Chap 9 - Natural Resources and Land

Question 1

What are natural ressources ?

Answer 1

Natural resources are real assets that have received no or almost no human alteration.

Question 1

What are real assets ?

Answer 1

Real assets are economic resources that create or add to the consumption opportunities available to people. All consumption ultimately originates from real assets

Question 2

What is a split estate ?

Answer 2

A split estate is when surface rights and mineral rights are separately owned.

In most jurisdictions, private land ownership is limited to surface rights, with the ownership of underground mineral and energy rights retained by governments. (US: private land ownership has typically included mineral rights. Although land is publicly owned, some states allow split estates). This creates the possibility of leasing the natural resource rights to developoers for eventual extractiion.

Question 3

What is a pure play ?

Answer 3

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. 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. ( through private partnerships or listed partnerships (MLPs)

Question 4

What is the option view of a natural ressource ?

Answer 4

A potential developer of a natural resource anticipates expending money to develop the natural resource into a commodity or another improved real asset just as a call option holder anticipates expending cash to acquire an asset. However, a key aspect of natural resources as options is that they are better analyzed as an exchange option rather than as a call option with a fixed strike price (ammount of money to develop is uncertain).

Question 5

What is an exchange option ?

Answer 5

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.

Question 6

The key idea is that both the price of the developed natural resource and the cost of developing the resource are stochastic, so the moneyness depends on the spread between the benefits and the costs of development.

Answer 6

Being in-the-money means that if the mineral rights are mined at the current price of the commodity (e.g., gold), then the revenues from the sale of the commodity will exceed the current costs of developing the commodity (i.e., mineral rights, fuel, labor, management, materials, and equipment).

Question 7

What is a perpetual option ?

Answer 7

The option to develop rights to a natural resource may have no expiration date or may be leased on a temporary basis. 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.

Question 8

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.

Answer 9

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 (first a property in a jurisdiction supportive of development, with easily accessible material, rich in gold , and (2) a property subject to strict environmental regulations and poorly accessible material with low concentrations of gold ore)

Deep-in-the-money and then deep out-of-the-money

Question 10

What are the intrinsic option value and the time value of an option ?

Answer 10

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

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

Question 11

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.

Answer 11

From a macroeconomic perspective, the price of the associated commodity rises or falls to either increase or decrease development rates so that the supply of the commodity matches the demand for the commodity.

Question 12

The steep slope of the option curve in Exhibit 9.2 for options that are far in-the-money indicates that changes in the price of the commodity are the dominant source of short-term volatility in the value of the option to develop the natural resource. 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. Conversely, natural resources that represent out-of-the-money development options have substantial sensitivity to uncertainty other than the price of the underlying commodity. The more distant time horizon for possible development increasesthe sensitivity of the natural resource’s price to changes in development costs, interestrates, and other factors.

Question 13

What is Raw (undeveloped, unimproved) land ?

Answer 13

Raw, undeveloped, or unimproved land is land that is not currently generating substantial scarce resources, such as food, shelter, or recreation. The value of any such land must be attributable to the possibility or option that the land can be developed, improved, or otherwise transformed into being productive.

Question 14

What is Land banking ?

Answer 14

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.

Question 15

What are the three types of lots that can be purchased for investment ?

Answer 15

1- 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.

2- 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 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.

3- 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.

Question 16

Lots far from urban areas trade at steep discounts to potential value because their development is longer-term and less likely, which implies higher risk and possibly more expenses from, for example, building paved roads and providing electricity and sewerage in a pioneering effort. Unfinished lots also face steep disounts because of the expenses required to develop lots into finished products. These concepts are best understood when land is viewed as a call option.

Answer 16

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.

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.

Question 17

What is a risk-neutral probability ?

Answer 17

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.

Question 18

The option view of land can therefore allows us to calculate the value of the option by a bionomial pricing technique :

Answer 18

Current Value = Expected Value = (UpValue × UpProb) + [DownValue × ( 1 − UpProb) ]

Question 19

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 :

Answer 19

E(Rl) = [Pd × E(Rd)] + [(1 − Pd) × E(Rnd)]

Where E(Rnd) 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.

Question 20

What is a negative survivorship bias ?

Answer 20

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.

Question 21

What does Reduced integration in the forest products industry refers to ?

Answer 21

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.

Question 22

What are Timberland investment management organizations (TIMOs) ?

Answer 22

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.

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.

Question 23

What is rotation in the context of timberland ?

Answer 23

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.

Timber does offer harvesting flexibility, which is a timing option. A harvest
schedule can be accelerated or postponed , giving the owner the opportunity to time a harvest to coincide with personal income needs or to wait for a more favorable price situation.

Question 24

What are the 4 key publicly traded ways to invest in timber in the United States ?

Answer 24

Most timberland is directly owned and privately traded by institutional investors.

1- Investors can directly own shares in publicly traded timber-related firms.

2- There are two major ETFs ( WOOD and CUT) that have been developed to track timber firm values.

3- Most popular way for retail investors to gain exposure to timber is through real estate investment trusts (REITs).

4- 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.

Question 25

What are three key potential benefits and key disadvantages of timber investment

Answer 25

Advantages:

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).

3- Timber may serve as an effective inflation hed.

Disadvantages:

1- Timber values are tied to cyclical industries such as housing that can experience prolonged slumps.

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.

3- The potential for losses due to natural disasters or adverse changes in legal standards.

Question 26

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.

Answer 26

The value of farmland, like all assets, is the sum of the discounted future cash flows. As a potentially perpetual asset, farmland value can be modeled with the perpetuity formula.

Value of Real Estate = Annual Operating Income∕Cap Rate

The cap rate (capitalization rate) or yield is a common term for the return
on assets. The annual operating income is the income before financing costs.

Question 27

What is Row cropland ?

Answer 27

Row cropland is annual cropland that produces row crops, such as corn, cotton, carrots, or potatoes from annual seeds. Row cropland comprises approximately 55% of the NCREIF Farmland Index, a major U.S. index of farmland
values.

Question 28

What is Permanent cropland ?

Answer 28

Permanent cropland refers to land with long-term vines or trees that produce crops, such as grapes, cocoa, nuts, or fruit. To provide an indication of relative sizes, permanent cropland comprises approximately 45% of the NCREIF Farmland Index.

Question 29

What is agency risk in the farmland context ?

Answer 29

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). In the case of farmland, the agency risk is the possibility, and perhaps the likelihood, that a farmer will fail to maximize the net economic benefits to the owner.

Question 30

What is political risk in the context of farmland ?

Answer 30

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.

Question 31

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.

Answer 31

Growth in yields, particularly in the developed world, has occurred largely as a result of four advances: (1) improved technology (including advancement of seed stock through plant breeding and, in certain cases, transgenic modification); (2) improved agronomy; (3) increasing use of inputs, such as fertilizer; and (4) increasing
use of capital assets, like machinery and agricultural infrastructure.

Question 32

What is agronomy ?

Answer 32

Agronomy is the science of soil management, cultivation, crop production, and crop utilization. Agricultural infrastructure, like other forms of infrastructure, derives economic return largely from the value of efficiency gains.

Question 33

What are three key potential benefits and key disadvantages of farmland investment ?

Answer 33

Advantages:

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

3- The supply of farmland may be more constrained than the demand for agricultural products.

Disadvantages:

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.

3- Farmland ownership can involve high levels of agency costs.

Question 34

What are the 3 approaches for institutional investors to access agricultural asset returns ?

Answer 34

1- Direct ownership of farmland to earn lease income.

2- Direct ownership of listed equities in agricultural firms or through pooled funds.

3- Long positions in agricultural futures contracts or similar financial derivative instruments. This provides exposure to agricultural prices, not directly land prices, and may not be highly correlated with farmland values.

Question 35

What are the 4 agribusiness industries tracked by stock indices ?

Answer 35

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.

Question 36

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.

Answer 36

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.

Question 37

What is smoothing ?

Answer 37

Smoothing is reduction in the reported dispersion in a price or return series.
Smoothed returns can mask true risk.

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. 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.

Question 38

What is a Managed returns ?

Answer 38

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.

Question 39

What is A favorable mark in the context of Managed returns ?

Answer 39

A favorable mark is a biased indication of the value of a position that is intentionally provided by a subjective source.

Ex: Favorable marks may be used to obtain high real estate appraisals that enable larger mortgages.

Question 40

What is Selective appraisals in the context of Managed returns ?

Answer 40

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.

Question 41

What is Model manipulation in the context of Managed returns ?

Answer 41

Model manipulation is the process of altering model assumptions and inputs
to generate desired values and returns. 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.

Question 42

What is Market manipulation in the context of Managed returns ?

Answer 42

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.

Question 43

What are 4 causes of return smoothing due tu reliance on infrequent transactions or stale data ?

Answer 43

1- In highly illiquid markets 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.

2- 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.

3- 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.

4- 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.

Question 44

What are Stale prices ?

Answer 44

Stale prices are indications of value derived from data that no longer represent current market conditions.

Question 45

The previous sections implicitly viewed returns based on market prices as true indications of risk while viewing smoothed returns based on appraisals as flawed indications that underestimate the true risks. However, in some cases, there is considerable debate regarding the reliability of market prices versus appraisals.

Answer 45

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. For example, if the equity market experiences a huge sell-off and the listed prices of real assets similarly decline, do the large losses correctly reflect actual diminished value of real assets or do they overstate the true losses?

Question 46

What is contagion ?

Answer 46

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.

Question 47

Both appraised values and market values of real assets are used to estimate historical mean returns and volatility. Clearly, the results need to be viewed in light of the likelihood that the reported volatility of farmland and timberland based on appraisals substantially underestimated the true volatility because of the use of smoothed valuations rather than market prices.