This is the second article in a series of articles designed to educate forest landowners about some of the basic principles involved in owning and investing in forest land. The motivation to begin this series comes from conversations with forest landowners and investors. I realize that some of the principles may be simple and straightforward, while some principles may be extremely complex and may require more explanation. I would like the topics in this series to be timely, relevant and dynamic, so I would appreciate your feedback. Please send feedback on the articles and suggestions for future articles to email@example.com.
Let’s begin our discussion on risks associated with forest land ownership and investing by discussing internal risk. The most common type of internal risk associated with forest land ownership and investing is financial risk. There are several types of financial risks associated with forest land 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 cause forest landowners 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 forest land can be very 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 forest land 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 forest land. As a caveat, let me say that 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 forest land 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 forest land through financial planning and preparation for future financial needs. By doing so landowners will be forced to prematurely withdraw monies dedicated to forest land investments.
A third type of internal financial risk is the risk of the unexpected cost of owning and managing forest land. Those of you who 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 a 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, 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 forest land investment and could affect the money available to conduct scheduled management activities on your property. At worst, a landowner may have to sell 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 the investment.
The final type of internal financial risk associated with forest land 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 forest land 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 very wise forest landowner educated me about his risk premium. He told me that if the internal rate of return on a forest land investment would not yield 5% to 6% 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 by 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 forest land investments and tree farms.
Robbie Hutchins is an associate area agent specializing in forestry for the AgCenter in the Central Region.