3.1 Natural Resources and Land

intrinsic option value

An intrinsic option value is the greater of $0 and the value of an option if exercised immediately.

Political Risk

Another risk faced in farmland ownership as well as other forms of land ownership is political risk. Political risk is economic uncertainty caused by changes in government policy that may affect returns, perhaps dramatically. Political risk can arise both from government's failure to take beneficial actions and its initiation of harmful actions. For example, political risk of farmland ownership includes the risk that the government will terminate support payments, such as corn ethanol subsidies, and the risk that the government will abrogate ownership rights or expropriate land, as reportedly occurred in recent years in Venezuela.

Binomial Option Pricing

Binomial option pricing is a technique for pricing options that assumes that the price of the underlying asset can experience only a specified upward movement or downward movement during each period.

Sharpe Ratio

measures excess return per unit of risk -the larger the better

The future supply of agricultural products could be driven by:

(1) changing agricultural yields, (2) changing quantities and qualities of agricultural infrastructure (including irrigation, transportation networks, and processing), and (3) the quantity of land under cultivation and/or changing use of aquaculture.

There are three primary approaches for institutional investors to access agricultural asset returns:

(1) direct ownership of farmland to earn lease income, (2) direct ownership of listed equities in agricultural firms or through pooled funds, and (3) long positions in agricultural futures contracts or similar financial derivative instruments. Note that the third use provides exposure to agricultural prices, not directly land prices, and may not be highly correlated with farmland values.

The key benefits of farmland investment are:

(1) farmland as an inflation hedge, since farmland is a real asset linked to food and energy production and prices; (2) farmland as a diversifying source of return being subject to distinct physical and economic dynamics and not, in the short run, directly linked to financial markets; and (3) the supply of farmland may be more constrained than the demand for agricultural products.

The future demand for agricultural products could be driven by:

(1) worldwide population growth rates, (2) substantially changed incomes in emerging markets leading to changing diets, including increasing consumption of animal protein and (3) the use of agricultural products in biofuels and other non-food-based end uses.

Key Observations Regarding Historical Returns of Farmland

1. Farmland returns had low historic volatility relative to world equities. 2. Farmland returns generated a very attractive Sharpe ratio of 1.4. 3. Farmland returns had a markedly positive skew. 4. Farmland returns had a markedly positive excess kurtosis. 5. Farmland returns reported an incredibly small drawdown (i.e., a 0% drawdown). 6. Farmland returns had a markedly high fourth-order partial autocorrelation, indicating a large one-year lag in recognizing changes in value. 7. Farmland returns were very tightly clustered around their mean.

The three types of land lots

1. Paper lots 2. Blue top lots 3. Finished lots

Risk Neutral Probability

A risk-neutral probability is a probability that values assets correctly if, everything else being equal, all market participants were risk-neutral. A risk-neutral probability may be viewed as being equal to a statistical probability that has been adjusted for risk so that it can be used to price risky assets in a risk-neutral framework.

Land as an Option

Investment in undeveloped land is an option on development much like investment in land with mineral rights. The strike price of the option is the cost of developing or improving the land (e.g., constructing an apartment building). The time to expiration of the option is typically unlimited. The receivable asset of the option is the combination of the land and its improvement or development (e.g., a finished apartment building with the land beneath it). The payoff of the option is the spread between the value of the completed project and the cost of constructing the project.

observed volatility of the stale return series equation

Simply put, the observed volatility of the stale return series will equal the volatility of the true return series divided by the square root of N. For N = 2, the return volatility of the true series will be higher than the volatility of the observed (stale) series by a factor of √2. For N = 4, the stale price series will exhibit only half the volatility of the true return series.

Return on Assets (ROA)

Net Income/Total Assets, or Operating Income/Total Assets Measure of profit per dollar of assets

Return on Equity (ROE)

Net Income/Total Equity

Net Income

Operating Income - Interest

Paper lots

Paper lots are sites that are vacant and approved for development by the local zoning authority but for which construction on streets, utilities, and other infrastructure has not yet commenced.

Permanent Cropland

Permanent crops are crops that do not need to be replanted annually, such as tree-based crops (e.g., apples, oranges, nuts). Permanent cropland refers to land with long-term vines or trees that produce crops, such as grapes, cocoa, nuts, or fruit.

Real Assets vs Financial Assets

Real assets are economic resources that create or add to the consumption opportunities available to people. All consumption ultimately originates from real assets. Financial assets are the counterpart to real assets. Financial assets serve as conduits of value rather than as direct creators of consumption opportunities.

Row Cropland

Row cropland are crops that need to be replanted each year, such as soybeans, as corn, grains, cotton, carrots, or potatoes from annual seeds.

Disadvantages of farmland investment include:

(1) like most other forms of real estate investing, farmland is illiquid, with potential exposures to natural disasters; (2) the transaction costs of searching for, buying, and selling farmland tend to be high, with sales that are arranged through brokers that can charge fees of 3% to 5% for negotiating the sale of the land and with potentially high search costs; and (3) farmland ownership can involve high levels of agency costs.

In the case of an exchange option, the volatility depends on:

(1) the volatility of the price of the asset(s) being delivered, (2) the volatility of the price of the asset(s) being received, and (3) the covariance or correlation coefficient between the prices.

The three key disadvantages to timber investment

(1) timber values are tied to cyclical industries such as housing that can experience prolonged slumps, such as the housing slump that began in 2007, (2) timber's long growth cycle makes its value subject to risks of changes in technology and other factors affecting demand that may occur during the long rotation periods, and (3) the potential for losses due to natural disasters or adverse changes in legal standards.

Key Observations Regarding Historical Returns of Timberland

1. Timber returns had low historic volatility relative to world equities. 2. Timber returns generated an attractive Sharpe ratio of 0.6. 3. Timber returns had a modestly positive skew. 4. Timber returns had a markedly positive excess kurtosis. 5. Timber returns enjoyed a very mild maximum drawdown (i.e., only −6.5%). 6. Timber returns had a markedly high fourth-order partial autocorrelation, indicating a large one-year lag in recognizing changes in value. 7. Timber returns were very tightly clustered around their mean.

favorable mark

A favorable mark is a biased indication of the value of a position that is intentionally provided by a subjective source. For example, a trader may ask a brokerage firm to provide an indication of the value of a thinly traded asset for reporting purposes when the trader has reason to believe that the brokerage firm has an incentive to bias the valuation process in a particular direction to assist its client. Favorable marks may be used to obtain high real estate appraisals that enable larger mortgages.

Rotation

A key concept in timber management is rotation. Rotation is the length of time from the start of the timber (typically the planting) until the harvest of the timber. Natural stands of pine frequently require a rotation of 45 to 60 years. Hardwoods may need 60 to 80 years to produce high-quality saw-timber products. Even though intensive management of planted pine can shorten the rotation to approximately 25 to 35 years, the investment is still very long-term and subject to risk—such as fire, drought, and other natural disasters—as well as obsolescence due to innovation or government restrictions on ownership rights, such as harvesting.

pure play

A pure play on an investment is an investment vehicle that offers direct exposure to the risks and returns of a specific type of investment without the inclusion of other exposures. Pure plays on a private investment in natural resources are rare. Since most underground natural resources are not privately owned and most U.S. privately owned natural resources are commingled with surface rights, there are few institutional-quality investments with returns determined almost solely by the values of the underlying natural resources. There are some opportunities for pure plays on natural resources through private partnerships or listed partnerships (MLPs); however, most global natural resources are either owned by governments or leased to operating firms.

Timberland investment management organizations (TIMOs)

A second reason for the change in ownership was the rise of timberland investment management organizations. Timberland investment management organizations (TIMOs) provide management services to timberland owned by institutional investors, such as pension plans, endowments, foundations, and insurance companies, and have been a key reason for changes in timberland ownership. The growth of TIMOs facilitated the migration of timber ownership from longtime corporate manufacturers of timber-related products. Most institutional investors rely on TIMOs to advise them about their investments in forestland. Instead of actually owning the timberland, TIMOs arrange for investors to buy the timberland and then manage the timberland on behalf of those investors. TIMOs usually collect a management fee and a share of the profits at harvest.

split estate

A split estate is when surface rights and mineral rights are separately owned. A large portion of natural resources is under the earth's surface. In most jurisdictions, private land ownership is limited to surface rights, with the ownership of underground mineral and energy rights retained by governments. However, in the United States, private land ownership has typically included mineral rights. Although much U.S. land is publicly owned, some states allow split estates.

Land Banking

A term for investment in and acquisition of undeveloped land or vacant lots is land banking. Land banking is the practice of buying vacant lots for the purpose of development or disposition at a future date. This practice is common in the home-building industry and allows home builders to secure land tracts for eventual use in the fulfillment of housing development pipelines. The key investment strategy is to purchase at a relatively low-cost land that is vacant, rural, or underutilized and hold it in anticipation of substantial value increases as the location emerges in the path of future development.

Agency Risk

Agency risk is the economic dispersion resulting from the consequences of having another party (the agent) making decisions contrary to the preferences of the owner (the principal). An investor in farmland does not necessarily actively manage the crops. Typically, the owner of the farmland leases the land to a local farmer, a cooperative, or even an agricultural corporation. Since lease payments are made on a calendar basis, the cash rents provide a steady stream of payments that are not tied to a particular growing season. Investment in farmland and other real assets operated by another party introduces agency risk.

Agronomy

Agronomy is the science of soil management, cultivation, crop production, and crop utilization.

Exchange Option

An exchange option is an option to exchange one risky asset for another rather than to buy or sell one asset at a fixed exercise or strike price.

Blue top lots

Blue top lots are at an interim stage of lot completion in which the owner has completed the rough grading of the property and the lots, including the undercutting of the street section, interim drainage, and erosion control facilities, and has paid all applicable fees required. At this stage, a home builder can obtain a building permit upon payment of the ordinary building permit fee.

Contagion

Contagion is the general term used in finance to indicate any tendency of major market movements—especially declines in prices or increases in volatility—to be transmitted from one financial market or sector to other financial markets or sectors. When comparing the high volatility of listed real estate prices relative to appraised real estate prices, it may be argued that the high volatility of listed real estate prices is driven by contagion effects from other listed securities, such as the equities of operating firms that are listed on the same exchange. Within this interpretation, the high volatility of listed real estate prices were driven by potentially temporary contagion effects rather than indicating true volatility in the value of the underlying properties.

The reliability of market prices versus appraisal-based data example

Did actual U.S. real estate values plunge from February 2007 to March 2009 or from June 2008 to December 2009? Did agreements regarding sales of commercial real estate begin to reflect lower prices in the United States as early as 2007? Did unleveraged commercial real estate in the United States decline only 24% from the quarterly high to the quarterly low during the financial crisis? Traditional expert-based appraisals and prices from listed equity markets provided entirely different indications. There is no consensus, but, clearly, indices based on traditional appraisals indicated the declines on a delayed basis. However, the market prices of REITs traded in the U.S. equity markets appear in retrospect to be driven at least in part by contagion.

Farmland Harvest Schedule

Farmland can be contrasted to the prior discussion of timberland. Timberland has great flexibility in terms of its harvest schedule, which can be timed to take advantage of better pricing. Conversely, farm crops must be harvested annually and generally within a window of just a few weeks. Timber has a long growth cycle between seeding and harvesting. Farmland allows the farmer to harvest from seed to crop within one year. Farmland's shorter growth cycle provides annual cash flows and allows for a more valuable multipurpose option than timberland, since farmland's crop selection is a shorter-term decision, and there are numerous potential crops.

Farmland

Farmland represents ownership of a real asset (land), yet unlike many real assets, farmland also generates current cash flow, as crop income is a potentially steady and renewable stream of cash. Farmland differs from traditional real estate in that the annual cash flow is more closely linked to commodity prices (i.e., crop prices) rather than rent; therefore, the market price of farmland may be closely linked to commodity prices.

Finished lots

Finished lots are fully completed and ready for home construction and occupancy. All entitlements, including infrastructure to the lot, finished grading, streets, common area improvements, and landscaping, have been completed. All development fees, exclusive of the building permit and inspection, have been paid.

Four Causes of Return Smoothing Due to Reliance on Infrequent Transactions or Stale Data: 1

First, in highly illiquid markets such as those for natural resources, timberland and farmland, there can be a substantial gap in time between the date at which a deal is struck and the date at which the transaction is consummated. Appraisers often are forced to rely on data observed from the dates on which transactions are consummated because the transactions and prices are not typically revealed publicly until after the deal is completed. The delay between the agreement on a price and its revelation to the public can cause a substantial delay in the recognition of price changes in appraisals.

The reliability of market prices versus appraisal-based data

For U.S. real estate, there are reliable data on both appraised prices from unlisted properties and market prices of similar real estate held inside funds that trade in liquid markets. Often the returns computed from appraised values diverge substantially from the returns computed from market prices, even though the underlying real assets are similar. Specifically, the volatility of returns based on market prices is often substantially higher than the volatility of returns based on appraised values. A critical issue is whether the price volatility of listed real assets reflects true changes in the value of the real assets or whether the price changes reflect trading conditions in the equity markets.

A Model of Stale Prices

For example, if the true return of asset i in period 1 was 10%, the true return in period 2 was -5%, and the value of α is 0.6, the appraiser reports a return of 1% for period 2. This return is found as: (.6 × -5%) + (.4 × 10%) The next two sections use this model to evaluate the effect of stale pricing on estimated means, volatilities, and correlations.

Four Causes of Return Smoothing Due to Reliance on Infrequent Transactions or Stale Data: 4

Fourth, appraisals may rely on data regarding revenues (e.g., rental income) and expenses (e.g., maintenance contracts) that themselves exhibit time delays in reflecting the effects of changes in market conditions. For example, actual rental revenue does not change to reflect changes in market conditions until leases are renewed. Note that variable delays in recognition of changes in market conditions tend to dampen the volatility of appraisal-based prices.

The Effect of Stale Pricing on Historic Mean Returns

Here is the key point. The error in estimating the true mean of a return series by using stale returns based on stale prices occurs from overweighting the return prior to period 1 (i.e., it is included in the computation in the mean when it should not be included) and underweighting the return in the final period (T) (by including only a partial weight). But, as the number of observations in the sample increases, the magnitude of the difference between the averages decreases. Therefore, for large samples there would typically be only a small difference between the mean based on stale returns and the mean based on true returns, so the use of stale valuation tends to have little effect on estimations of long-run returns. This is important information to understand when stale (or smoothed) return series are used.

Implications of Moneyness for Risk of Natural Resources

Higher moneyness shortens the time horizon of the exercise of the option and reduces the chance that the option's price will be substantially altered directly by changes in the costs of developing the natural resource.

Conclusion of Timberland and Farmland

In conclusion, note that both timberland and farmland have highly smoothed returns, as noted by the strong autocorrelation results. Analysts need to adjust for this artificially low level of volatility before using these risk estimates in asset allocation models.

Cap Rate

In real estate, the cap rate (capitalization rate) or yield is a common term for the return on assets (ROA) Operating Income/Total Assets or Annual Operating Income / Value of Real Estate

NCREIF Farmland Index

Row cropland comprises approximately 55% of the NCREIF Farmland Index, a major U.S. index of farmland values. To provide an indication of relative sizes, permanent cropland comprises approximately 45% of the NCREIF Farmland Index.

When should in-the-money development options be exercised?

In traditional option theory, most options should be held until expiration. There are limited cases in which an option should be exercised early, such as deep-in-the-money put options and call options prior to ex-dividend dates. Since the option to develop a natural resource is generally a perpetual option, the critical issue is how the owner makes the decision of when to exercise the option. A natural resource should generally not be developed until the option is substantially into the money. But how far into the money should the option be to justify it being exercised? Consider the following scenario: A tract of land has moderate quantities of ore containing gold. Suppose that at a market price of $1,500, the gold can be mined at a cost of $1,400 per ounce, for a profit of $100 per ounce. Does it make sense to mine the gold now because of the positive time value of money? The answer is that it depends on three things: the volatility in the price of gold, the volatility in the cost of mining the gold, and the correlation between the two.

Risk and Return of Investing in Land

Investment in land is a departure from the traditional forms of real estate investment by institutional investors, who tend to purchase commercial real estate that is then leased, providing both capital appreciation and an annual cash flow. As a result, land development tends to be riskier and more speculative than other real estate investing, owing primarily to its lack of revenue, its long holding period, and its uncertain prospects. However, raw land does not deteriorate in value the way developed real estate does. Whereas developed properties require constant upkeep to maintain their value, the downside risk of owning undeveloped land can be low.

Expected return of Land formula

Land may be viewed as a call option. As with the expected return of a call option on an equity, the expected return of land depends on its systematic risk. The expected return of land is a probability-weighted average of the expected return of the land if it remains undeveloped and the expected return of the land if it is developed: *where E(Rl) equals expected return on land, Pd equals probability of development, E(Rd) equals expected return conditioned on land being developed, and E(Rnd) equals expected return conditioned on land not being developed.

Managed returns

Managed returns are returns based on values that are reported with an element of managerial discretion. There are four primary ways that values and returns can be managed: favorable marks, selective appraisals, model manipulation, and market manipulation.

Market manipulation

Market manipulation refers to engaging in trading activity designed to cause the markets to produce favorable prices for thinly traded listed securities. As an example of this extreme practice, a buy order may be placed very near the close of trading to generate a higher closing price (or, conversely, a sell order may be placed to generate a lower closing price) in order to report more favorable returns for the current period or to smooth price variations, since valuations are frequently based on closing prices. To the extent that investment managers and fund managers are rewarded for exhibiting stable returns, there is an incentive to reduce observed volatility by managing returns. Smoothing can also be generated inadvertently. In the case of real assets, the appraisal process can introduce smoothing, as discussed in the next section.

Model manipulation

Model manipulation is the process of altering model assumptions and inputs to generate desired values and returns. Model manipulation can occur in complex unlisted derivative transactions and other unlisted assets that are valued using models. The reported values can be manipulated by altering the parameter values that are inserted into the model. For example, use of higher estimates of asset volatilities can generate higher option prices.

Four Publicly Traded Ways to Obtain Exposure to U.S. Timber Returns

Most timberland is directly owned and privately traded by institutional investors. There are four key publicly traded ways to invest in timber in the United States. First, investors can directly own shares in publicly traded timber-related firms. Second, there are two major ETFs (exchange-traded funds in the United States, with ticker symbols WOOD and CUT) that have been developed to track timber firm values. The two ETFs have a combined market value of very roughly $1 billion, track different indexes, and have returns that can differ substantially. The most popular way for retail investors to gain exposure to timber is through real estate investment trusts (REITs). There are four primary REITs that specifically invest in timberland and have combined values of over $30 billion. Finally, there is a futures contract (Random Length Lumber contracts) that trades on the CME and offers exposure to timber prices, which are part of—but not perfectly correlated—with timberland prices. See the next exhibit.

Appraisals and Return Smoothing Due to Behavioral Biases

Much has been written about human nature and the potential tendency of appraisers to be overly conservative and reluctant to modify their beliefs regarding valuation levels. Behavioral finance theory cites an anchoring effect in which participants place an inordinate importance on previously accepted beliefs. Appraisers in 2007 had reported virtually continuous quarterly price increases in commercial real estate for 12 years. It is possible that these appraisers were reluctant to conclude that the trend suddenly had reversed until well into the financial crisis when substantial evidence had emerged of a directional change.

Natural resources

Natural resources are real assets that have received no or almost no human alteration. Undeveloped land and timberland are almost always classified as natural resources. Examples of natural resources include oil, natural gas, coal, ore, land, water, wind, and other inputs to production that largely remain in a natural state and location. Most natural resources are related to facilitating energy consumption because energy is such a major input to the world economy. For example, energy consumption tends to represent approximately 8% to 10% of the gross domestic product in the United States. Other substantial sectors of natural resources include land and metal ores and other minerals.

Four Causes of Return Smoothing Due to Reliance on Infrequent Transactions or Stale Data: 2

Second, the transactions that occur in illiquid markets may be biased indications of widespread valuation changes. For example, it is possible that transaction data in the early stages of an economic slowdown might focus on sales of high-quality properties at relatively high prices, whereas the data in the early stages of a recovery might be drawn more from sales of lower quality properties at or near the previously observed lowest prices.

Selective appraisals

Selective appraisals refers to the opportunity for investment managers to choose how many, and which, illiquid assets should have their values appraised during a given quarter or some other reporting period. Appraisals are relatively expensive, so the normal practice is to appraise a subset of assets infrequently (e.g., annually or even once every three years) and to quote asset values between appraisals using inexpensive internal updates. This practice enables investment managers to alter the timing of appraisals and the selection of properties to be appraised to manage reported returns.

Smoothing

Smoothing is reduction in the reported dispersion in a price or return series. Smoothed returns can mask true risk. An example from money markets illustrates this important concept. Consider a one-year U.S.-government-guaranteed certificate of deposit (CD) and a one-year U.S. Treasury bill (T-bill). The two investments offer the same risk-free cash flow in one year. Assuming that the one-year CD is nonnegotiable and has a substantial withdrawal penalty, the CD is riskier than the one-year T-bill because the T-bill offers the investor better liquidity. However, the methods of reporting the values of the two securities may vary. Most investors receive financial statements of their positions in T-bills indicating that the market prices of the T-bills fluctuate as interest rates fluctuate. In many financial statements, on the other hand, CDs are given a very stable value that accrues slowly at the CD's coupon rate and ignores the impact of interest rate changes on present values. This accounting simplification causes a smoothed reported price series relative to the economic reality. The smoothing of the CD prices causes the CD returns to be smoothed. When interest rates change, the true value of a fixed-rate CD changes regardless of whether the valuation method used for accounting purposes recognizes the volatility. The owner of a CD observing the smoothed prices might wrongly conclude that the CD is less risky than the T-bill because its reported value is more stable. Of course, the reality is that the T-bill is less risky because it offers better liquidity.

Stale prices

Stale prices are indications of value derived from data that no longer represent current market conditions. This section provides a simplified example of the effects of stale data on estimations of risk and return.

Operating Income (annual operating income)

The annual operating income is the income before financing costs (interest). gross profit - operating expenses

Autocorrelation

The correlation of current demand values with past demand values

The Effect of Stale Pricing on Volatility

The key point is that the observed volatility of a return series based partially on current data and partially on old data (i.e., stale valuations) will understate the true return volatility by a factor that can be economically significant.

low-hanging fruit principle

The low-hanging fruit principle states that the first action that should be taken is the one that reaps the highest benefits over costs. Thus, the order in which natural resource properties are developed should tend to be driven by the low-hanging fruit principle.

perpetual option

The option to develop rights to a natural resource may have no expiration date or may be leased on a temporary basis. We examine here the case of a perpetual option. A perpetual option is an American option with no expiration date. All perpetual options are American options, since a European perpetual option could never be exercised and therefore would have no value.

Natural Resources as Exchange Options

The process of developing a resource involves using the mineral rights along with fuel, materials, labor, management, and equipment to bring a commodity to market. It is for this reason that a natural resource should be viewed as an exchange option in which the developer exchanges one set of resources with stochastic prices (the production inputs) to obtain the output (with a price that is also stochastic). For example, a firm that owns mineral rights to gold ore can be viewed as owning an option to exchange the mineral rights, fuel, mining equipment, labor, management, and materials necessary to extract the gold for a long position in the underlying gold, as depicted more generally in the next exhibit, Receivables and Deliverables in Exchange Option.

Option Value

The sum of an option's intrinsic value and its time value is equal to the option's total value (or price) Option Price or Value = Intrinsic Option Value + Time Value of Option

The three key potential benefits of timber investment

The three key potential benefits of timber investment are: (1) it has the potential for returns that have a low correlation with traditional stocks and bonds (i.e., diversification potential), (2) timber offers flexibility in the timing of its harvesting (i.e., timing options that may lessen the risk exposure to short-term economic fluctuations), and (3) timber may serve as an effective inflation hedge.

time value of an option

The time value of an option is the excess of an option's price above its intrinsic value.

Three Factors of Multiple-Use Option Values

The value of the multiple purposes of farmland is driven by three factors related to the multiple uses (other than the moneyness of the current best use): (1) the current closeness of the profitability of each alternative to each other, (2) the volatility of the profitability of each alternative, and (3) the lack of correlation between the alternatives as to profitability. For example, suppose that a farmer has two main crops that are suitable for the farmer's land and equipment: corn and soybeans. The option to plant either crop has high value if: (1) each crop becomes the best choice at least periodically, (2) both corn and soybeans have profitability that varies substantially through time, and (3) if corn and soybean profitability is only mildly or negatively correlated. In all three cases, the option to switch from one crop to the other has higher value.

Regarding publicly traded pools related to agriculture and farmland, there are several stock indices that track the agribusiness industry.

These industries vary in their exposure to publicly traded companies in four areas of the agribusiness industry: (1) agricultural products, (2) seed and fertilizer, (3) farm machinery, and (4) packaged foods.

Four Causes of Return Smoothing Due to Reliance on Infrequent Transactions or Stale Data: 3

Third, managerial discretion can often be used to time or select appraisals to smooth performance. In some cases, the property manager's decision of when to update particular appraisals are not random but rather are selected carefully to manage apparent returns—delaying bad news and sometimes saving some of the good news for a future time. In addition, returns can be managed through model manipulation defined as inflated or deflated model inputs to generate particular values. One example of this practice is the use of an unrealistically low discount rate that has the effect of elevating the property's value. A favorable mark (i.e., a biased indication of value that is provided by a third party) can be used to inflate the reported value of a portfolio of real assets.

Reduced integration in the forest products industry

Timber ownership has changed in recent decades. At one time the forest products industry was integrated, with firms owning all of the components of the process: trees, pulp mills, and sawmills. More recently there has been reduced integration. Reduced integration in the forest products industry refers to the increased separation of ownership of trees, pulp mills, and sawmills and is a key reason for changes in timberland ownership. The reduced integration occurred over the past 30 years, with timberland increasingly viewed not so much as part of an entire system but as an input into a different system. A rise in leveraged buyouts in the 1970s and 1980s helped break up the integrated companies.

negative survivorship bias

Undeveloped land is sometimes criticized as an investment with poor returns, based on the observation that values of undeveloped land do not increase substantially through time. However, historical returns of undeveloped land may suffer from a negative survivorship bias. A negative survivorship bias is a downward bias caused by excluding the positive returns of the properties or other assets that successfully left the database. In this case, a return index on properties that remained undeveloped excludes the high returns obtained on the properties that were developed. In most investment analyses, survivorship bias is positive.

Value of Real Estate equation

Valueof Real Estate = Annual Operating Income / Cap Rate

When do you exercise (develop) a land option?

While land is generally a perpetual option, it should be exercised (i.e., developed) when the net benefits of development exceed the net value of retaining the option. Therefore, the decision to develop property can be modeled using option theory and depends on the moneyness of the option. The option value also depends on the volatility of the spread; the dividend yield (income) of the completed project; the risk-free rate; and any costs of holding the undeveloped land, such as property taxes, insurance, and maintenance.