How To Understand Teak Investments

Teak Investments – An Intransparent Market Teak is a prime tropical hardwood and requires 20 – 25 years to grow in a commercial plantation. The plant origins from …

Teak Investments – An Intransparent Market

Teak is a prime tropical hardwood and requires 20 – 25 years to grow in a commercial plantation. The plant origins from Asia but today teak plantations can be found in various tropical climates such as Central and South America, Asia and Africa. Teak investments in a plantation are said to be one of the most attractive investment opportunities over the long term, avoiding deforestation of natural prime forest and producing investor returns in excess of 10%.

When looking at concrete available teak investment opportunities, the individual investor is faced with a jungle of different providers and "Best Buy" options. Doing a proper comparative analysis can be difficult and time consuming because of the lack of data. For the non-expert it is nearly impossible to compare various teak investment offerings, and because of this the investor can become lost.

IRR

Most teak investments highlight the return potential returns, using Internal Rate of Return (IRR) as best proxy (or sometimes also referred as the Return on Investment ROI). IRR is a subjective and forward-looking estimate, derived from expected cash flows. Showing a stream of cash in and out does not necessarily mean the financials are put in stone, though. In contrast those estimations are heavily dependent on the underlying assumptions. For teak, only a few assumptions define most of the cash flows:

  • Price inflation estimate 
  • Base selling price assumption per m3 of teakwood
  • Commercial timber volume of a tree (in m3)
  • Thinning schedule 

Inflation is difficult to estimate going forward, and in some cases historic data is being used for justification purposes. Just to mention, supply and demand dynamics in the future might be very different from the past while a base selling price should correspond to a realistic achievable price currently observed in the target market.

When estimating expected timber volume for an existing plantation, pay close attention to tree diameter. However, even if the diameter appears superb, make sure the trees are straight and have enough space to grow  — maximizing commercial value.

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The thinning schedule defines when commercial thinnings are going to be made — taking out the bad trees and leaving more space for the good ones to grow further (natural selection). In order to have commercial value, the wood needs to be a certain age. For estimation purposes, setting the thinning schedule earlier on will positively impact IRR, since the investment horizon is shorter.

Changing one or two key assumptions in such a model results in significantly different cash flows and IRRs. Thus, more important than looking solely at the outcome (IRR), it is crucial to review the underlying assumptions and potential risks of the investment proposal.

Since all those assumptions are subjective, they can be used to “push” IRR up, showing a more optimistic picture to attract investors. Thus its important to check that the assumptions are consistent with real observations. Without having a proper comparative basis, it will be very difficult for the single investor to challenge and put those assumptions into context. Teak investments are long term in nature, and require strict discipline in cash management. Compounding effects of incorrect assumptions could have a devastating impact on investors. If the company runs short of cash, and requires more funding, existing investor shares could get diluted. Thus from an investor point of view, it is more important to be comfortable with the assumptions in addition to the IRR.

Risks

Teak investments have various risks starting with improper site and location analysis. Fires can also cause tremendous damage to younger trees, while older trees typically are more resistant. These risks are especially relevant for Greenfield projects in the first few years after planting trees. After the first few years the need for maintenance is reduced and the results are more clearly visible. Entering a plantation at a more mature stage lowers risk for the investors.

Beyond the technical risks, here are some of the investment risks:

  • Quality of the plantation manager
  • Asset being illiquid
  • Overpaying at time of acquisition
  • Underfunding of the investment
  • Legal

It is important to be confident of the plantation manager’s ability to maintain the trees, and maximize their commercial value. It is helpful to look at reference projects, and actually check that the underwood has been cut and the branches are pruned.

Private teak investments are illiquid in nature, and investors should be prepared to stay invested during the entire time of the project. One way to mitigate this risk is to invest in a project involved in plantations of various maturities. By investing in this manner, investors can expect ongoing cash flows rather than lump sums tied to one final harvest year. The other option is to sell the investment before harvest, e.g. in year 10, which in theory could be attractive to a new investor (shorter investment horizon). However, in practice this is difficult since the market is intransparent, and it is difficult to find a buyer. In this instance, contacting an independent broker would be advisable.

Price Per Hectare

Teak plantations have similar activities – growing trees – and the cost structure is pretty similar.  Thus, Price Per Hectare is an ideal quick ratio to compare investment options across the industry. From an economic point of view, Price Per Hectare should be low when entering an investment. However, Price Per Hectare should always be considered in the context of a risk analysis. There might be valid reasons why it is worthwhile to pay a higher Price Per Hectare if it helps to reduce risk:

  • Sustainability certifications such as FSC should allow to sell the timber to more buyers than non-certified timber, thus reducing risk
  • Value additions such as a mill can allow to capture more value along the value chain
  • Quality of the plantation manager since it affects the risk of improperly maintaining the plantations

Factors like these influence the risk / return equation, thus providing arguments to pay higher price per hectare than a similar opportunity which shows less premium arguments.

Conclusion

Some folks in the industry might tell you that financial forecasts are just numbers, based on estimations, rather than the reality of the investment — which is growing a tree. From an investor point of view they are wrong. Visiting a plantation and seeing it in good condition is not enough to complete Due Diligence on a project. You should only invest if the expected return outweighs your risk. This requires an in-depth look at the financial forecast, entry price, risks and how the investment relates to other investment proposals.

Investing Alternatively was founded to facilitate teak and other tropical forestry investments by creating a secondary marketplace and make it easier for the individual investor to understand such opportunities. Investing Alternatively works with the project managers to assist them to become more transparent for their investor’s benefit. Investors or project managers are free to list their opportunities with IA, enhance the transparency of their investment opportunities and attract more interest from investors truly interested to understand what they are buying.

For further information, please refer to www.investingalternatively.com

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