Timber ROR Basics

"ROR" is Rate of Return. You already knew that, but many forest owners use the ostrich approach to timber investments. They grow trees like grandpa or smokey bear did, and hope that scary math and economic theories go away by the time they pull their heads out of where ever they hid 'em.

TreeCents Answers Real Forestry Questions

Although forest economists really get off on the esoteric mathematical elegance of Faustmann formulations, the real reason you're using TreeCents is get straight forward answers to real management questions. On my own 400 acre Nora Creek Forest I've used TreeCents to ask questions such as:

How can I make my family forestry profitable?...Ask TreeCents!

How much should I pay for adjacent forested acres?...AskTreeCents!

Which wildlife habitat improvement also has timber income?...AskTreeCents!

Would log sales mitigate firescaping & view enhancement costs?...AskTreeCents!

Should I plant crops or trees into my conservation reserve acres?...Ask TreeCents!

Should I thin, or prune, or fertilize?...Ask TreeCents!

Does costly log sorting to different markets pay?...Ask TreeCents!

How long should my harvest cycle be?...Should I cut now or wait?...Ask TreeCents!

Estimate lost production costs of roads...landings...ponds...campgrounds?...Ask TreeCents!

How BIG are the tax breaks of private forestry...Ask TreeCents!

TreeCents Makes Complex Financial Stuff Easy

We're slowly building these pages to discuss the basics of the financial analysis theories and techniques that TreeCents uses to calculate financial returns. That should make what TreeCents does more understandable and credible. Unfortunately, business has been so hectic that this page is growing slower than we intended. By the time we're done, you'll find that timber finance is simpler than you thought, makes straight-forward logical sense, and can be really useful in making forestry choices. But you'll also be convinced that TreeCents will make it all easier.

Key Timber Financial Analysis Elements

	Financial & non-financial private forestry objectives are compatible
	God controls site quality, but you control how your trees grow and your pay off
	Visualizing the classic timber investment cash flow patterns
	Oops, costs don't occur in the same time or patterns as incomes
	Adjusting for pesky interest rates, inflation and value changes
	Profitability implies that it's nicer to have benefits bigger than costs&
	Taxes are inevitable, but manageable
	Making sense of obtuse acronym financial indicators
	Making profitable forestry and land use choices
	Tweak analyses to forage for even better returns
	Laughing all the way to the bank

We built some of this into the TreeCents manual, and you can download an example manual (see the TreeCents manual web page)

Financial and Non-financial Private Forestry Objectives

	Private forest owners rarely list profits as a reason for tree farming. There are usually 5 to 7 higher priority objectives ranging from family traditions, aesthetics, environmental stewardship. A recent study of newest forest owners shows rural lifestyle has highest positive appeal while timber management potential has negative appeal.
	The inconsistency is studies that find private forests to be among the most responsive to short-run timber market price changes. This is not hypocritical--for a private forest to exist long enough to be sustainable for any other purpose, it must be profitable.

TreeCents is designed to assess timber profitability in the context of silvicultural designs to achieve other objectives. Given two forest structures that control erosion or improve wildlife habitat or provide aesthetic vistas, with TreeCents we can easily spot the most cost effective option or even eke out dollar returns.

How Management Affects Quantitative Timber Yields

	There are so many forest practices applied to so many different forest types, it is impossible to describe or analyze a typical timber investment. That's why TreeCents is designed flexibly to allow owners to reflect their own unique forest and market conditions. First they need to know how their different silvicultral options affect forest biology and the physical condition of the forest.
	In this discussion, we'll ask a very basic silvicultural question about planning whether to thin an existing plantation after 10 years more growth. Presumably, thinning would not only accelerates income flows, but also concentrate growth on fewer healthier and more valuable trees. We'll ask this question in a forest region (the Inland West) that is not known for vigorous growth nor high valued markets. This investment decision should be really sensitive to both biological and financial decisions.
	First we went to a growth and yield model (FVS) to calculate future growth of the unthinned and thinned stand options over time. For this example we assumed that we had one acre of 40-year-old Douglas-fir plantation with 218 uniform trees on site index 90 land. We asked FVS to thin it next decade at age 50 and project the future yields. FVS took out a hypothetical 6.7 Thousand Board Feet (MBF) of merchantable timber and reflected lower future volumes in the thinned stand. In the graph unthinned yield is blue...thinned yield is green.

	Both yield options are biologically plausible. Thinning at age = 50 years would give us a cash flow from the 6.7 MBF removed. Future yields are lower, but presumably the remaining trees are healthier and more valuable. Indeed, FVS says if we wait to harvest at age 80, we'll be choosing between 85 trees with 20.6" DBH or 238 trees with 15.2" DBH.
	Oops, did you notice that even this simple example has a couple of complicating new wrinkles. Would a thinning of small trees in 10 years offset thinning costs? If do thin, what is the size premium ($$/MBF) for the bigger trees? And when should we cut the older stands to maximize our returns in either case? Thank goodness we can ask TreeCents!

Visualizing Timber Cycles as Cash Flow Patterns

	Forest owners aren't used to visualizing forest futures as cost and income flows. I rely on simple diagrams to convert acres, leaves and trunks into gross revenue and expenditure patterns. This step isn't necessary to run TreeCents cause it does all the math and finance conversions automatically. However, humans find this step to be a real visual aid.
	First, don't even think about what you invested in establishing this stand from time zero to today's age 40. The decision of whether to start this plantation is behind you--a done deal. Sunk (or historical costs) should have little influence on what's best to do with the 40-year-old Douglas-fir stand now.
	Next, make your forest changes really abstract. Visualize this as $/acre at particular points in time. You have thinned volume in 10 years (stand age 50) and harvest volume in 40 years (stand age 80). I like to convert my yield curves into gross cash flow/acre bar graphs. I can then expand this per acre estimate by the number of acres in the stand later.
	Multiply the volume harvested (MBF) per acre in some time by the average stumpage value ($/MBF) for that size class of trees. TreeCents does this internally in lots more detail from delivered log values, harvesting and hauling costs and volumes of logs from different tree sizes. For us, let's display our calculations simply in the bar graph. Use the conventions that costs are bars of different lengths down, gross revenues are bars appropriate length up and that the bars are spread along the x-axis according to their time of occurrence.

	In this example, only a $30/MBF size premium on 85 larger trees almost equilibrates the potential cash flows on 238 smaller trees out 40 years. So the apparent financial choice is between a little income next decade plus lots in year 40, or none today and slightly more in 40 years.
	Our example is so simple that it ignores operating costs, taxes, capital costs and market value changes. TreeCents remembers all the extra variables that you're willing to enter and would build them in automatically.

Building in Costs a Bit at a Time--The Biggest One First

	Remember that we're ignoring any costs prior to today, and there are probably no immediate costs in time zero.
	The biggest cost in forestry is the cost of the financial capital we have tied up in the trees. It represents the alternative amount that we could have earned if we had the same amount of financial capital represented by our initial 40-year-old plantation invested instead in a mutual fund paying 5%.
	This cost accumulates over time while the trees grow. At any moment that we don't cut we are reinvesting the forest stand capital into our on-going timber investment instead of into that tempting return in the mutual fund. Luckily, we can account for this cost easily and at the same time generate a financial indicator that will answer the "Should we thin?" question.
	Discounting is the process of adjusting for the alternative cost of capital. A future sum is recalculated as its present equivalent. This is the inverse of interest on a savings account where a present sum is compounded over the years by an interest rate to get a future value of the account in some year.
	The math of this involves exponential discounting. The simplest formula is called Net Present Value (NPV). It is the sum of costs (C) in some time (t) discounted by a discount rate (i) from their time of occurrence subtracted from the sum of discounted benefits (B) from their time (t). This is the classic formula. I’ve left out all the intertemporal adjustments and contingent cash flows that really complicate the forestry applications formulas

Not to worry. Any decent calculator will do this. But in TreeCents the process is so automatic that you don't even have to think about it.

A difficult part of the process is determining the right discount rate (i). There are complications like: which alternative investment return?...is it in real or inflated terms?...Is there a risk rate component? We're lucky that TreeCents would incorporate many of these concerns for us. In this simple example, we'll use a 5% annual percentage rate and assume away inflation. TreeCents would keep track.

	@ 5%, the NPV of not thinning is: $7500/(1.05)⁴⁰ or $4604/acre
	@ 5%, the NPV of thinning is: $900/(1.05)¹⁰+ $7200/(1.05)⁴⁰ or $4973/acre

	Anyway, the simple answer is thinning looks good. NPV thin > NPV unthinned
	Notice that the present discounted value is lots less than the future equivalent cash flows. Keep this in mind next time you win the lottery. The current payout will also be lots less than the total prize that the state typically drips our over 20 years.
	The NPV actually represents the current wealth equivalent of this acre to our personal financial portfolio. If more wealth is preferred to less, then the highest NPV tells us what the best forest management regime is. Thinning increases our current wealth by $369 per thinned acre.
	Is the 5% assumption critical? You bet your birches it is! A different rate gives a radically different estimate and if there are any significant up-front costs can easily reverse the decision. TreeCents will check the sensitivity of this assumption in about 7 seconds.

The highest NPV of all the hundreds of possible future regimes tells us the very best financial forestry management. It also gives us another insight to the value of this type of forest asset in a market transaction. If the NPV of forestry is higher than what your neighbor wants for his similar forest, buy it! If it is lower than what a subdivision developer offers you (and you have no non-dollar valued attachments to the place) you would sell it to be financially better off.

And if you do have non-dollar valued attachments that keep you in forestry, this tells you your own threshhold of at least how much you value them.

What About the Other Costs--Operations, Taxes, Administration?

	In real life these cash flow patterns can get really complicated--so much so that even financially astute analysts assume away the complications. Over simplification is a dangerous approach. Sometimes all it takes is one detail being large enough to radically change the basic answers to your forestry questions.
	In this example, what if thinning revenues were zero (precommercial thinning) and thinning costs weren't tax deductible? Yiii! You would have an up-front nondeductible cost that would blow away the present value of long run returns to thinning!

MORE TO COME AS WE CONTINUE TO BUILD THESE FINANCIAL ANALYSIS PAGES

However, the bottom line of this section is clear.

Financial analysis is really important

Although the logic is obvious, the math and formulations can be prohibitively complicated.

Why not let an inexpensive algorithm do the job for you?