Forestland Investment: Addressing Production Risk

Firefighters on Sunday battled wildfires across the state, with at least one blaze expected to burn for much of he week. Officials were monitoring 64 fires and mopping up 23 others, including one that that had destroyed nearly 7,000 acres and caused more than $1 million in damage in Sarasota and Charlotte counties. (From wire reports, April 2001)

Such news reports can really make forestland investors wonder: Just how risky is this business? Of course, reports of this kind never seem to mention that the vast majority of American forestlands never are severely damaged by nature. But the fact remains: There is risk associated with forestland ownership.

Forestland risk is broadly defined as the potential for not meeting projected investment returns. It reflects uncertainty that projected harvest and cash flows will be realized. As part of active management, sophisticated forestland managers include careful monitoring and management of the following general risk categories:

1. Production Risk: includes the risk of unforeseen volume and quality losses caused by natural events and losses from inaccuracies in projecting merchantable timber volume and quality.
2. Price Risk:
includes uncertainties in forecasting prices for timber products.
3. Regulatory Risk:
includes risk associated with changes in state and federal regulations that may affect timber harvesting or other forest management practices.
4. Liquidity Risk:
includes risk of receiving below market prices when selling forestland assets in short time periods. 

Each of these risk categories has its own character, yet they all come into play. This particular article focuses on production risk. Future issues of Growth magazine will address the remaining risk categories. But for now, let's look at production risk

Production Risk: Natural Events

Forestland losses from natural events include those caused by wildfires, ice storms, hurricane-related weather, insects, and disease. Catastrophic wildfires occur when drought conditions, warm weather and high fuel loads combine to create fires that burn for several days or more. Suppression of fires of this magnitude is difficult and often requires rainfall or other favorable changes in weather conditions.

Fortunately for southern forestland owners, this region of the U.S. rarely experiences forest fires of the frequency seen in western states. Ready forestland access, diverse land uses and plentiful rainfall keep wildfire risks low. When large forest fires do occur, they cause widespread and near-complete loss of timber values - from young premerchantable stands to fully mature stands.

Ice storm accumulations are relatively infrequent and occur where air temperatures are above freezing and ground temperatures are at or below freezing. Rain freezes upon contact with trees, accumulating to the degree that it can bend, break and uproot them. But the type and extent of damage varies. For example, accumulated ice on a young stand of trees probably will only cause the trees to bend. As the ice melts, the younger trees will again stand straight.

Effects on older trees also can vary, depending on the density of the stand -- i.e., the number and spacing of trees. The worst damage takes place immediately after a stand has been thinned. At that particular point, trees in the stand are more susceptible to damage from ice storms. But, in the absence of an ice storm, those same trees grow more quickly and are better able to tolerate ice buildup in the future.

Not all ice storms are damaging, and when damage does occur it is usually localized. Risks from ice storm damage in the South are highest farther inland and to the north. Historically, the greatest incidences appear to follow a line from Dallas to Birmingham, Alabama, to Richmond, Virginia. Along the Gulf and Atlantic coasts, they rarely if ever occur. 

Hurricane damage occurs most often to trees that normally would be large enough and strong enough to resist the wind. But, given the rain that accompanies hurricanes, these trees are toppled over by high winds because their root systems are less able to resist movement in the water-saturated ground. Incidences of hurricane-related losses are limited to roughly a 75-mile band from the Gulf and East coasts inland. 

Southern Pine Beetles attack trees that are highly stressed from lack of moisture, overly dense growing conditions or from other damage that reduces the vigor of the tree. Infestations are greater in areas with long, dry summers, on sites with poor water storage, and in stands that are too dense. 

While this hazard can never be eliminated, the incidence of Southern Pine Beetles can be greatly reduced by maintaining healthy, vigorous trees through stocking control and other management measures. This includes reduced planting rates on sites with low water storage and implementing timely thinning of stands to maintain rapid tree growth.

Pine beetle infestations are common across the southern United States. Certain locations have high historical infestation rates that may be attributed to the presence of large forested areas of over-mature timber or other conditions that produce timber stands in stress.

Harvest Yield Risk

Along with the losses associated with natural events, production risk includes harvest yield risk -- potential losses from inaccuracies in estimating the amount of volume and quality a stand will have at harvest. Put another way: There is a risk that a forester's "measurement of what's in the forest" will prove to be wrong at harvest time. Obviously, this could have a major impact on your investment.

To best address harvest yield risks, forest managers use a collection of equations that predict how a stand of trees will grow. These equations look at such factors as diameter and height of trees, which allows for an accurate prediction of weight; age, growth rates, and mortality rates of trees; stand density; and what kind of end products can be made from timber in a given stand. 

But estimates based on these equations are just that - estimates based on models of similar tracts of land. They assume all stands starting off with the same conditions will end up with the same volume. The reality is that timber volume on an individual stand might differ from the initial estimate. Thus, uncertainty exists.

A sound forest protection strategy eases uncertainty, and it also minimizes the risk of your investment. It will also minimize losses should nature deal your property a blow.

A good forest protection strategy takes into account a few basic principles: 1) that risk can be minimized but not eliminated; 2) healthy, vigorously growing trees are less susceptible to insects, disease, and weather-related risks; 3) loss from damaging agents is usually localized and has a minimal impact over a large acreage, especially where the forest is actively managed; 4) and diversification minimizes risk.

(In the next quarterly issue of Growth magazine, we'll take a close look at risk involved with the pricing of timberland and how to address that risk.)

This article was printed in the summer 2001 issue of Growth magazine and was posted to AFOA's website by permission of Resource Management Service, Inc., publisher of Growth magazine.