There are many reasons why one may choose to own forestland and every landowner’s reasons are different and unique to them. In addition, each landowner’s management goals are unique to them and often multifaceted. Each landowner is as diverse as each tract of forestland they own. However, for the purpose of providing some background information, let’s divide the various forest landowners into two very large, very inclusive groups.
Forestland for Investment
For the first group of forest landowners, the primary reason they choose to own forestland is for investment purposes. Typically, these landowners have invested in forestland because they view their forestland investment as a hedge against inflation and an opportunity to diversify a portion of their portfolio into assets with long-term performance that is not directly correlated to the performance of the stock market.
This group of landowners include private, nonindustrial forest landowners, traditional timber companies or one of the two common regulated entities that own forestland known as real estate investment trusts (REITs) or timber investment management organizations (TIMOs). This type of landowner is primarily concerned with making a profit on their investment through forest management and the associated timber harvests. Even though other non-timber forest resources such as wildlife may be important to them, these are secondary to their primary goal of timber production.
Forestland for Enjoyment, Conservation
For the second group of forest landowners, their primary reason to own forestland is because they want to enjoy non-timber forest resources such as recreation, water or wildlife. However, these landowners still manage their property for timber production by practicing sound forest management because they understand that good forest management promotes and protects their non-timber forest resources.
This group of forest landowners is made up primarily of nonindustrial forest landowners, government agencies, hunting clubs, conservation and preservation organizations and companies that specialize in outdoor recreation. In all but the most extreme cases, these landowners still want to profit off of their forestland through periodic timber harvests. These landowners also conduct a wide variety of forest management activities provided that those activities do not negatively affect the non-timber attributes for which they are managing.
No matter which group you may find yourself in both groups have three things in common. First, just like in any investment, both groups have to invest capital to own and manage forestland. Second, just like in any investment, there is a chance that an investment in forestland can be profitable. Third, just like in any investment, there is a chance that all or a portion of the invested capital could be lost or the investment may be unprofitable. This third point is commonly referred to as risk or business risk.
When asked about risk, Warren Buffett said, “Risk comes from not knowing what you are doing.” From my experience, it seems that only the most educated and sophisticated forest landowners and investors actually understand the types of risks associated with timber and forestland and their potential impacts on their forestland investment. Lets look at risk and how risk may affect your forestland and your investment.
Business risk can be divided into two broad categories: internal risks and external risks.
Internal risks are risks which arise from factors that can be influenced or controlled by the business owner or management. Internal risks cannot be eliminated, but in most cases their effects will be minimized and the duration of the impacts will be shortened through prior preparation and sound business management.
External risks are risks that arise from some variable that is outside the control of the business owner or management. Like internal risks, external risks cannot be eliminated. However, unlike internal risks, it is extremely difficult and sometimes impossible to lessen the effects of external risk by making sound management decisions. About the best one can hope for is that through prior preparation and active management the duration of any impacts resulting from external risks will be shortened.
It is very important for forest landowners to understand that both types of risks can result in losses, but sudden catastrophic losses in forestland investment are most often associated with external risks.
Lets begin our discussion on risks associated with forestland ownership and investing by discussing internal risk. The most common type of internal risk associated with forestland ownership and investing is financial risk. There are several types of financial risks associated with forestland ownership and investing. Remember, the good news is that you have the ability to minimize the impacts of internal risks by making wise management decisions. The bad news is failure to take into account any of these risks could be cause a forest landowner to lose part or all of their investment.
The first type of internal financial risk a forest landowner needs to be aware of is the risk of overpayment. Determining the true value of a tract of forestland can be difficult without proper knowledge and experience. That means that the risk of overpayment is extremely high. Overpayment at the time of purchase is a financial hurdle that can never be overcome. In redneck terms, it is practically guaranteed that forest landowners that pay too much for a tract of forestland will lose money on their investment without selling the land.
The good news is a potential landowner can eliminate the risk of overpayment by securing the services of a consulting forester to conduct a land and timber appraisal of the property to determine the market value of the tract prior to purchase.
The second type of internal financial risk a forest landowner needs to understand is the risk connected with the illiquidity of an investment in forestland. As a caveat, let me say this risk does not exist if a landowner is willing to sell the land. However, most forest landowners are unwilling to sell their land except in an absolute emergency. For these landowners any monies allocated to the value of premerchantable timber on any potential forestland purchase or any monies spent on the establishment of a timber stand on a tract currently owned constitute an illiquid investment. An illiquid investment is any investment that cannot easily be sold or exchanged for cash without a substantial loss in value. Premerchantable timber fits this definition perfectly.
In reality, standing timber has no real value to a forest landowner if the need to recover all or part of initial investment occurs prior to the timber growing to merchantable size. The only way a landowner can recover any of their initial investment in standing premerchantable timber is if the landowner sells all or part of the property.
The good news is that forest landowners can minimize the risks associated with illiquidity of an investment in forestland through financial planning and preparation for future financial needs. By doing so, landowners will be forced to prematurely withdraw monies dedicated to forestland investments.
A third type of internal financial risk is the risk of the unexpected cost of owning and managing forestland. Those of you that have owned property for years could do a better job discussing this than I will because of your experience. Most forest landowners understand the basic costs of land ownership.
Items such as periodic mortgage payments and property tax payments are expected. However, there are many unexpected costs associated with land ownership. These costs can really add up quickly. Unexpected costs could include costs of property improvement and maintenance such as surveys, gates, fences, posted signs, boundary line maintenance, culverts, dirt and gravel, mowing equipment, road building and road maintenance, fire line construction and maintenance, nuisance animal control, food plot installation and maintenance, utility costs and more.
At best, unexpected costs decrease the rate of return on your forestland investment and could affect the money available to conduct scheduled management activities on your property. At worst, a landowner may have to sell their land because the cost of ownership is higher than expected. The good news is that a forest landowner has the opportunity to effectively manage the risks associated with unexpected costs and minimize their impact on their investment.
The final type of internal financial risk associated with forestland ownership is the lack of a risk premium. Risk premium is the return in excess of a risk free rate of return an investment is expected to yield. In layman’s terms, risk premium is the extra money an investor gets paid to compensate for the risks involved with an investment.
An investment in forestland can be a very risky investment. Unfortunately, we will see that in greater detail when we discuss external risks. From a financial perspective, it is foolish to invest in risky assets unless you are getting paid a risk premium that justifies the risk.
When I was a young inexperienced forester, a wise forest landowner educated me about his risk premium. He told me that if the internal rate of return on a forestland investment would not yield 5 to 6 percent more than a AAA rated bond, his company would invest money in bonds instead of timber because of an insufficient risk premium. There is no real way to guarantee that you will receive a risk premium that compensates you for your investment risk. However, you minimize the risk of not receiving a risk premium doing everything you can to increase your overall return on your investment by not paying too much for your property, managing costs, especially the unexpected costs, and by taking advantage of the IRS tax breaks for actively managed forestland investments and tree farms.
Now let’s discuss external risks. Forest landowners and investors tend to be more concerned about external risks than internal risks even though external risks tend to materialize at a much less frequency than internal risks. That is because external risks are the risks typically responsible for catastrophic losses of standing timber and forestland investment capital. To compound the issue, there is little a small, nonindustrial, private landowner or investor can do to minimize the effects of external risks on their forestland or investment.
A real life example of one of the major external risks associated with forestland ownership known as market risk occurred with the unexpected decision of Georgia-Pacific to close the communication paper division, the wood yard, the pulp mill and the decision to discontinue accepting pine and hardwood roundwood deliveries at the GP Port Hudson facility. That affected mill workers, loggers, forest landowners and foresters across a large geographic area for a long time. For forest landowners with property in the affected area, the only local market for their pine and hardwood pulpwood literally disappeared overnight. Unfortunately, there is nothing landowners and investors could have done to minimize the effects of this decision on their investment. Thankfully, this degree of catastrophic sudden market disruption is very uncommon.
However, market risk involves much more than the potential for the complete closure of markets.
Many investors and landowners sometime forget that timber is a commodity and as a commodity the price fluctuates daily depending on supply and demand. Contrary to some investor presentations I have seen, stumpage prices do not increase each year in a nice straight line. Future increases in stumpage prices are not guaranteed and there is a real possibility that prices will not be at some previously predicted level when a tract is ready to harvest.
Market risks and risks to profitability resulting from pricing pressure often go hand and hand. It is important to understand that risks related to pricing pressure that often result in lower than average stumpage prices can be especially impactful to forest landowners who own relatively small acreages or for landowners whose holdings are concentrated in a single geographic area.
Another one of the major external risks of forestland ownership and investment is the risk of the loss of standing timber associated with natural factors. Natural factors often cause catastrophic loss of timber and other property in a concentrated geographic area. Natural factors can also temporarily disrupt markets by causing mill closures or transportation issues. Natural factors also can cause downward pricing pressure because of the large amount of salvaged timber forced into the supply chain in a short period of time.
Natural factors include a host of weather-related events that could damage tracts of timber such as hurricanes, tornadoes, ice storms and floods. Natural factors also include insects and diseases that cause widespread timber losses. Examples include insects such as the southern pine beetle, the emerald ash borer and the gypsy moth. Examples of diseases include oak wilt, chestnut blight and Dutch elm disease. Fire, whether started naturally or by man, also can damage or destroy large tracts of timber and cause widespread property damage.
The final type of external risk factor we will discuss is political risk. Political risk is the risk of financial or market losses resulting from political decisions or disruptions. For forest landowners and investors, political risk most often materializes when local, state or federal agencies attempt to increase their jurisdiction and scope of their regulatory authority or make government regulations more restrictive.
However, political risk is not limited to bureaucratic agencies. Political risk also can include the risks that new legislation or tariffs may be passed that may negatively affect operations or markets. Government shut down is another type of political risk that could affect forest landowners or investors. Thankfully, political risk is extremely low in the United States compared to other countries.
Even though there may be risks involved, owning and investing in forestland is a great way to diversify your investment portfolio while enjoying all the benefits of the American dream of land ownership.
(Robbie Hutchins is the LSU AgCenter Area Forestry & Wildlife Extension Agent for Central & Southwest Louisiana. You can reach him by email at email@example.com.)