US institutional investors currently have over $10bn (E10.4bn) invested in US timberland. These institutional investors include such well-known pension funds as CALPERS, BellSouth Corporation and State Teachers Retirement System of Ohio, Massachusetts Pension Reserve Investment Management, Delta Airlines and Eastman Kodak.
The level of institutional investment in timberland in the US has increased steadily over the last 20 years. Figure A shows the growth in institutional timberland investing in the US between 1981 and 2001, from $4.2bn to over $10bn.
The interest of US pension funds and other institutional investors in timberland is growing.Timberland is a low risk investment with low or negative correlation to most major asset classes, as well as consistent, competitive returns.
Institutional investors typically include timberland as 1-2% of their investment portfolios. Many make the allocation from real estate, though timberland performance has a negative correlation with commercial real estate. Others simply classify timberland as part of the alternatives portion of their portfolios, while others create a separate asset class for natural resources.
Some savvy institutional investors include timberland in their fixed income allocations, because of its low standard deviation, low volatility and manageable cash flow.
Timberland offers highly competitive returns as a stand-alone asset. Figure B shows how timberland performs as compared to other major asset classes in the US. Though some European investors say that real returns for timber or forestry can range between 4-12%, most say that 5-7% is more typical. US investors say the annual average is higher, around 7-10%.
Second, timberland is a low risk asset. Figure C shows timberland risk as measured by the standard deviation of returns in the US. The standard deviation of timberland is far less than that of equities and roughly the same as fixed income.
Timberland’s high returns combine with low risk to make it extremely competitive on a risk-adjusted basis. Figure D shows the return/risk, or Sharpe ratio, ratio for US timberland as compared to other assets.
Timberland provides portfolio diversification. In addition to competitive returns and low risk, timberland returns have consistently had a low correlation with other assets, including real estate.
Figure E shows timberland’s low or negative correlation with other major US asset classes. Figures show that the correlations with other assets are low, with most close to zero.
The low or even negative correlation of timberland with other assets makes it an ideal diversifier for investors seeking to increase portfolio efficiency.
Experts observe that timberland is less volatile than many traditional financial assets. This is largely because the biggest component of timberland investment returns is tree growth, generating over 60% of investment returns. And that growth is the single largest contributor to investment returns, pushing always in a positive direction.
Many institutional investors consider timberland to be a hedge against inflation. Unlike income from fixed-rate financial instruments, the real value of timberland does not necessarily decline during an inflationary environment. Some managers question whether ‘hedge’ is the appropriate terminology, observing that timberland simply performs independently of inflation. The returns are similar regardless of inflation.
There are three major drivers of timberland investment returns: 1) biological growth; 2) timber product prices; and 3) land prices. Of these, biological growth is by far the most significant, generating over 60% of total investment returns. Timber product prices account for approximately 33% of timberland returns and land prices 6%.
Biological growth is the unique feature that separates timberland from other assets, because it results in value changes that are largely independent of financial markets. Biological growth is both stable and measurable and always moves in a positive direction. As a result, biological growth consistently pushes investment returns in a positive direction.
Professional forest management can increase returns. Skilled foresters know how to identify and purchase forests to meet the investor’s objections, as well as when to sell. They utilise high-tech operations, fertilisation and culling and timed logging to maximise value from tree growth.
Although US timberland investments have grown from just $4.2m in 1981 to over $10bn in 2001 (figure A), they still represent just a tiny piece – about 0.1% – of the $5trn total US investment pie. Even among real estate investors, timberland is still generally considered a niche investment.
There are several problems that have limited the asset’s popularity.
Like private equity and other popular investments, timberland does not trade on an organised exchange and its price is not reported publicly. For many years, investors had no performance benchmark or index to compare timberland with other asset classes. There were ‘synthetic’ performance indexes, but they were based on hypothetical investments and not fully accepted. Investors wanted an index like the S&P, which uses returns from actual investments.
In 1994, two new performance measures were introduced, both based on actual properties. The first, the Timberland Performance Index (TPI) calculated quarterly returns on existing funds managed by a cross-section of timberland investment companies. The TPI was compiled from data submitted by managers, and returns were weighted by the dollar value of the assets in each fund. The TPI was discontinued in 2001, however, so its primary value lies in showing timberland investment returns for the period from 1981 to 2001.
The second performance measure introduced in 1994 was the National Council of Real Estate Investment Fiduciaries Timberland Index (NCREIF). The NCREIF also calculates a quarterly return of timberland properties managed by participating members, each of whom reports to a centralized database. The NCREIF includes returns beginning in 1987 and continuing until the present day.
While these performance measures have largely confirmed what the old, synthetic indexes showed, their basis in real investments provides greater assurance in timberland performance.
Concerns about the asset’s liquidity have been another major reason investors have avoided timberland.
It’s true; timberland is not as liquid as publicly traded assets such as stocks and bonds. It generally takes from 12 to 18 months to fully invest a timberland portfolio, whether it is $30m or $300m; and it generally takes the same amount of time to liquidate.
Nonetheless, liquidating a timberland portfolio, or an individual property, is not as difficult as generally perceived. In fact, timberland is generally more liquid than traditional real estate.
Investment concerns about timberland liquidity often spring from two misperceptions. The first is that one has to buy and hold a property for the term of the investment, which is typically 10 years or more. An investor may be long term in timberland, but that does not mean that properties held today will still be in the portfolio five plus years later. As in a stock portfolio, individual properties can be bought and sold to respond to changing markets, return projections, financial maturity of the property and the diversification needs of the investor.
The second misperception is that an investor must hold a property for many years before receiving any income. In reality, a portfolio can be structured to generate a relatively stable pattern of cash flow from timed timber harvests.
A skilled timberland manager can create a portfolio to address an investor’s liquidity and income needs, assuming this is consistent with the investor’s overall return requirements and risk tolerance. Mature trees are more liquid than younger trees, but they are also subject to higher price volatility and lower appreciation, as figure F shows. Younger trees are less liquid, but benefit from long-term appreciation.
The performance characteristics of a timberland property based on age class is called the ‘biological yield curve’, shown in Figure F. The appropriate place for an investor to invest across the biological yield curve – ie, what age class or group of age classes – depends on the investor’s return requirements, risk tolerance, and requirements for income versus long-term appreciation.
An investment horizon of 10 or more years optimises the performance of a timberland portfolio, though some investors choose shorter time frames. Many pension funds have found the longer time frame well suited for meeting their liabilities.
Another deterrent for the typical institutional investor is the amount of money required up front to invest in timberland. US timberland investment managers say it typically takes a minimum of $25-30m in order to piece together a properly diversified portfolio. However, individual investor subscriptions to a commingled fund that closes at $25m can be as little as $500,000.
This amount of capital is needed in order to acquire the proper array of properties. However, once the initial capital investment is made, timberland assets generate enough income on their own to pay for property management expenses. The only other costs incurred by the investor should be the management fee and, if agreed upon, a performance fee.
There are two kinds of risks in timberland investments: physical and economic risks. Physical risk refers to potential losses from fire, insects, disease, and weather. Economic risk refers to the volatility of investment returns that can arise from changes in timber and land prices over time.
There is a long-standing – and incorrect – public perception that biological risks from timberland ownership are high. In fact, annual losses from physical risk factors are low. For example, in the southern US, which contains the largest concentration of US institutional investor assets, annual losses from physical risk factors average approximately 1/10 of 1%.
Assembling timberland portfolios that are diversified geographically, by forest age and by species composition can mitigate the already low physical risks.
In addition, professional forest management implements fire, disease and insect controls that effectively minimise physical risk.
Timber product price volatility is the factor that contributes the greatest risk to timberland investments. As discussed above, changes in timber prices are the second most important driver in terms of their impact on investment returns. While biological growth accounts for 61% of timber land returns, and are always positive, timber prices account for 33% of timberland returns, can move up or down or stay unchanged for the term of an investment.
Fortunately for investors, timberland investments can be structured to minimise timber price volatility by acquiring a diversified portfolio of properties across those market areas and age classes that have low correlations with one another. Unlike biological growth, timber prices are influenced by many factors, from housing starts and interest rates on a national level, to transportation and weather on a local level. Because local factors are equally influential, correlation across geographic areas and product categories tends to be low.
Like timber prices, land values are related to local supply and demand conditions, and vary from market to market. Land prices, however, are far less volatile than timber prices. More important, although land prices generally make a small contribution to investment returns, their tendency to change slowly means they also tend to buffer downside return volatility. Land therefore actually adds stability to long-term investment returns.
The diversification decision for timberland is conceptually similar to the diversification decision as applied to financial assets. Research has demonstrated that diversifying across different geographic timberland markets and timber age classes generally results in more risk-efficient portfolios than acquiring assets in a single geographic market or age class.
Similarly, constructing a fully diversified portfolio of timberland assets controls economic, as well as physical risks.
Though the growth of institutional investment in timberland has been dramatic, institutional investors have barely begun to penetrate the vast timberland market. The breakdown of US timberland by ownership about 29% is in pubilc ownership, 13% is in forestry industry land, and 58% is owned by non-industrial private. At present, institutional investors own only about 2% of the US’s vast timberland resource.
Right now, entry opportunities abound for institutional investors in the US because of a cyclical low in timber pricing. The sluggish economy has resulted in good lands for sale at undervalued prices. Moreover, because of earnings pressure, a number of major US forest products companies are aggressively liquidating their timberland holdings to get them off their balance sheets. Increasingly, companies want to focus on increasing the efficiency of their processing facilities, while divesting their timberland assets.
UK and European investors have expressed concern about the timberland market’s ability to absorb the substantial investments made by institutional investors. This is not a problem in the US. With over 500m acres of commercial timberland, and active timberland markets, the US provides ample opportunity for a variety of investments.
Many US timberland investment companies are also trading on the global market. If an investor wants to diversify into Australia or South Africa, for example, managers generally can provide that option.
US timberland investment managers maintain that investors should be concerned not with whether there is enough timberland to absorb their money – there is – but whether or not their properties are being acquired in a portfolio context and carefully assembled. For example, most timber investment mangers can easily spend $300m on a single property. But a single property normally will not offer adequate diversification to provide a high risk-adjusted return, which is the major reason to invest in US timberland in the first place.
It generally takes 12-18 months to invest a properly diversified portfolio. This time frame is true regardless of the allocation size, be it $25m or $300m. So UK and European investors don’t need to worry about sufficient investment opportunities. Rather, they need to be sure to hire a manager who will construct a timberland portfolio that is strategically constructed to meet their investment objectives.
Timberland is an attractive investment in today’s market, with clearly identified benefits. US timberland investments are prospering. Institutional timberland investments have repeatedly outperformed most major traditional asset classes for varying periods over the past 15 years. Over the same time frame, timberland has been a lower risk investment on a stand-alone basis, with risk-adjusted returns matched only by large-cap equities. Finally, timberland’s low return correlation with other assets increased portfolio efficiency on a consistent basis.
There are some limitations, however. First, timberland investment is more difficult for smaller funds. The large capital outlay needed for a properly diversified portfolio makes the investment prohibitive for small funds. Timberland investment managers typically solicit only those funds with a minimum of $750m in total assets. Smaller funds may be able to participate in a co-mingled fund, but these are harder to come by.
Liquidity is low compared to stocks and bonds, but it is not as limited as commercial real estate. The extent to which liquidity is an issue really depends on the needs and objectives of the particular investor. As with private equity, benchmarks have been a problem. The NCREIF now promises to be a fairly reliable benchmark. It is relatively new, however, and has not yet received universal acceptance.
The manager maximises returns and minimises risk through timed timber sales and strategic property acquisitions, as well as insect, disease and fire controls. In addition, the skilled manager can maximise tree growth.
It is critical for an investor to hire a timberland investment manager with the highest level of financial sophistication in portfolio construction. It is also necessary to have a manager with the forestry skills and on-the-ground knowledge of local and regional markets to manage the portfolio for maximum profit with minimal risk.
While timberland holds great promise as an asset, it may well be relegated to its niche position until institutional investors demand research into the performance of timberland investment companies so that sound investment decisions can be made.
Blair Batson is with Timber Vest, based in Berlin
All the figures, charts and tables in this article were prepared by Jon Caulfield. The article content is based directly on the research and reports of Caulfield and D Rhoads