Economics of Timber Production on Private Land in Indiana Economics or Finance? Economics Timber owner is in general a price taker Competitive market position Market for high quality timber of preferred species is global, unitary to slightly elastic demand Market for low quality timber and non-preferred species is local, highly inelastic demand Weighted Average Price, Quality Stand 700 600 Nominal 400 1982 $’s 300 Trend line – 1.4% 200 100 Year 05 03 01 99 97 95 93 91 89 87 85 83 81 79 77 75 73 71 69 67 65 63 61 59 0 57 $ per MBF 500 Black Cherry Sawlogs, Real 1600 1400 1000 800 600 400 200 Year 5 02 99 96 93 90 87 84 81 78 75 72 69 66 63 60 0 57 1982 $'s per MBF 1200 Year 5 02 99 96 93 90 87 84 81 78 75 72 69 66 63 60 57 1982 $'s per MBF Beech Sawlog Prices, Real 250 200 150 100 50 0 Indiana Farm Real Estate 3500 3000 2000 1982 $’s Trend line 1.3% 1500 1000 Nominal $’s 500 0 19 57 19 60 19 63 19 66 19 69 19 72 19 75 19 78 19 81 19 84 19 87 19 90 19 93 19 96 19 99 20 02 20 05 $ per Acre 2500 Year Economics or Finance? Finance Capital intensive Land Growing stock Long-term Highly appreciated Position in Investment Markets Primarily a “life-style” investment Highest and best use not timber production Some vertical integration Not attractive to institutional investors and private equity capital Cost of entry may exceed income potential Can’t capture economies of scale Can’t economically accumulate tracts into investment grade bundles Limits resale market to other lifestyle investors Standard Measures of Financial Return Net present value (NPV) Present value of discounted stream of revenues and expenses V0 = Vn/(1+i)n Internal rate of return Discount rate that makes NPV zero NPV Calculation Enter land and timber growing stock as upfront CAPITAL cost Standard assumption – capital costs based on fair market value, Life style assumption – capital cost based on actual cost, or zero if inherited Discount (interest) rate used Nominal – rate on long-term corporate bonds Real – nominal reduced by average inflation rate Real Interest Rate, 10-Yr. Treas. Sec., 3-Yr. Moving Average 12.00 10.00 8.00 6.00 4.00 2.00 -4.00 -6.00 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 -2.00 1964 0.00 NPV Calculation Time period Date of acquisition, to Expected date of death, or date of liquidation Ending return on capital Bequest - none Standard - sale price (FMV) of land and growing stock Operating Costs Allocate between personal and business use Property taxes Management fees Depreciation on equipment Other Operating Revenues Timber income Generally assume all-age management with periodic harvests Estimate mean annual increment Project timber price Other income Hunting lease payments Non-timber forest products Sale of development rights Willingness to Pay for Land (WPL) Net present value of stream of revenues and expenses Represents amount that can be paid for land and growing stock Discount rate represents opportunity cost of tying up capital in timber production instead of next best opportunity Base Case, WPL, No Bequest Liquidate at dod, assumed to be 40 years 3% real discount rate Liquidate land at $1,500 per acre Liquidate all timber at $587/MBF real Base Case, WPL, No Bequest Per acre costs Annual - $20.00 Every 5 years - $250 Mean annual increment – 250 mbf Harvest revenue Every 10 years, 2.5 MBF Price – quality stand price series, $643 nominal, $397 real Linear real price increase, $4.33 per year Base Case, WPL, No Bequest – Liquidate WPL40 = $1,755 per acre, real WPL40 = $2,845 per acre, nominal Base Case, WPL, Bequest WPL40 = $755 per acre, real WPL40 = $1,208 per acre, nominal Barton Tree Farm (BTF) Acreage – 292 Initial acquisition in 1980 Acquisition cost - $175,250 Total timber revenue - $324,800 BTF Initial Cost and Timber Revenues 1980 -$175,248.00 1984 $11,313.00 1985 $11,678.00 1988 $9,503.60 1990 $14,323.35 1995 $21,951.08 1997 $61,746.95 1998 $387.91 1999 $85,300.00 2001 $70,102.00 2005 $38,500 BTF Rate of Return, No Expenses, Bequest No operating or holding costs included i = ($324,800/$175,250)1/25 -1 = 7.4% IRR = 2.50% nominal Internal Rate of Return 3.65% nominal 2.65% nominal after-tax Inflation averaged 2.31% from 1980 to 2005 BTF, Rate of Return, Bequest Annual cost - $15.05 per acre per year, $4,400 per year Before tax IRR – 0.89% After tax – 28% ordinary, 15% capital gain IRR – 0.5% after-tax No Bequest, Liquidate $15.05 per acre per year cost Sell land for $1,500 per acre Sell 2,354 MBF timber for $660/MBF $438,000 $1,553,640 ($5,320/acre) IRR Before tax – 10.8% After tax – 10.2%