Estimating Returns from Forest Investments

Kim D. Coder
Extension Forester

Coleman Dangerfield
Extension Agricultural Economist

February 1990

Land, capital, and labor have costs associated with their use because there are many competing uses for each. Only when there are unlimited resources, including time, can costs be disregarded. Economic analysis helps the potential investor determine the value, costs and potential returns of an investment.

Three types of economic analysis are discussed here. They are simple and can provide a landowner or forester with decision-making criteria based upon future dollar production. Long-range goals and objectives will influence the interpretation of economic analysis.

This publication is a summary of common economic analysis techniques. It will not provide detailed information about economic analysis techniques, but will provide a framework within which to work closely with your financial/forestry advisors. For your specific analysis, seek assistance from bankers, accountants, county Extension agents and professional foresters.

Forestry investments differ from other investments in several ways. Some expenses, such as management costs and property taxes, are annual. Other expenses, such as prescribed burning or thinning, occur irregularly. Expenses occur through forest stand rotation periods varying from five to 100 years.

The major return for most forestry investments comes at the end of a rotation, when final harvest occurs. A timber sale can include several products, such as veneer or peeler logs, pulpwood, sawtimber, chip-e-saw, plywood, poles and pilings, each of which must be inventoried, harvested and marketed. Hunting leases and intermediate harvests used to thin stands can also generate revenue.

Revenue is based upon volume of product produced, price for that product, and interest and inflation rates. Product volume depends upon site quality and past management history. Price depends upon local and regional market conditions, ease of stand access and stand quality. Economic analysis considers costs and revenues, investment time span and capital cost to estimate how quickly site and stand quality can be converted from trees into money.

Production forestry requires money to be invested for long periods. Costs and revenues occur at different times within a single rotation. The year in which each cost and revenue occurs, viewed over the time needed to complete one full rotation, determines the value of an investment. All costs and revenues can be recorded in a cash flow table that displays when in time costs and revenues exist.

Failure to analyze cash flow correctly can lead to two types of errors. The first occurs when a bad investment is accepted, and the second occurs when a good investment is rejected. The first type of error is far worse than the second. Careful analysis using correct cash flow information is critical to make wise forest investments, because unexpected costs or revenues can change the value of an investment completely. For example, an annual hunting lease fee could be a significant benefit, whereas a clump of beetle-killed trees would involve a significant cost.

Land purchase, taxes, inflation, land costs, cost of money and effects of time are some of the many factors that can influence economic analysis.

Land Purchase:

Purchasing forest land requires close attention to any factor affecting cash flow. The purchase price may or may not reflect the use of the land for timber production. Site productivity, slope, access and location relative to markets determine potential returns. Competing land uses and landuse regulations may preclude production forestry. If the land is already forested, the species, quantity and quality of the trees present are important factors for consideration.

Taxes:

Forestry investments should be calculated on an aftertax basis. Federal and state tax laws may recognize them as unique, long-term investments and provide some special benefits. Failure to take advantage of special tax treatments such as capital gains, reforestation expenses and management expenses costs money and discourages new or continued investment in timber production. An accurate analysis must reflect after-tax cash flows.

Factors affecting tax treatment include cost-share payments, professional management fees, physical maintenance of the site, protection costs and your tax bracket.

Inflation:

Inflation affects all cash flows, so they should include an estimated inflation rate factor. Interest rates used in an analysis should be adjusted for inflation. If the rates are not adjusted, cash flow estimates are incorrect because values are in current dollars, but all future income and costs are paid or received in future dollars. Future dollars are worth less than current dollars (see Table 1). A portion of this value loss is due to inflation.

Table 1: Comparison of present values of $1.00 at given interest rates over time (use a table with four or more decimal places for a more accurate analysis).

TIME	INTEREST RATE (%)															TIME
(years)	1	2	3	4	5	6	7	8	9	10	12	14	16	18	20	(years)
1	.99	.98	.97	.96	.95	.94	.93	.93	.92	.91	.89	.88	.86	.85	.83	1
2	.98	.96	.94	.92	.91	.89	.87	.86	.84	.83	.80	.77	.74	.72	.69	2
3	.97	.94	.92	.89	.86	.84	.82	.79	.77	.75	.71	.68	.64	.61	.58	3
4	.96	.92	.89	.85	.82	.79	.76	.74	.71	.68	.64	.59	.55	.52	.48	4
5	.95	.91	.86	.82	.78	.75	.71	.68	.65	.62	.57	.52	.48	.44	.40	5
6	.94	.89	.84	.79	.75	.71	.67	.63	.60	.56	.51	.46	.41	.37	.33	6
7	.93	.87	.81	.76	.71	.67	.66	.58	.55	.51	.45	.40	.35	.31	.28	7
8	.92	.85	.79	.73	.68	.63	.58	.54	.50	.47	.40	.35	.31	.27	.23	8
9	.91	.84	.77	.70	.64	.59	.54	.50	.46	.42	.36	.31	.26	.23	.19	9
10	.91	.82	.74	.68	.61	.56	.51	.46	.42	.39	.32	.27	.23	.19	.16	10
11	.90	.80	.72	.65	.58	.53	.48	.43	.39	.35	.29	.24	.20	.16	.13	11
12	.89	.79	.70	.62	.56	.50	.44	.40	.36	.32	.26	.21	.17	.14	.11	12
13	.88	.77	.68	.60	.53	.47	.42	.37	.33	.29	.23	.18	.15	.12	.09	13
14	.87	.76	.66	.58	.51	.44	.39	.34	.30	.26	.20	.16	.13	.10	.08	14
15	.86	.74	.64	.56	.48	.42	.36	.32	.27	.24	.18	.14	.11	.08	.06	15
16	.85	.73	.62	.53	.46	.39	.34	.29	.25	.22	.16	.12	.09	.07	.05	16
17	.84	.71	.61	.51	.44	.37	.32	.27	.23	.20	.15	.11	.08	.06	.05	17
18	.84	.70	.59	.49	.42	.35	.30	.25	.21	.18	.13	.09	.07	.05	.04	18
19	.83	.69	.57	.47	.40	.33	.28	.23	.19	.16	.12	.08	.06	.04	.03	19
20	.82	.67	.55	.46	.38	.31	.26	.21	.18	.15	.10	.07	.05	.04	.03	20
21	.81	.66	.54	.44	.36	.29	.24	.20	.16	.14	.09	.06	.04	.03	.02	21
22	.80	.65	.52	.42	.34	.28	.23	.18	.15	.12	.08	.06	.04	.03	.02	22
23	.80	.63	.51	.41	.33	.26	.21	.17	.14	.11	.07	.05	.03	.02	.02	23
24	.79	.62	.49	.39	.31	.25	.20	.16	.13	.10	.07	.04	.03	.02	.01	24
25	.78	.61	.48	.38	.30	.23	.18	.15	.12	.09	.06	.04	.02	.02	.01	25
30	.74	.55	.41	.31	.23	.17	.13	.10	.08	.06	.03	.02	.01	.01	0	30
35	.71	.50	.36	.25	.18	.13	.09	.07	.05	.04	.02	.01	.01	0	0	35
40	.67	.45	.31	.21	.14	.10	.07	.05	.03	.02	.01	.01	0	0	0	40
45	.64	.41	.26	.17	.11	.07	.05	.03	.02	.01	.01	0	0	0	0	45
50	.61	.37	.23	.14	.09	.05	.03	.02	.01	.01	0	0	0	0	0	50
75	.47	.23	.11	.05	.03	.01	.01	0	0	0	0	0	0	0	0	75
100	.37	.14	.05	.02	.01	0	0	0	0	0	0	0	0	0	0	100

Land Costs:

Forest investments concern timber production and land value or alternative land use. If a forest landowner can sell land, any income generated must exceed costs over time for value production and must exceed forgone opportunity costs associated with continued ownership. Forest landowners who will not sell land can ignore opportunity costs of holding onto the land. If land can not be sold and the money used elsewhere, then land costs are not considered in an analysis.

Cost of Money:

There are several ways of thinking about the cost of money. The cost can be considered the highest rate of return for the greatest amount of risk you can realistically accept. Alternatively, the cost of money is the least amount of income you will accept for making a particular investment. What rate of return, in a compound interest rate percentage, is the least you will accept? If the investment return rate goes below this value, your money should be invested elsewhere.

View all alternative investment opportunities in a similar fashion to decide which to choose. In all cases, be sure to examine after-tax returns. Your cost of money depends upon your credit rating, tax bracket, risk environment and possible alternatives.

Effects of Time:

Economic analysis accounts for the effect of time on money. In forestry, revenues are always at some future date, although costs may be incurred from the start. Because of the effect of time on money, maximizing simple dollar amounts will not work as an investment criterion. Income received in the future is worth less than an equal amount received now. Table 1 compares the present value of a dollar to its value up to 100 years in the future. The longer revenue is delayed, the less it is worth.

In production forestry, time is a valuable resource and can be considered a productive input with cost associated with its use.

Time influences interest rates, growth rates, taxes, risk and many other factors in forestry. Because forestry investments require decision tools that account for the time value of money, cash flows with compound interest rates are required. Compound interest rates ensure the time value of money is represensed in analysis (see Figure  1).

Figure 1: Time effercts on the financial aspects of an investment.

As costs and incomes occur further in the future, the uncertainty and risk associated with each increases. Time obscures future risks and leads to the acceptance of shorter investment periods.

Be aware of future price changes. Real price inflation for southern pine has historically amounted to two or three percent per year, although the rate some years is significantly different. This historical price data may or may not represent future price trends. Misjudging price trends can result in significant errors in analysis.