What do the vineyards and wineries in California have in common with over half of the country's forestland?
They are owned by family businesses, and there will be a huge ownership or generational transition-probably in the next 10 years.

For the most part, though, millions of dollars in capital in these businesses is tied up in the land itself. This illiquid asset does not generate a big income or cash flow, so it doesn't allow a family to carry out the generational transfer techniques most businesses use.

Vineyards and wineries are also complex assets. It's well known, for example, that many of them are "lifestyle" businesses and it's become increasingly difficult in recent years to turn a profit from them. Similarly, timberland is for most families "part business, part recreation and part family heirloom," says David Watson, president of D.A. Watson & Company, an independent financial advisory firm in Chesterfield, Mo., that helps families plan the intergenerational transfer of non-traditional assets like timberland, family farms and conservation properties.

"For landowners, their families and family culture-who they are, their worldview-is wrapped up in this piece of property," he says. "And unlike financial assets, this property is not easy to divide."

During the last 30 years or so, vineyards and timberland have become popular alternative assets with endowments like Harvard's and Yale's and other institutional investors like John Hancock and TIAA-CREF. In timberland, these investors have reaped average annualized returns in the high single digits, 6.5% to 10% in the past five years. While historically these returns were high for low amounts of systematic risk, that has changed as more players have jumped into the game, says Clark Binkley, a managing director at International Forestry Investment Advisors LLC, in Portland, Ore.

Though these holdings are considered long-term investments by Wall Street standards, they are short-term holdings if you consider the biological growth to maturity of most trees. In the U.S., that can range from 35 to 40 years for commodity Southern yellow pine to a century or more for hardwood oak growing in the northern Midwest. Because people are holding them as short-term investments, not for their long tree life, they are more correlated to other investments than people think, says Binkley.

"The argument is that trees grow while the sun shines, but they do not read The Wall Street Journal," he says. "If you buy bare land and plant the trees, 100% of the return will come from tree growth. But are investors doing that? We believe the only structurally uncorrelated component of returns from timberland is tree growth."

Income from growing trees, Binkley points out, accumulates tax-free. When that quality is taken alongside the non-correlation of returns in properties held for the very long term, forests create an interesting opportunity for intergenerational wealth transfers. He cites a conversation he had with a Hungarian national whose family lands were returned after communism ended in that country. One branch of the family got back a factory that was not only worth nothing but had a big liability due to the high cost of cleanup. The other branch of the family got back a forest. "It was beat up and full of shrapnel," he says. "But it was still worth a lot."

Timber And Vineyard Wealth Transfer
So how do the economics of traditional timberland and vineyard investing play out?

There are two sources of returns in timberland. First is the income generated from the sale of the timber itself. The second source is the capital gains generated when the owners divvy up large plots of land and sell them in smaller chunks for real estate development. Whereas timber sales offer an annuity, sales of land for real estate development are more cyclical, depending on housing demand, etc.

Here's how it works: If the land is nursing seedlings or pre-merchantable timber, it is generally valued at the price of the bare land, plus the discounted future value of the young trees. If the timber is merchantable-that is, big enough to sell as timber or pulpwood-the price can also include an amount anywhere between 10% and 70% of the timber's value. In recent years, those prices have become extremely volatile. They are affected by the variable costs of logging and hauling. 

As trees grow, their value grows. Harvests yield cash flow. Forest economics also differ substantially by species, and prices for the same species can vary by as much as 25% to 30% between mills in the same micro-market.

For example, Southern yellow pines harvested from the ages of 15 to 20 (for pulpwood and paper) currently sell for $8 or $9 a ton. From the ages of 18 to 24, some of it is used for pulpwood and the rest for construction lumber and 2-by-4's, and sells for $15 to $18 per ton. And from ages 27 to 35, when it's mostly used as structural lumber, it fetches $24 to $27 per ton. (These prices are the lowest in decades, no doubt because of the financial crisis and the slowdown in construction.)

Note the "S" curve: A tree grows fastest physically-and reaps its largest economic gains-during its teenage years. After it reaches maturity, both its physical growth and its financial value grow at a slower rate.

While the principles are the same, timber economics differ by species. Douglas fir and hemlock, which grow in the Northwest, are not merchantable until they reach middle age, during the ages of 30 to 45. (They are harvested for saw logs; pulpwood and paper are residuals.) But at maturity (between the ages of 55 and 70) they are four times as voluminous as a Southern yellow pine. That renders their quality, and pricing, superior.

In addition to trees, forests provide a host of "ecosystem services"-clean water, flood control, habitats for fish and wildlife, soil building, carbon storage, etc. According to the United Nations-backed Millennium Ecosystem Assessment (2005), there are 24 main ecosystem services-most of them found in forests. Another United Nations-backed project, the Economics of Ecosystems and Biodiversity (TEEB), has estimated the negative externalities from forest loss and degradation at $2 trillion to $4.5 trillion per year-an amount equivalent to nearly half the U.S. GDP.

As a result, there is a growing interest in investing in bona fide forests with their ecosystem services intact-not just timberland and the wood it produces.

Vineyards are a similar story. In this case, the rule of thumb is that it takes three years to get a crop (and some cash flow), five to six years for the crop to mature, and seven years for it to earn a return. While vineyards are generally 30-year investments (meaning they generate an income for roughly 23 of those years), even 60- to 70-year-old vines can be prized.

As with timber, the bare land can be worth substantially less without the vines. According to Jay Silverstein, a partner at Moss Adams LLP in Santa Rosa, Calif., for example, the value of the land part of a recent deal in Sonoma was roughly $60,000 while the vines were valued at $20,000.

But the value of acreage varies substantially with geography. According to Mario Zepponi, a winery and vineyard investment broker with Zepponi Group, in Santa Rosa, Calif., the current values for non-trophy properties in Napa range from $200,000 to $225,000 per acre-whereas the value of land and vines together is $80,000 in Sonoma, $35,000 to $60,000 in the Central Coast region, and $10,000 to $15,000 in Mendocino and Lake counties.

A key difference between the two investments is that the income generated from a vineyard counts as income for tax purposes, while the income derived from selling timber generally counts as a capital gain. And if you are actively engaged in the management of the timberland (which is not a full-time job), you can also deduct operating costs against your ordinary income (depending on the passive income rules). "In effect," Binkley notes, "your after-tax returns can be higher than your pretax returns."

In the past, U.S. and European patriarchs in their old age harvested or bought cut-over land and planted new trees or vines in order to pass wealth to future generations. In this way, the land was passed when the value was low. It's still not unusual for different vine rows to be split among the progeny in Bordeaux, France, says Neil Campbell, founder and CEO of Carlsbad, Calif.-based FUTR Family Management LLC, a financial advisory firm that specializes in intergenerational wealth transfer.

Campbell believes that by planning for several generations and matching the lifetime cash-flow requirements of different family members to the assets and liabilities of timber and/or vineyards, families can earn another 0.5% per year compounded. "You know how long it takes the trees [or vines] to grow," he says. "Just as with fixed income, you can plot out an income stream over time based on the age of the trees [or vines] and when you choose to cut them."

Preserving Family Lands-and U.S. Forestland
To a certain extent, ecologists bristle at such notions. "The global economy is a wholly owned subsidiary of the environment," Ecotrust founder Spencer Beebe says, quoting former U.S. Sen. Gaylord Nelson, founder of Earth Day-not the other way around.

As this suggests, green forestry is about working with the land-and making sure that what you do is within the capability of the land. That means clear-cutting can be biologically appropriate-but not for all forest types and certainly not for all species, says Clint Bentz, a partner at Boldt, Carlisle & Smith, an accounting firm in Salem, Ore., and managing partner at Blue Den Ranch LLC, a 700-acre tree farm. "It is 60 to 80 years between planting and harvest for the trees in the Pacific Northwest and in the inland/Midwest," he says. "That's four to six generations of people. So cutting the trees down every generation doesn't make sense biologically."

The challenge, of course, is passing the family wealth in the form of land when there is little or negative cash flow. In California's wine country, these assets can be worth tens or even hundreds of millions of dollars, Zepponi says.
And much of the U.S. forestland owned by families was acquired after World War II-much of it by blue-collar workers. "These people don't think of themselves as rich, but you don't necessarily have to be a big landowner to have assets of $10 million or more," says Mary Sisock, who directs the Ties to the Land Initiative, a program at Oregon State University that helps with land succession.

The first question to ask in determining the value of land is its "highest and best use"-not what's on it, says Stephen J. Small, a Newton, Mass.-based attorney specializing in the preservation of family land and conservation. For most timberland in the U.S., he says, the "highest and best use" is development-not timberland. That means appraised value is development value-period.

According to Small, one of the first tools in the toolbox for passing family farms, ranches or forests is the conservation easement-something he wrote the income tax regulations for at the IRS more than 30 years ago. In effect, this limits the ability to develop the land in perpetuity by reserving the right to do some timber cutting, farming or ranching while protecting conservation values.

Here's how it works: The landowner maintains ownership of the land, but donates the easement to a "qualified conservation owner"-usually a land trust (though it can be a government agency). The landowner receives charitable deductions on her income tax return for an amount equal to the value of the easement (the development rights) for a period of up to six years. This can reduce the value of the land by at least 30%-and up to 90% in some cases, depending on where it is.

Some families don't want to tie their kids' hands with an easement, he says, but he emphasizes that it is a good multigenerational planning tool. "I've had some clients who want to put a conservation easement on the property so future generations don't fight about selling the land for top dollar," he says.

If Mom and Dad don't discuss this with the kids, however, it can backfire. According to Bentz, there have been cases where kids have found out about the easement only after their parents died, and they later challenged it in court. "The kids have already spent the money and they are lawyered up," he says.

In any case, Watson cautions that this tool is not available to everybody because land trusts have their own priorities for what type of land they want to preserve. While they will not own the land, he says, it is their responsibility to make sure the landowner complies with the terms of the easement-something that has costs associated with it. Those costs skyrocket, of course, if the land trust is forced to defend the easement in court.

Another key tool, which can be used in combination with a conservation easement or by itself, is an LLC formed for family members to own the land jointly. The members own shares representing minority interests in the company, which owns the land. Because the shares are so restrictive, they can be worth 30% to 40% less than the liquidation value of the underlying assets, says Paul Lusby, partner at Horn & Lusby LLC in Glendale, Calif.

"That's real economics," he says. "In the marketplace, willing buyer and willing seller, nobody's going to pay you a pro rata share of the liquidation value of the asset so they can liquidate it."

An LLC cannot be formed simply to reduce taxes. There must be a business purpose-for the continuity of management, for generational succession planning, even for the enjoyment of the property by members of the family. One important aspect of this structure is that it can allow family members to move in and out of ownership without having to subdivide the land. And because they now own the land through a company, that company must have a governance code. "It means that families have to set up ways to make decisions and communicate with each other," Sisock says. "It makes you think about those things you don't necessarily think about."

According to Lusby, there are also a host of estate planning tools that work on the principle of present interest and future interest that can apply to a vineyard or another income-producing land. With a grantor retained annuity trust, for example, the parent creates a vehicle to own the land and gifts it to the children at a point in the future but retains the income until that time. The IRS publishes a table specifying the property's discounted present value, which is substantially lower than its current market price, and the parent gifts the property today at that price.
He also points out that an enterprise that is a "qualified family-owned business" can pay a person's estate taxes, normally due nine months after he or she dies, over a period of 10 years. (If the company is sold, the taxes are due right away.)

There's No Such Thing As A Functional Family
But while there are lots of creative ways to pass the property, the heirs often end up selling it because they simply cannot get along. According to Watson, Oregon State University's "heirloom scale" can be a useful tool to help sort out family values. The scale ranges from "1" (the property only has financial value) to "10" (it's all about the property and who the family is). "If one kid is a '1' and the other is a '10,' that's a formula for potential disaster," he says, pointing out that spousal attitudes, though often hidden, also play into the mix.

There are financial tools that allow families to get around any of these issues-if they plan up front. "Certainly there are financial and tax aspects to the timberland planning process," Watson says. "But it's really about the timber and the resource, and who in the family has the knowledge to manage it. And it's about the family history and the attachment to it, and it's about the family dynamic for that particular family.

"You're really passing on more than a financial asset," he says, "and you really need to do the proper planning for it."