have escaped the attention of the financial crisis news coverage during 2008. But trace the supply chain, and the housing starts lead to the forest with intervening links of retail and wholesale commerce along the way. The flow of dimension lumber from source to destination varies with housing demand, which in turn responds to capacity of credit markets. A robust housing market in the first half of the decade attracted new investors to private forests, seeking a hedge in capital markets, as well as refuge from the Internet bubble.
Fund managers recruited investors by promoting the historic performance of U.S. forests. Over the long term, timberland offered two hedges on the boundaries to investment returns: inflation and risk. Timberland historically appreciated above inflation during periods when other assets remained flat. By including timberland in a portfolio, investors also reduced risk because timber values moved counter to the performance of other assets. Since timberland increased in value when other assets decreased, timberland reduced aggregate risk for the investor's portfolio.
By spring of 2006, industry analysts reported economic trends that were rapidly pruning the hedges, revealing a different financial horizon than described prior to these conditions. Trends included:
Over 25% of housing starts were built for investors speculating on appreciation, compared to an historic average around 5%.
North American lumber demand was 80% of North American production capacity.
Home equity loans, the primary stimulus for consumer spending, were reaching a maximum, a harbinger of decreased consumer spending.
The speculative investment, using "easy credit" , created a housing inventory for a market demand that simply did not exist. Adding "troubled assets" on top of the observed 2006 trends compounds the potential impact on timberland investors.
Newcomers to the investment neighborhood arrived during this same period of the pseudo housing boom, and ownership of private industrial lands shifted. Millions of acres nationally transferred from vertically integrated corporations to Real Estate Investment Trusts (REITs) and Timber Investment Management Organizations (TIMOs).
Among the investor newcomers are three publicly owned timber REITs, restructured from vertically integrated companies. Combined, the three companies manage some 12 million acres. The stock prices for the REITs gage timberland valuation change perceived in the capital market.
In the figure above, the stock price for Potlach, Rayonier, and Plum Creek tracks with the housing boom until 2006. The monthly housing starts (seasonally adjusted), increased from 2000 through the first quarter of 2006. The decrease from first quarter 2006 to fourth quarter 2008 is dramatic. By contrast, stock prices for the three REITs progressed on an upward climb for more than a year until making an abrupt adjustment the last quarter of 2008.
TIMOs manage a total area approaching 50 million acres. They are not publicly owned corporations, and therefore do not have the disclosure requirements of the three REITs. Suffice it to say, however, that the pattern of REIT stock prices indicates a reduction in timberland value common to both types of forest investment organizations.
TIMOs and REITs are facing a production throughput problem that may increase the frequency of land sales and forest fragmentation. The problem is a reduction in profit per acre, regardless of the land's inherent productivity. The average annual net revenue per acre for each of the forest enterprises has decreased as a result of the housing bubble. Stumpage volume sold and unit price have both dropped. Real estate sales previously provided a hedge for volatility in stumpage markets. However, the current real estate market offers little promise of filling the gap through the sale of land for development.
The search is on - what can fill the income gap left from the pruned hedges? This is an important question for the REIT which has a stock price dependent on dividend yields. For the shorter term TIMO landowner, whose anticipated return on investment depended heavily on land appreciation, the dent in annual net revenue translates into a perceived decrease of forest land value.
The figure above is a simple example of the potential impact. For any single organization, the total net profit divided by total acres provides a performance metric: average net operating revenue per acre for the year. The value can be treated as annual rent to the landowner. Dividing the rent by a capitalization rate produces an estimate of average land value today for a series of annual future payments. The x-axis is a range of average acre net revenue. The y-axis is the capitalized value. The lines in the figure represent different capitalization rates.
Assume an investment made in 2000, with expectations of a double digit returns by 2010 when the investor's contract closes. A decrease in net revenue (from $40 to $30 for example) during that ten year period decreases the perceived land value in the eyes of a subsequent buyer. Instead of an overall land appreciation, the $10 per acre drop in revenue translates into a $125 per acre decrease in average land value (at an 8% capitalization rate).
An extended recession and housing slump will cause some investors to allocate their capital to alternatives and exit the timberland market. Those investors remaining will need to develop strategies that find additional sources of revenue. Potential sources include biomass, carbon sequestration, recreation, watershed services, and wildlife habitat management. Collectively, analysts refer to these emerging markets as ecosystem services.
Momentum is building for ecosystem service markets; the recent announcement of a federal Office of Ecosystem Services and Markets is a notable example. News of Spatial Interest will explore these topics in upcoming issues, examining their potential to fill the gap for investors by developing markets on the Edge.