Forest finance tools help us manage forest resources as investments. Analysts use finance to compare projects and identify those that satisfy the criteria of clients or managers. Timberland investors naturally care about cash flows and distributions from timberlands 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 return as a performance metric for timberland investments has narrow applications, if any.

What are Cash-on-Cash Returns?

Cash-on-cash return (COCR) 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). If, for example, before-tax cash flow for an investment property is $15,000 and our invested cash is $100,000, then cash on cash return is 15% ($15K/$100K).

The “annual dollar income” is the cash flow the property expects to generate during the first year of operation. The “total dollar investment” is the total cash invested to acquire the property including down payment, loan points, title fees, appraisals, and inspection costs.

Why are COCRs Problematic for Timberland Investments?

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.

However, 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 fact that timber growth rates differ by age, investment objectives differ by timber portfolio, and 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 less over the same period. 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).

While cash-on-cash returns provide one way for real estate investors to quickly compare the profitability of different income-producing properties or investments, it has limits for measuring returns or wealth creation over time. This makes cash-on-cash returns a problematic performance metric for timberland investments.

Read more: Timberland Investing From the Ground Up

This guest post is courtesy of Brooks Mendell, Ph.D., President and CEO at Forisk Consulting, a Georgia-based firm that specializes in forest-industry, timber-REIT, bioenergy, and timber-market research. For more information, visit www.forisk.com.