Time to discount the discount rate?

Q: In a recent LinkedIn article, you clearly express a preference for an approach that combines Implied Discount Rate and relative-risk analysis, compared with WACC/CAPM, to compute discount rates. What proportion of investors already follow such a method, as far as you know? 

RH: I think that most timberland investors use a combination of approaches to decide how to price an acquisition. Direct investors, such as family offices or institutional investors, may have cost-of-capital or return targets dictated to them by their portfolio or cash and return requirements. Most timberland investment managers are guided by their investment guidelines (return targets) which dictate the investments or regions where they might be competitive in acquiring assets.

I think that most timber investment managers already consider the country and asset risks of an investment relative to other investments in their acquisition proformas and adjust the discount rate accordingly. However, there is no set approach for this analysis, and appraisers have yet to formulate a standardized approach to “relative risk”, so tend to fall back on trying to calculate WACC and CAPM’s which have little relevance to the asset class.

Q: How can you get an objective measure of asset-specific risks in the relative-risk method?

RH: In work I have done previously on this question, I considered: 1. physical asset risks (susceptibility to fire, insect or disease relative to the “gold standard”); 2. legal risks (availability of title insurance, government support of titles, prevalence of invasion, squatting, takings); and 3. market risks (breadth, depth and volatility of the local markets for all assortments of timber produced by the asset) in formulating an index I used to compare assets. It remains mostly qualitative, but the data on these factors continue to improve, so more quantitative analysis is becoming easier.

Q: What are the risks, both at the investor and industry levels, of getting discount rates wrong?

RH: The main risk for an investor is, of course, that you overpay for an asset, and that performance does not come close to the return modelled in the acquisition model as you have underestimated the risks or volatility of the asset. For the industry, the same risk exists on a regional level, which means that properties in a certain geography are acquired at prices that are not justified by the true risks of the assets.

Let’s use Brazil over the past 10 years as a perfect example. Timberland investors overall probably bought into Brazil at too low a discount rate that did not reflect the fact that there are still substantial legal risks (such as the government’s restriction on foreign ownership in 2010-11), market risks (both the pine sawmill industry and eucalyptus for charcoal industries collapsed during the GFC and have yet to recover), and currency risks (investors bought in at all-time BRL highs of 1.6 to the dollar, which in recent years fell to as low as 4.0 to the dollar). As a result, investments have dramatically underperformed and many investors have walked away from the geography.

Q: How long before we get more standardized performance data in timber?

RH: Unfortunately, there is no international measure of timberland investment performance at the current time. The NCREIF group has tried to create one, but it has not yet been successful. Although NCREIF data suffer from a variety of problems, they are the best available for the US market. There are indices in the UK, and others scattered around, but no uniform timberland investment performance measurement index. I suspect we are five to 10 years away from any kind of index that might be useful – and that is only if quarterly performance data from “open-ended” funds become more available to the marketplace.

Q: In the article you forecasted a marginal increase in discount rates. By how much do you think they’ll rise, and in what time frame?

RH: I think there is upward pressure based on global increases in interest rates, but we are talking about 1-1.5 percent upward movement, and not until the supply of timberland assets available to the market exceeds the demand of capital looking to buy those assets, which is three to five years out. If timber prices begin to increase (I expect to see continued upward movement in conifer timber prices over the next 10 to 15 years – which is a reversal from the trend of the past 20 years), discount rates may remain in the 5 percent range for the “gold standard” as more capital will want into the space.

Q: Where do you see the strongest appetite for timber assets coming from? 

RH: I think timberland investments will be increasingly funded by large investors (sovereign wealth, large pensions, insurance companies), and by small niche investors (family offices, impact investors etc.) on a separate-account basis. There is likely to be a decline in small pension fund investors as returns don’t justify the complexity/uniqueness of the asset class, and also a decline in commingled fund products.

Robert Hagler is the principal of ForestEdge, an investment advisor and timberland investment manager.