Timber REITs and the “Dividend Tax” Cliff, Part I

29 11 2012

This is the first in a two-part series summarizing implications to timber REIT shareholders from expiry of the current tax provisions specific to dividend income.

Fear battles greed once again as chronicled by the business press in the looming “fiscal cliff” faced by U.S. investors and taxpayers.  See, for example, “Stocks Diving off the ‘Cliff’” and other lemming-oriented reports. For those of us nestled in the woodsy world of timberlands and timber REITs, how might changes in the tax code affect timber REIT investments?

How are dividends taxed currently?  In December 2010, President Obama signed into law a two-year extension of many provisions signed into law by President Bush in 2001 (often termed the “Bush-era tax cuts” and enacted in 2002 and 2003).  The extension retained the current 15% maximum tax rate of qualified dividends for most taxpayers and 0% for those in the 10 to 15% ordinary income tax brackets.

What are “qualifying dividends”? These include dividends received by shareholders (1) of qualified corporations and (2) who held the underlying stock for at least 61 days within an IRS-defined 121-day period relative to the ex-dividend dates of the firms.  Importantly for us, this includes dividends paid by real estate investment trusts (REITs).

What happens if the dividend tax rate expires as scheduled on December 31, 2012?  Shareholders would pay taxes on dividend income at their ordinary income tax rate.  Currently, for example, unmarried individuals who earn more than $85,650 and joint-filing married couples who earn more than $142,700 pay basically 35%, on the margin, in Federal taxes.  However, the issue varies with timber REITs because most dividends qualify as long-term capital gains.  Currently, the qualified dividends and long-term capital gains are taxed at 15%. If the current extension expires, capital gains would be taxed at the pre-2003 rates of 20% (still lower than the marginal ordinary income rate paid by most investors).

Ultimately, changes in dividends or net cash received affect valuations as investors compare after-tax yields and expected returns across asset classes.

Part II provides numerical examples to quantify the implications to shareholders. Dr. Brooks Mendell delivers keynotes and workshops related to forest finance and timberland investment vehicles.  Click here to learn about and register for “Applied Forest Finance” on February 7th in Atlanta, Georgia.

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Did “Superstorm” Sandy Supercharge Short-Term Timber REIT Returns?

19 11 2012

No.

Let me explain.

On October 29th, 2012, Hurricane Sandy – crowned “Superstorm Sandy” by the media – landed on the East Coast of the United States, disrupting businesses from North Carolina to Maine and west to Michigan and Wisconsin, with concentrated damage in the Northeast.  According to The Wall Street Journal, initial estimates of the insurable losses exceeded $15 billion with total damages falling between $30 and $50 billion (“Sandy’s insured-loss tab: up to $20 billion”, 11/2/2012).  In response to multiple questions from investors and reporters about the potential effects on timber stocks, I conducted a simple “event study” to see if, in the short-term, we observed statistically “abnormal” moves in timber REIT stocks immediately before or after Sandy.

Testing the effects of Hurricane Sandy on the publicly-traded timberland-owning sector presents issues that complicate potential results:

  • Our “event” hit the U.S. on October 29th, a Monday.  Wall Street, in response, closed for trading on October 29th and October 30th, and reopened on October 31st.  From a research standpoint, this gave investors a couple of days to sort things out (if that was possible in this case) and diminishes potential relevant price moves.  (It also suggests a “long-term” event study may be worth revisiting several months from now….)
  • There was this other “event” occurring around the same time: a U.S. Presidential Election.  History suggests Presidential Elections affect trading activity, too….
  • Pure manufacturers of building products, such as lumber and OSB, may show more direct effects in this type of post-catastrophe environment.

We used a simple regression to estimate the relationship between returns from the S&P 500, which represents the overall market, and the Forisk Timber REIT (FTR) Index, which represents the publicly-traded timber sector.  Then we create an “event period” that frames when Sandy might impact timber REIT stock prices.  For this short-term study, we used an eleven-day period starting five trading days before the event and ending five trading days after the event.  The table below summarizes the results.

The estimated “Cumulative Abnormal Return” for the event window totaled -1.3%.  For the five days following the event, the CAR totaled -0.8%.  In sum, for this particular question and this particular timeframe, Sandy proved much ado about nothing.





Managing Financial Risk in Forestry, Part III: Pricing Options and Wood Supply Agreements

12 11 2012

This is the third in a three-part series related to managing financial risk associated with timberland investments, wood procurement and forest management activities.

Colonel Kurtz, in the movie “Apocalypse Now,” says “you must make a friend of risk.”  While I don’t like people telling me who I need to be friends with, I acknowledge the need to embrace inevitabilities.  This brings us to Mother Goose, who advised:

For every ailment under the sun
There is a remedy, or there is none;
If there be one, try to find it;
If there be none, never mind it.

Part I of Managing Financial Risk in Forestry (Real Options and a Practical Question) summarized efforts related to using financial derivatives in the forest products industry and timberland investing sector.  Part II, To Hedge or Not to Hedge, introduced the concept of hedging risk in forest and timberland management. This post, Part III, discusses the pricing of options and use of supply agreements to manage timber prices.

Wood procurement managers at sawmills, pulp mills and wood bioenergy projects seek stable or predictable wood flows at low or predictable prices. In that sense, wood procurement manages wood flows with cash flows. Tools or strategies that improve the control over these wood flows at no additional cost or reduce wood costs with minimal impact on wood flows are desirable. We can picture this both as a portfolio of activities and menu of alternatives.

In developing risk management strategies for forestry investments, I modeled the application of “options on forwards” for wood procurement systems and supply agreements.  These models build on the work of Black-Scholes (1973).  In 1976, Black extended applications to cover commodities, such as agricultural products.  In 1985, Thorpe developed a model to price options on forwards, which, by default, accounts for logistical issues associated with forestry operations.  Why were these developments important?  Because in forestry and timberland investing, we must wrangle imperfect data and irregular trees into standardized contracts.  “Options on forwards” represent relatively flexible contracts that actually account for the time required to drive a load of logs to a mill.

What did we learn?  First, “valuing” and “pricing” options on forward contracts for timber applications reflect two different exercises.  The fact remains that available timber price data and the irregularity and localized nature of timber values challenges the capability of standardized financial models.  In the end, pricing options in forestry, while guided by models, includes negotiation.  Second, valuing options in forestry supports efforts to price wood supply agreements and insurance-based strategies.  When, as Mother Goose implores, we “try to find” remedies, we generate new alternatives for managing risk that may include operational and other readily available approaches.  For example, option pricing helps us evaluate the costs and benefits of building or buying wood yards and the length of wood supply agreements.  Finally, option modeling provides a useful benchmarking tool.

Timberland-owning firms and investors may work with sufficiently long time horizons – typically 10 years or more – to mitigate log price exposure by adjusting harvest levels with log price levels.  However, these same firms may require short-term regular cash flows, and hedging can, in theory, reduce cash flow volatility.  This is especially true for wood procurement operations, where daily, weekly and monthly wood raw material needs drive the schedule.  Isolating transactions and exposures that may result in variable cash flows provides a basis for evaluating risk management and hedging alternatives.

Since 2003, Dr. Brooks Mendell has delivered keynotes and workshops throughout North and South America, in English and in Spanish, related to risk management in forestry and timberland investment markets. To schedule Dr. Mendell for your event, please contact Heather Clark at 770.725.8447 or hclark@forisk.com





Managing Financial Risk in Forestry, Part II: To Hedge or Not to Hedge

2 11 2012

This is the second in a three-part series related to managing financial risk associated with timberland investments, wood procurement and forest management activities.

Part I of Managing Financial Risk in Forestry (Real Options and a Practical Question) introduced industrial views and academic efforts related to the use of financial derivatives to manage risk in the forest products industry and timberland investing sector.  Gaston, in the 1958 movie “Gigi”, captures the general forest industry sentiment when he said “if you like that sort of thing.” Regardless, derivative securities improve the liquidity of risk (if you like that sort of thing).

Let’s name our parts.  Derivative securities “derive” their value from the prices of other underlying assets, such as stocks, bonds, currencies or commodities (i.e. wheat, gold or lumber).  The most common of these financial instruments are forwards, futures and options. In theory, these derivative securities manage exposure to risks associated with the underlying assets.  They do this by locking in prices and volumes in advance, thereby reducing uncertainty.  For example, a lumber manufacturer can lock in prices for future lumber sales by buying lumber futures contracts traded on the Chicago Mercantile Exchange (www.cme.com).  If lumber prices go up, the gain in the lumber sales price is offset by the loss from the lumber futures contract.  If lumber prices fall, the loss in the lumber sales price is offset by the gain from the lumber futures contract.

When used correctly, futures and options act as a form of insurance against unexpected price movements.  This phenomenon, where risk associated with one asset is offset with a position in financial derivatives, is called hedging. Alternately, “speculators” trade futures and options simply to profit from price level changes.

How can hedging strategies apply to forest management and timberland investing activities?  I have conducted research and analysis on risk management in forestry and timber using derivatives related to weather (crazy, huh?), currency exchange rates, energy prices, fertilizers and stumpage prices.  For example, a significant price relationship exists between urea cash prices and urea futures prices.  (Urea is the most common nitrogen fertilizer used in forestry.)

Discussions with forest managers revealed that high, short-term urea prices can lead them to forgo planned forest management investments.  This decision to “underinvest” relies on short-term cost and cash flow considerations. Using estimated hedge ratios, we calculate net realized urea prices for the U.S. South cash market for nine fertilization seasons over five years.  [Mendell, B.C. 2006. Hedging urea for forestry applications in the US South, Southern Journal of Applied Forestry, 30(3): 142-146]

Does hedging add value to overall forestry investments? Answers to this vary.  For example, the diversification of timberland investment portfolios is an operational hedge that produces clear, unequivocal benefits to investors. Alternately, the use of derivative contracts for day-to-day forest management activities works better on paper than in practice because of issues associated with the relatively small scale of individual forestry activities and the relatively large scale of standardized financial contracts.

Part III discusses the pricing of options and use of supply agreements to manage timber prices.  Since 2003, Dr. Brooks Mendell has delivered keynotes and workshops throughout North and South America, in English and in Spanish, related to risk management in forestry and timberland investment markets. To schedule Dr. Mendell for your event, please contact Heather Clark at 770.725.8447 or hclark@forisk.com