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You’ve got it wrong on discount rates

Investors continue to rely on traditional metrics when trying to price timberland acquisitions. That’s a mistake, and it will have consequences.

It’s rare for a single number to exert such outsize influence. Yet discount rates can “make or break” the performance of an investment, says Robert Hagler, the principal of timberland investment manager ForestEdge. Get it wrong and your months of due diligence instantly become irrelevant.

“The main risk for an investor is that you overpay for an asset, and that performance does not come close to the return modelled in the acquisition model as you have under-estimated the risks or volatility of the asset,” Hagler told us. “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.”

It’s worth noting that debates over discount rates are raging across several private asset classes. Intermittent valuation tends to create a host of problems that investors are trying to reconcile when appraising infrastructure assets, for instance.

Those issues are just as acute when dealing with forestry. The only timber performance data available so far – NCREIF’s indexes – remain largely confined to US investments; although they do a decent job at that, their reliance on periodic appraisals also means they are not watertight. Elsewhere we’re mostly in the dark. “There are indices in the UK, and others scattered around, but no uniform timberland investment performance measurement index,” Hagler says. “I suspect we are five to 10 years away from any kind of index that might be useful.”

This lack of a benchmark means investors are left to their own devices when trying to come up with a discount rate. Often, a timberland investment manager will use a combination of approaches, factoring in the return target stated in their investment guidelines and adjusting to reflect asset and country risk. As Hagler points out, however, there is no standardized way to carry out such analysis, so timber managers “tend to fall back on trying to calculate WACC and CAPMs.”

Yet, traditional metrics have little relevance to timber investments. Computing a Weighted Average Cost of Capital involves assessing the equity performance and capital structure of listed timber companies, which remain scarce and tend to be much more leveraged than private investments. Using the Capital Asset Pricing Model is similarly problematic: it requires investors to calculate a Beta, which gauges the volatility and performance of timberland vis-à-vis equities. Since timber assets are only periodically exposed to the market, however, the comparison is hardly fair.

Alternative approaches are therefore needed. Hagler has one in mind. It starts off by reverse-engineering market discount rates from recent comparable transactions, a method he calls “Implied Discount Rate Analysis.” The past can’t predict the future, but the approach’s empirical grounding gives it more robustness than theoretical models. Yet it, too, has limits: it relies on private information – harvest schedules, price forecasts and capital structure, Hagler says – that is rarely available to third parties.

He therefore recommends combining IDR with an approach assessing an asset’s “relative risk” compared to some “gold standard,” or industry norm. This is trickier than it sounds: based on qualitative analysis, the method is susceptible to subjective bias. But Hagler argues there are ways to make it more rigorous. By drawing up a list of physical, legal and market risk, he’s come up with an index that he uses to compare assets. “The data on these factors continue to improve, so more quantitative analysis is becoming easier,” he says.

This nuanced approach may suit a category of investors. Hagler thinks timber deals will increasingly become the purview of large institutions (such as sovereign funds, insurance companies and sizeable pensions) and “small niche investors” (including family offices and impact investors), via separate accounts. But he anticipates small pensions to make a gradual exit. For them, he says, “returns don’t justify the complexity/uniqueness of the asset class.” Whichever way you look at timber, it remains a numbers game.

For more detail on timberland and discount rates, read our interview with Robert Hagler in full by clicking here.

You can also write to the editor at matthieu.f@peimedia.com