Real Assets: Seeing the forest for the trees
A slow housing market during the financial crisis certainly hacked away some of timber’s appeal. But Joel Kranc finds that the long-term potential remains strong
Because of their unique investment needs and obligations, institutional investors often seek long-dated investments with bond-like characteristics operating in stable regulatory environments – think of real estate, toll roads and utilities. Added to that list, increasingly, is timberland.
However, timberland is a unique investment. It has the potential to create long-term, sustainable wealth – but the volatile nature of interest rates and housing markets can occasionally make it a challenging investment.
At the peak of the US housing boom in 2005-06, housing starts reached staggering proportions. Ultimately, this unsustainable growth pattern was the beginning of the end for the lumber market during the financial crisis.
“Domestic lumber demand is very highly correlated with residential construction activity and housing starts,” says Keith Balter, director of economic research with the Hancock Natural Resource Group.
“If you go back to the mid-2000s you are looking at peak levels of two million housing starts per year. At the depths of the most recent recession, they had dropped to 500,000. That was a huge retrenchment.”
Even during peak lumber demand North American producers were able to satisfy those needs domestically – and that meant that when the retrenchment and recession hit those same producers were forced to either curtail production or ‘mothball’ facilities. And because credit was essentially non-existent during the crisis, lumber mills were even more hesitant to build inventories, creating the potential for a tight market.
That was the situation until about the second half of 2012 through to April 2013 when there was a large increase in demand as the US housing market started to recover, reaching the million-start mark.
“It took a long time for the whole supply chain to respond to the increased demand in the domestic market while still selling very aggressively, primarily to China and Japan,” says Reid Carter, managing partner with Brookfield Timberlands. “That ramp-up caught people offside and there was an inventory shortage resulting in some very high prices.”
Carter adds that the high prices experienced in the first half of 2013 helped stimulate increased harvesting, an increase in labour needs and a more robust supply-chain infrastructure coming back on line. He says confidence in the market has been regained and “the ability to respond to market opportunities will be quicker than it was last year”.
In fact, in late August, Brookfield Asset Management held the final close on Brookfield Timberlands Fund V, with equity commitments reaching $1bn (€0.75bn) – well above the $750m target. The fund will invest in timberland in the US, Brazil and Australia and with the potential for opportunities in Canada, Chile, Uruguay and New Zealand.
The ‘tapering’ effect
One of the macro-economic issues tied to the timber and lumber markets is monetary policy. Earlier this summer, US Federal Reserve Chairman Ben Bernanke mentioned the idea of “tapering” quantitative easing.
While the fear of higher interest rates creates a potential downward trend in home building, and ultimately demand for the lumber and timber needed for those homes, many believe the price volatility this year has less to do with the Fed and more with immediate market conditions.
Carter notes that even with mortgage rates moving up 40bps and the Fed’s comments, affordability still remains extremely high for home buyers. “Concerns about rates rising in the future or near future may simply bring people off of the sidelines,” he suggests. “We might actually see more activity rather than less. I can’t say we’ve seen any obvious impact from the Fed’s comments.”
Olivier Lebleu, head of international distribution for Old Mutual Asset Management, which owns and distributes funds for The Campbell Group, a timberland boutique, agrees: “The correction in lumber prices had a lot more to do with supply catching up with demand than a reaction to ‘tapering’. It was really much more of a technical adjustment between lumber production ramping up and some softening of end-use demand – but certainly not a collapse.”
Lebleu adds that, despite housing starts languishing well below pre-bubble levels, there is still potential to earn strong returns in the lumber and timber markets. “
On a normalised estimate of household formation and single-family housing starts, with good economic growth, you can have good sustainable demand for timber much better fundamentally than it has been in some time,” he says.
Lebleu further states that the fundamentals are there for the market and do not need to be supported by “massive amounts” of quantitative easing or additional monetary stimulus.
Balter agrees and says over the past 18 months investors have begun to see the demand for housing and the fundamentals supporting it realised. The combination of pent-up demand, increased affordability and improved economic fundamentals all started coming to the surface, he notes. The increase in lumber prices between last winter and this past spring occurred because builders were finding limitations in availability of the product. Those prices, however, normalised once supply improved.
Because timberland investments are valued using discounted cash-flow models over a very long time – sometimes as long as 100 years – timberland prices did not cause too much pain, even during the height of the Great Recession, according to Carter.
“The marquee transactions disappeared but your basic timberland transaction maintained its value very consistently with what we saw in 2006-08,” he says.
And while there is an expectation that timber will go up due to the current housing (and economic) recovery in the US, and some investors will be looking for those short-term growth opportunities, overall most are still using flat pricing expectations for the long term.
“Institutional investors continue to be interested,” says Lebleu. “The good news is, when you own a portfolio property and housing is the primary consumer of your product, if [that market] goes into downfall you don’t have to do anything but ‘store on the stump’ – you don’t have to cut down the trees [and sell into that market].” That is one reason why Lebleu agrees with Carter, saying that there have not been any ‘fire sales’ of timber assets.
In fact, by mid-2013, less than a million acres of timberland changed ownership, including the Brookfield-Weyerhaeuser Longview Timber holdings transaction that occurred earlier this summer, where 645,000 acres in California and Washington State changed hands for $2.65bn.
“It still generates a positive cash flow from whatever logging you do and it’s never had a negative cash flow year,” adds Lebleu. On the other hand, he adds, potential sellers are not interested in selling at the bottom of the market and so while interest in the asset remained high, investment has been low, simply due to availability. “The ability of institutions to deploy into the investment will be better in the next three to five years than they have been in the last few years.”
In any case, focusing too much on US housing and Fed monetary policy may be missing the bigger picture – the effects of globalisation. While Asian economic markets were showing signs of slow GDP growth earlier this year, there has been some recovery there too.
According to the ‘Timber Trends’ report by the Campbell Group (a subsidiary of Old Mutual Asset Management), the North American market share for lumber and logs to China in the first quarter of 2013 accounted for 51% and 23%, respectively. The report also says that during the first four months of 2013 the import value for softwood logs and lumber from North America to China totalled $940m – a 30% increase from the same period in 2012.
In terms of globalisation, Lebleu points out the connection between China’s needs and Australia’s geography, and the ability to help supply those growing needs. First, he says, Australia’s consumption is expected to grow through to 2050; and second, China’s expected interest in more timber products is leading to more investment in timberland in that part of the world.
“That has created an environment in timberland that is relatively new – and has attractive characteristics for institutional investors – such as a developed infrastructure, processing infrastructure and a well-established legal structure,” he says. “It will create an interesting opportunity for institutional investors to think about timber as a more global investment than they have before, where it has been predominantly a US play.
He adds that there is also growing interest, as well, in places like Brazil, Uruguay and South Africa. Also, some Western European countries are looking at selling public lands as a way to ease deficits and raise cash.
Overall, timberland is a long-term, income-generating investment that can match the revenue needs of large institutional investors and pension funds. Volatility in end-product and end-markets has not yet fed through to volatility in timberland pricing. And despite the correction in lumber prices, and even tapering from the Fed, timberland is poised for more sustainable growth.