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Why interest rates differ in timberland investments?

Posted by on Aug 16, 2017 in forest business |
Why interest rates differ in timberland investments?

Like in every business, financial analysis is the core of timberland investments. If it is properly done, it can reduce the level of risk in our forestry investment portfolio. This post describes why interest rates differ in timberland investments, and why investors should be careful in their decisions. 

What complicates financial analysis in forestry?

Generally speaking, alternatives in forestry that generate the most money, after expenses, are the most profitable. However, things in our financial analysis in forestry can appear more complicated than that.

One of the primary factors that complicates our financial analysis is the timing. Because forestry is a very capital-intensive business (a lot of money is usually tied up in the land and trees), the knowledge of discounting and compounding is crucial in the process of evaluating the cash flows associated with different management scenarios in order to determine their relative profitability.

The interest rate, which can be interpreted as the cost of capital because the use of capital always has opportunity costs (you can always invest it somewhere), is an important concept in financial analysis in forestry.

Interest rates- why they differ?

Why do we have so many different interest rates? Why are the interest rates on credit cards so high, while the interest rate on savings accounts are so low? Often, these question arise and confuse many people.

The answer is that each investment is simply different, and risk, liquidity and other factors described below are perhaps the most important here that make difference between different investments. Each individual investment shapes the particular interest rate for each investment.

Every rate of return on an investment can be broaken down into following equation:

RATE OF RETURN = PURE INTEREST RATE + INVESTMENT SPECIFIC FACTORS

Pure interest rate reflects the pure cost of using money. Let’s focus now on five factors that affect the expected rate of return.

Risk

In forest and any other business, risk is often defined as the likelihood that the invested money will be lost, or that the rate of return will be lower than expected. Since the future is inherently uncertain, all investments involve some level of risk. Some investments, like government bonds have minimal risk, and the risk premium on such investments is quite small. On the other hand, other investments, like venture capital and futures opitons, are quite risky. Usually, such investments offer a higher expected rate of return, and the extra interest is the premium investors earn for bearing the risks associated with these investments.

Although some sources of risk could change the forest production (such as pests and diseases, fire, wind, climate change, etc), and some sources of risk could change the net present values (e.g. price fluctuation and marketing), forestry and timberland investments, in general, are considered as a safe and long-term investments. For instance, NEPCon provides forestry risk profiles for countries such as Cameroon, Brazil or Indonesia, where some types of risks are discussed.

Nevertheless, the interest rates depends often on the location of our timberland investment, and related to that growing conditions. Generally speaking, interest rates in forestry can vary from very low, e.g. around 0-2% for hardwoods with long rotation age in Europe, up to even 10-15% for fast-growing Eucalyptus and Radiata Pines in Brazil or New Zealand.

Liquidity

No doubt, investments also differ in terms of their liquidity – that is, the ease with which investors can withdraw their money prematurely from the investment. In this aspect, timberland investments are not like saving accounts in a bank, where we can withdraw money at any time. Sometimes it takes time. In other words, forest assets are relatively illiquid, and it takes sometimes more time to withdraw our money prematurely from such investment.

Nevertheless, such investements that lock up investors’ money would be expected to produce a higher rate of return, relative to investment where investors can get their money out at any time.

Transactions costs

In this big group, we can include, for instance, appraisal fees, loan orgination fees, different commissions etc.

Taxes

As B. Franklin said “in this world nothing can be said to be certain, except death and taxes”  and forestry here is not an exception. Different forest investments around the globe have different tax implications: such as capital gains tratment, property taxes etc.

Time period

In forestry, time period plays very important role as longer forest investments tend to be less liquid and more uncertain.

Without doubt, each of above factors generally adds to the pure rate of return that an investment must earn in order to be attractive to investors. It is good to remember that the interest rate, includes a pure rate (the opportunity costs of using money) and premiums to account for the riskiness, illiquidity, taxes, transactions costs, and time period of the particular investment. These premiums are very important, because without them people would not be willing to place their money in more risky investments. 

High nominal rates are nice, but high real interest rates are even nicer

To sum up, each forest investment is often different in terms of riskiness, liquidity, taxes, time period, and transaction costs. These components are very crucial and necessary to compensate investors for different aspects of the investment. Nevertheless, a key component is inflation. We should never ignore inflation, and we should always remember that in a world with inflation, the interest rate must cover both inflation and the cost of capital.

Sometimes we can get very high and nice looking rates of returns, but when we include inflation, we will notice very fast that maybe the investment is not as attractive as we thought at the beginning.


Author of the post: 

Rafal ChudyRafal Chudy – PhD Candidate in forest and resource economics at the Faculty of Environmental Sciences and Natural Resource Management, Norwegian University of Life Sciences (NMBU). He has acquired the international experience in forestry and forest economics at North Carolina State University, Swedish University of Agricultural Sciences, Oregon State University, University of Helsinki, University of Hamburg and Warsaw School of Economics. Rafal has gained profesional experience as forest economists and analyst at United States Department of Agriculture, National Forest Holding in Poland and many other companies from private sector.