Forest Finance Q&A: Cash-on-Cash Returns versus IRR and ROI for Timberland Investing

9 01 2013

While cash-on-cash (COCR) return – a percentage often used by investors to evaluate income-producing real estate – has limitations when applied to timberland investment performance, it consistently generates interest from institutional investors.  Below are questions analysts asked us about COCR:

Q:           When estimating internal rate of return (IRR) for a timberland investment since inception based on cash returns, why are timberland portfolios often zero or negative?  How can we recommend such investments?

A:            Timberland investments often have periods of low or negative cash flows, especially when timber prices are low and forest managers delay harvest activities.  In fact, noting that a given tract of timberland has negative cash flows for a given year does not tell us much at all about the quality of the investment.  For example, replanted timberlands generate negative cash flows today and may represent robust and attractive investments.

Calculating negative net IRRs that fail to include an assessment of net asset value (NAV) is like summing cash flows to date and subtracting the purchase price.  This would represent “payback analysis” misapplied.

Q:           What is the difference between return on investment (ROI) and COCR?

A:            Consider the following example:  you acquire a timberland tract for $500,000 and sell it later for $550,000. Your ROI is 10%. The 10% return ($50,000 increase on $500,000 purchase price) reflects the increase in your “total investment (Loan + Down Payment).”  If you put down 50% ($250,000), not accounting for closing costs and commissions, your cash on cash return is 20%. The return you made on invested CASH is 20% ($50,000 increase on $250,000 cash invested).  If you paid all cash for the tract, then COCR and ROI are equal.

Click here to register for “Applied Forest Finance” on February 7th in Atlanta.  The course details necessary skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments. 





Forest Finance: Cash-on-Cash Returns, Part II

6 01 2013

As noted in Part I of this series, cash-on-cash return (COCR) provides one way for real estate investors to quickly compare the profitability of different income-producing properties or investments. However, it has limits for measuring returns or wealth creation over time.  This makes cash-on-cash returns a problematic performance metric for timberland investments.

Specifically, COCR does not account for the time value of money. Cash-on-cash return must be restricted to simply measuring a residential income property’s first year cash flow and not its future year’s cash flows.  Why?  The first year’s COCR estimate will be the most accurate; each successive year becomes increasingly speculative.

Also, COCR does not account for appreciation.  Lower COCR today may lead to a greater opportunity for appreciation than acquiring a property with steady COCR and little or no appreciation.  For timberlands in particular, a meaningful analysis should account for the facts that rates of timber growth differ by age, investment objectives differ by timber portfolio, and the pace of increased values vary as forests grow and move through higher product classes in changing markets over time.

For example, buying and owning a juvenile 8-year old forest for ten years may generate minimal cash flows while appreciating in value through biological and product growth.  Alternately, buying and owning a mature 30-year old plantation may generate tremendous cash flows in the first year while appreciating minimally.  While the juvenile forest may have a low COCR, it may in fact prove a superior value creating investment when evaluated using discounted cash flow (DCF) measures such as net present value (NPV) and internal rate of return (IRR).

The next post will compare COCR to internal rate of return (IRR) and return on investment (ROI) for evaluating timber investments. Click here to register for “Applied Forest Finance” on February 7th in Atlanta.  The course details necessary skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments. 





Forest Finance: Cash-on-Cash Returns, Part I

1 01 2013

Timberland investors naturally care about the cash flows and distributions from timberland investments over time.  These cash flows vary with the products grown, markets served and age distribution of the forest owned.  Also, timberland portfolios can be constructed to meet a range of cash flow objectives.  That said, the use of cash-on-cash returns as a performance metric for timberland investments has narrow applications, if any.

What is cash-on-cash (COCR) return?  It is a measure – a percentage – often used by investors for income-producing real estate.  It is calculated by dividing before-tax cash flow by the amount of cash invested (down payment amount).  If for example before-tax cash flow for an investment property is $15,000 and our invested cash is $100,000, then COCR is 15% ($15K/$100K).

Most reported returns from timberland investments reflect unrealized gains. Timberland indices and appraisals have limitations, complicating efforts to check the status of active timber investments.  This spotlights ways to use hard measures – like cash – to assess performance.   As such, investors new to the timberland asset class often ask about the use of cash-on-cash returns for timberlands, and seek to apply it as a point of comparison.  A meaningful analysis benchmarks cash flows relative to expectations – not just the current year – and relative to comparable investment alternatives.

Part II details limitations of COCR for evaluating timber investments.  In addition, this topic will covered more fully during the February 7th “Applied Forest Finance” course in Atlanta. Click here to register.  The course details necessary skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments.