Over the past 20 years, US institutional investments in timberland have increased remarkably, starting at just $4 million in 1981 and reaching $10 billion by 2001. In this article, we look at why timberland has gained the interest of institutional investors, and what the future holds for those considering timberland for their –portfolio.
Why invest in timberland?
Timberland provides both competitive returns and low volatility as a stand-alone asset. As a result, timberland offers outstanding risk-adjusted returns relative to other asset categories. And, because timberland returns have a low correlation with other assets, it provides an additional diversification opportunity in otherwise well-diversified portfolios. But the most compelling reason to invest in timberland is that trees are not only economically valuable, but they naturally and invariably increase in value and produce returns through the very biological function for which trees are designed: they grow.
q Competitive performance During the past two decades, timberland returns have competed strongly with traditional assets, regardless of the time period considered. According to the NCREIF Timberland Index (NTI), timberland returned 13.63% (nominal) for the 10-year period 1992–2001 (Figure 1).
In addition, timberland investments are far less volatile than most assets, which gives them very high risk-adjusted returns. For the 15-year period through 2001, the NTI, with a standard deviation of 9.30%, had about half the volatility of the S&P 500 at 16.04%. Timberland’s risk-adjusted return, as measured by the Sharpe Ratio for the same period, was 1.29, versus 0.53 for the S&P 500.
q Diversification Timberland returns are driven primarily by the biological growth of trees, which is a physical process. Consequently, timberland’s return generating process is independent of the factors that provide returns from equities and fixed income. The correlation of timberland returns with most traditional asset classes is not statistically different from zero.
q Tree growth: the primary driver of timberland returns Tree growth, timber price changes and land price changes are the three drivers of timberland returns. Biological tree growth is the unique feature that sets timberland apart from other asset classes. Tree growth is capable of providing 60% or more of total returns. It is unaffected by market forces. And, because it is invariably positive, tree growth consistently pushes returns upward.
Biological growth has another important characteristic; it increases tree value as the total volume of wood increases. As trees increase in diameter, they move into successively higher value product categories and are worth more per unit of volume than small trees.
Although biological growth is predictable for each tree species and geographic region, timber product and land price changes are not. Timber price changes are the most volatile return component. Unlike biological growth, the price paid for standing timber is influenced by exogenous factors, ranging from gross domestic product, local rainfall patterns, interest rates, and currency exchange rates.
Fortunately, because of a general lack of correlation of timber price changes across geographic areas and timber product prices, skilled managers can construct strategically diversified timberland portfolios to largely control price risk.
For long-term timberland investments, land prices 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. Consequently, land adds stability to long-term investment returns.
The future of timberland investments
During the 1990s, US timberland investors witnessed a rapid increase in timber prices, which provided strong returns regardless of age, species and investment location. Today, the global forest economy is undergoing fundamental changes in response to timber abundance and industry restructuring. As a result, timber prices are unlikely to increase at the rates observed in the 1990s. Going forward, the most successful investment strategies will be those that capitalise most effectively on biological growth. By strategically assembling a timberland portfolio that utilises tree growth, timberland investors can realistically expect to realise a real rate of return in the range of 8–10% with very low risk.
q Constructing the timberland portfolio in an era of timber abundance TimberVest believes that investments should be portfolio-driven. By contrast, deal-driven managers buy properties as they become available, making purchase decisions independent of the composition of the rest of the client’s portfolio. The end result is either an undiversified portfolio, or collections of assets where diversification is random. Such portfolios seldom provide high risk-adjusted returns.
Portfolio-driven managers structure acquisitions based on (1) an understanding of investment returns and risks of a forest’s different growth stages (2) investment return-risk characteristics inherent to individual regions and (3) return correlations across markets. TimberVest is a portfolio-driven manager.
TimberVest’s investment process – Targeted Timberland Investment Strategies (TTIS) – is founded on the three unchanging characteristics of biological tree growth. First, regardless of location or species, all timberland investments occur at some point along the biological yield (growth) curve. Second, returns and risks vary according to the point on the curve at which an investment is made. Consequently, the risk/return profile of a timberland investment is predictable by its position on the curve in accordance with age, species, and geographic location. Third, timberland returns tend to be uncorrelated at different points on the curve, and across geographic regions. By utilising these characteristics in our strategy development, TTIS results in customised timberland portfolios that are efficient in a risk/return context.
The TTIS process begins at the corporate level, where our in-house research analyses individual timber market trends, and their relationships with the biological yield curve. This work is used to create investment targets that are specific to age, species, and region. Client objectives determine how we combine these targets to create a customised portfolio diversification plan. Once the plan is established, each TimberVest regional forester receives a mandate with investment targets specific to age class and species in their region. While our regional foresters consider all acquisition opportunities, they carry out only those that will meet their specific mandates. This discipline is unique to TTIS.
q Managing the portfolio for investment and environmental success Because timberland investing is inherently a local business, we believe a decentralised management structure employing regional foresters is the most effective and cost-efficient. By assigning a forester to a specific region and requiring their residency full time within that region, they become intimately familiar with local timber markets, and establish deep networks among buyers, sellers, brokers, and forest products firms. Equally important, their regional expertise allows them to develop an acute awareness of appropriate social, environmental, and economic values for their regions.
For two decades, US investors have reaped the benefits of timberland’s high risk-adjusted returns, low volatility and diversification. The consistency and predictability of biological tree growth, which is unique to timberland, is the compelling reason to include timberland in institutional portfolios. As the global forest economy shifts to accommodate industry restructuring and the absolute abundance of timber in the marketplace, investors can continue to reap the benefits of timberland investment. However, portfolio construction must be strategic and investment strategies must rely primarily on biological growth, rather than an expectation of increased timber prices.
At TimberVest, we take a portfolio approach to investing by merging our research with the principles of tree growth to create investment targets specific to age, species and region. We then strategically assemble these targets in accordance with the client’s risk/return profile to create a customised, diversified portfolio. The result: a portfolio that provides each client with timberland’s long-term benefits of competitive returns and diversification, with limited risk.