Publication Date: September 2005
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Chapter 5 | Table of Contents | Chapter 7
6. Diminution of FMV: Verification
A. Requirement to Value SIP Before and After Loss
Under Treas. Reg. 1.165-7(a) (2), the casualty loss determination requires that the fair market value of the SIP (block) be ascertained by competent appraisal, immediately before and immediately after the casualty event to determine the diminution of value.
In a casualty loss audit, the valuation issue is the requirement that the reduction in fair market value be determined with reference to the SIP, which is the depletion block.
Fair market value, as defined in section 1.170A-1(c)(2) of the Income Tax Regulations is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.
An appraiser’s value estimate is his opinion of the probable price obtainable in the market free of abnormal influences. A basic limitation of any appraisal is that it is an opinion of value, and is therefore not a guarantee that a property will sell at the appraised value.
Highest and best use is the cornerstone of value in the appraisal process. The Dictionary of Real Estate Appraisal defines Highest and Best Use as “the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value”. (Appraisal Institute, 1993, p. 171)
B. Accepted Appraisal Techniques
Widely accepted appraisal theory suggests that market value can be estimated using one of three methods: the sales comparison approach, the cost approach, and the income capitalization approach. When properly applied all three approaches should be reconciled to one value conclusion. If inaccurate assumptions are used in any of the approaches, the range of value indicated by the three approaches can be very wide.
1. Sales Comparison Approach
The sales comparison approach is founded on the principle of substitution, which holds that a buyer would pay no more for the property than the price at which he could obtain a substitute property having similar utility. Estimates of before and after market values are based on open market prices recently paid for similar properties in the market area. Prices of the comparable sales must be adjusted to account for value differences attributable to the influences of financing, time, location, physical characteristics, and conditions of sale, size, and other factors that drive sale price. The transactions used in the analysis should be arm’s length transactions.
The sales comparison approach is particularly useful for undeveloped land, in active timberland markets, and where intangible non-timber values are important to the marketplace. In the United States, it is the most commonly used approach to timberland appraisal, particularly for smaller properties. It is generally considered superior to the other approaches where abundant sales of recent origin are available, and where one or more comparable sales have marked similarity to the subject property. The sales comparison approach is generally preferred by the courts because of its empirical character.
2. Cost Approach
The cost approach consists of the summation of two components: vacant land and the depreciated replacement cost of improvements. Like the sales comparison approach, it is founded on the principle of substitution: a buyer would pay no more for the subject property than the cost to purchase a comparable parcel of land and construct improvements having similar utility. When applied to timberland, it can be useful if there are several distinct economic units that can be valued separately. The bare land component can be valued from sales of cutover land, or from land allocations in timberland sales. Timber is treated as an improvement, and is valued by comparing it with open market stumpage sales of similar timber.
The cost approach is applied by extracting the value of these separate economic units from different sales transactions, and then “assembling” the value components into an indication of total property value. First, bare land values are derived from either sales of bare land or sales of stocked timberland in which appropriate allocations have been made to the bare land component. Reproduction and premerchantable timber values are derived from sales of land and timber and pre-merchantable stocking where appropriate allocations have been made using sales of merchantable timber; or by capitalizing the start up cost at an appropriate rate for the age of the reproduction (a cost forwarding method). Merchantable timber values, i.e. stumpage values, are derived from actual timber sales or through conversion return analysis. Conversion return consists of taking delivered log prices, at the first point of delivery, and subtracting all cost associated with the harvesting and hauling of the logs. The residual value from that computation is then attributable to stumpage. Just remember that cost associated with profit and risk should be a part of the logging cost. The sum of the land, reproduction, premerchantable timber, and merchantable components should be compared to the market sales as a check for reasonableness.
3. Income Capitalization Approach
The income capitalization approach is based on the principle of anticipation, which states that value is derived from the anticipation of future benefits (net income). It is most appropriate for properties that are regularly bought and sold on the basis of their ability to generate a sustainable net income stream.
Of the three approaches to valuation, the income approach is the most complex and most difficult to apply to timber properties. This is due not only to economic fluctuations over time but also due to an ever-changing forest products industry. Many of these changes are due to technological advances and many are due to global market supply and demand. It requires many assumptions on the part of the appraiser, who must integrate these assumptions mathematically to produce a value estimate. The value estimate is derived from projecting net operating income from the property, where income is the net of revenues from owning the property less the costs of ownership.
A key aspect of the income capitalization approach is that it recognizes the time value of money. This concept underlies much of investment analysis, and in general terms takes into account the fact that a dollar received today is worth more than a dollar received in the future. Where the income approach is used it should reconcile to the market data and cost approaches. If there is a significantly different amount indicated by the income approach it is highly possible that errors were made with some of the assumptions.
C. Performing an appraisal review
Current Timberland Appraisal Standards
Real estate theory and tax law throughout the U.S. hold that standing timber is both real estate and a capital asset. Therefore, when it is appraised in conjunction with the underlying land, general real property appraisal guidelines and rules apply.
Timberland appraisal in the United States occurs with the general framework and standards established for other types of real estate appraisal. There are two main appraisal standards in the United States: (1) the Uniform Standards of Professional Appraisal Practice (USPAP) and (2) the Uniform Appraisal Standards for Federal Land Acquisitions (USSFLA). Both cover real estate assets in general, of which timberland is only a small subset. USPAP is the controlling framework and standard for most private timberland appraisals.
Compliance with USPAP is administered by individual state appraiser certification and licensing boards. USPAP provides performance standards for appraisal of real property, mass appraisal, business appraisal, personal property appraisal and real estate consulting. Consequently, all timberland appraisals conducted by licensed appraisers must comply with USPAP.
USPAP provides important guidance in general valuation principles. Standard 1 sets forth appraisal procedures and Standard 2 presents appraisal-reporting standards. In general, appraisal techniques seek to duplicate the process, conscious or unconscious, by which a typical buyer of the property would arrive at the price to be paid. That is, in appraising property, the appraiser must put himself in the shoes of the typical buyer. The appraiser must think about what thought processes and techniques prospective buyers and sellers use to arrive at the price to be paid.
Regional Differences in U.S. Timberland Valuation Practices
The forest products market is increasingly a global market. However, while the markets for forest products are converging, there are differences among the timberland appraisal techniques applied to the various U.S. regions. The differences in analytical procedures are primarily a function of variances in the resource itself, but also include some differing regional views of the appraisal process.
In general, large timberland investors in the U.S. typically rely heavily on the income capitalization approach for purchasing large timberland properties. This is also true for timberland investors in Australia and South America. However, there are differences in the complexity of the models used in each region. The models used in the Pacific Northwest and South are typically more complex than those used in the Northeast and Appalachia, because forest management in the former areas is more intensive and projections are made on a stand-level basis, as opposed to a forest-wide basis. In general, the income capitalization approach requires a substantial amount of information and technical skill in growth and yield modeling, and thus may be more difficult for small investors to use.
The income capitalization approach is also used by timberland investors in evaluating whether to dispose of properties. However, here it is used in conjunction with the sales comparison approach. For instance, an investor will use the income capitalization approach to estimate how much the property is worth to them, in terms of net present value, and use the sales comparison approach to test the results against market transaction evidence. If the market promises to pay more than the asset’s value to the investor, he may choose to sell it.
The sales comparison approach to valuation is used by large and small timberland investors for both acquiring and disposing of properties. For large timberland investors acquiring timberland, the sales comparison approach is used as a reality check on the income capitalization approach. It is a way for investors to judge if the results of the income capitalization approach are reasonable. Smaller, less sophisticated timberland investors are more likely to rely heavily on the sales comparison approach, and if they use the income capitalization approach, they typically model a liquidation cut. Such investors may not have the technical capability or interest in financially modeling a property over long time periods. Smaller or short-term investors may also look at a combination of the sales comparison approach and GRTV (gross retail timber value) in acquiring properties. In disposing of properties, investors clearly evaluate their property in terms of the sales comparison approach. They seek to evaluation what their property would bring in the current market, and are interested in learning how similar timberland sales have fared.
Recognizing differences between wholesale and retail values
The sale price of timberland is a function of the component values of the asset. With larger and slower growing assets, prices usually reflect some level of discount off the gross retail timber value (GRTV) of the component parts. This has been described as a retail-wholesale relationship. Following are some factors that typically influence the level of discount. They explain why the contributory value of a component asset may be less than its retail value.
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Natural growth versus plantations
A. Natural growth is more complex, usually slower growing and harder to model. It is often attributed no value, either because the buyer expects to replace it with planted stock, or because it will take so long before it matures.
B. Plantation growth is faster growing and easier to model.
C. Plantation growth is often subject to little discount.
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Biological growth – Northern versus Southern versus Western
A. Northern growth is the slowest growing.
B. Southern and Western forests generally grow fastest.
C. The slowest biological growth is likely to receive the largest valuation discount, from retail.
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Value growth – a function of combined biological growth and the supply-demand structure of a region’s timber markets.
A. Fast growth and expected price increases produce lower discounts.
B. Slowest value growth is subject to the largest purchase discounts.
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Liquidity – a function of numerous factors, including logging and other environmental regulations, weather-related limitations, size issues, credit markets, etc.
A. Generally, the less liquid a market, the more the timberland is subject to discounting.
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Regional Distinctions
A. South – There are few restrictions on timberland markets in the South. For instance, there are few environmental restrictions and comparatively little inoperable terrain. There are good to excellent markets for all diameter logs, as well as for both bare land and forested land. Timber is almost always sold via stumpage sales. Most timberland consists of pine plantations, operated by mostly mechanized equipment. This region is perhaps the most liquid in the United States, with the most transparent values. All three approaches to value are commonly used.
B. Appalachia – There are very few environmental restrictions. Steep slopes may limit operability. Predicting growth and yield of this mainly hardwood resource can be difficult. Markets for low-grade products may be thin. Hardwood markets are well developed and unit stumpage prices are often very high. Timber is usually sold via stumpage sales. All three appraisal approaches may be used.
C. Northeast – This region has various levels of environmental restriction. Markets are thin for lower-grade products in some areas. Timber is usually sold via stumpage sales from smaller properties. However, managers of larger properties, particularly in northern New York and northern New England, have shifted primarily to direct marketing. (Note changed footnote size via superscript on font format – same with other footnotes) While all three appraisal approaches may be used, the analysis of smaller properties that are not being bought for investment purposes is usually confined to the sales comparison approach. The cost approach is often not used. Growth is often the slowest. Discount factors must be extracted from comparable sale analysis and income approach analysis, which are then applied to the cost approach. The complexity of hardwood forests, may limit the reliability of modeling. Appraisers tend to emphasize the sales and income approaches, but rely on the income approach to illustrate the limits of investment returns. These same factors may also apply to slow growing pine and fir forests in the eastern Rocky Mountain areas of Colorado and Montana.
D. Lake States – Most of what has been described for the Northeast applies here as well. Forest management often reflects more careful silviculture. Timber on larger ownerships is often marketed via direct sales, while stumpage sales are common on smaller ownerships. Environmental restrictions vary, but are less stringent than in many areas of the Northeast. Logging conditions are among the most favorable in the nation. Some areas have extensive softwood plantations, but natural hardwood predominates. Growth rates are comparable to the Northeast.
E. West – This area is mostly devoted to a combination of natural and planted Douglas fir, ponderosa pine, true firs and redwood on a regional basis. It is subject to the highest growth rates, largest saw logs, largest per acre volumes and highest timberland values. Pulpwood markets and other small log markets are poorly developed. Environmental regulation and the cessation of log exports over the last 20 years have greatly reduced the liquidity of timberland markets. Stumpage sales are less common than direct sales. All three valuation approaches are used, but some appraisers limit analysis to the sales and income approaches. Conversion return analysis is the standard method for deriving stumpage values. Timber products are classified as reforestation, premerchantable, and merchantable. Logging conditions are important features in valuing many properties. Timber prices have been very volatile when compared to other regions.
General Appraisal Review Checklist
An appraisal should be objective, descriptive and documented. The appraisal should reflect a reasonable analysis from the data presented and should draw credible conclusions. The appraisal should be performed by a qualified appraiser, who meets appropriate licensing and competency requirements.
Within these broad goals there are some specifics that the appraisal should contain. They include but are not limited to the following:
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Is there an adequate description of the timber damaged and/or destroyed to
include field data that would allow for independent verification?
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Are all improvements clearly listed and described?
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Are the property rights addressed in the report?
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Does the appraisal identify the SIP, that is the subject of the before and after valuation, with sufficient detail to understand that the entire SIP was valued in computing the claimed loss?
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Is the scope of the appraisal clearly explained?
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Does the report analyze the highest and best use for the property? Is the highest and best use different from the current use?
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The appraisal report should contain sufficient information and analysis to support the conclusions arrived at in the report.
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The appraisal analysis should incorporate sufficient analyses to adequately model market behavior.
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Does the report include a sales comparison approach, income approach, and cost approach to estimate value? If not, does it explain why not? Does the report contain a reconciliation of the value of all approaches used, supporting the final estimate of value, including well-reasoned justification?
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Timing. The appraisal should be as of a particular point in time, usually a specific date. Does the appraiser indicate the effective date?
If the taxpayer’s appraisal appears inadequate, unsupported, or otherwise unreliable, consider a referral for an IRS forester’s assistance.
D. Nonconforming Valuation Methods
1. Additive Method
The additive method does not look at the before and after value of the SIP (for LMSB cases this is usually the depletion block), but estimates the loss by determining the volume of the timber damaged or destroyed and multiplies this volume times per unit stumpage rates to determine the total loss. Since this method does not determine diminution in value with reference to the SIP, it is not an acceptable valuation method.
2. Non-physical damage
Some appraisals have claimed losses associated with nonphysical damage attributable to casualty events. Examples include:
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Buyer resistance;
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changes in lumber recovery/production in the taxpayer's processing facility;
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changes in lumber quality associated with smaller size logs or altered products;
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disruption of harvest schedules;
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impact on ability to borrow because of loss of collateral.
Courts have repeatedly rejected the inclusion of non-physical damage in the computation of casualty losses. Casualty losses must be the result of damaged or destroyed property.
3. End product conversion return
Some loss determinations are based on using a discounted cash flow projection to value reproduction and/or premerchantable timber as either pulpwood or saw logs. In some extreme cases, the valuation attempts to project premerchantable value based on lumber recovery from the reproduction or premerchantable timber at some future date. There are two problems with this approach. First, it is a variation of the additive approach in that it values the affected volumes but does not determine the diminution in value of the SIP. Second, there is the difficulty with using DCF in predicting future end product (i.e. lumber) prices. The method involves many assumptions for both production costs and future end product prices. These variables are susceptible to manipulation. In addition, the uncertainty of future technological advances in forest products manufacturing will have a huge impact on the assumptions used in this method of valuation. Empirical observations of the results of DCF for lumber price projections indicate that often the predicted value exceeds the value derived from market sales data by 2-3 times.
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