Appraisal Methods
Key Term(s):
Discount Rate - The rate (%) used to discount future benefits to the present.
Net Present Value - Present value of all future benefits and costs.
Discounted Cash Flow Analysis - Method used to derive the Net Present Value (NPV) of the income stream produced by the property.
The process of appraising timberland is no different than any other real estate. The three generally recognized approaches used in real estate appraisal (including forest valuation), are:
- Sales Comparison Approach
- Cost Approach
- Income Capitalization Approach
Although it is not required that all three techniques be applied during the appraisal process, each of these techniques is closely related to the others. Information or values used under one technique to determine market value may first be determined or calculated under a different technique. Thus the most accurate appraisal will result from one that utilizes all three techniques in the analysis.
Sales Comparison Approach
In the sales comparison approach, market value is estimated by comparing properties similar to the subject property that have recently been sold, are listed for sale, or are under contract. A major premise of the sales comparison approach is that the market value of a property is directly related to the prices of comparable, competitive properties. The more comparable sales that can be found the better the final analysis.
Comparative analysis focuses on similarities and differences among properties and transactions that affect value. Once a set of comparable sales has been determined they are adjusted to the subject property based on the date each sale occurred, the buyer or seller motivation, the average volume per timbered acre, the site features (e.g., road costs, operability, terrain), the timber quality, the average age of the timber, the species mix, property location and size, property rights conveyed, and conditions of the sale.
Applicability and Limitations of Sales Comparison Approach
The sales comparison approach is applicable to all types of real property interests when there are sufficient recent, reliable transactions to indicate value patterns or trends in the market. When the market is weak and the number of market transactions is insufficient, the applicability of the sales comparison approach may be limited.
The sales comparison approach is a significant and essential part of the valuation process, even when its reliability is limited. Although the dissimilarities in factors affecting property value cannot always be properly identified and quantified, the sales comparison approach may still provide a probable range of value in support of a value indication derived using one of the other approaches.
Cost Approach
The cost approach can be thought of as the sum of the parts. Value of the whole property is derived by summing the value of the individual timber components (merchantable and non-merchantable young growth) with the value of the land. This separation is made for analytical purposes only, the goal is still the value of the property as a whole. Thus, the value of the subject property is a direct function of the combination of the site and improvements it contains.
Like the sales comparison and income capitalization approaches, the cost approach to value is based on comparison. In the cost approach, the appraiser estimates the value of a subject property in comparison to the cost to produce a new subject property or a substitute property. Please note that the cost and value of an asset are not necessarily the same. Cost equals value only if the asset is new or to be purchased
The techniques used to value the individual components of the subject property are a mix of the other two appraisal methods:
Merchantable Timber — The merchantable timber component can be valued using either comparable "timber only" sales, with adjustments similar to those used in the sales comparison approach, or through the income (conversion return) approach. The goal is to derive a stumpage (dollars/MBF) value.
Non-Merchantable Timber, Land and Other Uses — The non-merchantable timber and land are valued using transaction evidence from previous sales, with adjustments for time and other factors. The goal is to derive a dollars/acre value.
Once the values of the individual components have been determined they are added together to determine a final market value.
The appraiser should make sure that the value indicated by the cost approach is estimated as of the effective appraisal date and that it is consistent with value indications derived from the other two approaches to value.
Applicability and Limitations
The cost approach is particularly important when a lack of market activity limits the usefulness of the sales comparison approach. When the physical characteristics of comparable properties differ significantly, the relative values of these characteristics can sometimes be identified more precisely with the cost approach than with the sales comparison approach. Because the cost approach requires that land and improvements be valued separately, it is also useful in appraisals for insurance purposes.
Income Capitalization Approach
An investor who purchases income-producing real estate is essentially trading present dollars for the expectation of receiving future dollars. The income capitalization approach uses mathematical procedures (discounted cash flow analysis) to analyze a property's capacity to generate benefits (usually monetary) and convert these benefits into an indication of present value.
The principal of anticipation is fundamental to the income capitalization approach. Because value is created by the expectation of benefits to be derived in the future, value may be defined as the present worth of all rights to these future benefits. All income capitalization techniques attempt to consider anticipated future benefits and estimate their present value.
The anticipation of receiving future benefits creates value, but the possibility of losing future benefits detracts from value. Appraisers must recognize investor's attitudes in analyzing market evidence, projecting future benefits, and applying capitalization procedures. Investors expect to earn a higher rate of return on investments that are riskier. This should be reflected in the discount rate used by the appraiser.
The techniques used to value the merchantable timber, non-merchantable timber and land are based on discounted cash flow analysis:
Merchantable Timber — The merchantable timber is valued by calculating net present value based on a harvest (management) plan for the subject property. The process starts with the stumpage rate (dollars/MBF) from the cost approach. Real stumpage appreciation and biological growth is factored in for each harvest period. Then the future value of each harvest is discounted to present time.
Non-Merchantable Timber, Land and Other Uses — The non-merchantable timber, land and other uses are valued by calculating net present value of all future cash flows by class (stand) type. First the future income by harvest period for each class and appropriate number of periods is calculated then discounted to present time. The future value of all periodic expenses, by class, is calculated and discounted to present time. All annual costs are discounted to the present. The final value of non-merchantable timber, land and other uses is determined by subtracting the present value of all expenses and costs from the present value of all income.
Applicability and Limitations
Future values cannot be known with certainty, but the discounting process weighs the near term cash flows more heavily than those that will occur in the more distant future. This makes the choice of the discount rate very critical.
The analysis of cost and sales data is an integral part of the income capitalization approach, and capitalization techniques are frequently employed in the sales comparison and cost approaches to valuation.