Inflation Assets: Timber
Investors recognise the inflation-hedging properties of timberland. Martin Steward asks whether it can be managed for regular inflation-linked cash flows
The English like to say that ‘money doesn't grow on trees'. Which is odd, considering that timber has housed us, kept us warm and cooked our food for as long as we have used tools. It has always been a valued commodity, demand for which has grown broadly in line with the population over the centuries. But if money does grow on trees, does it follow that we can squeeze cash flows out of them, too? And even better, inflation-sensitive cash flows?
Might timberland fit into the same family as the real estate-related cash flow assets explored in our preceding article.
If we accept that the correlation we see in figure 1 is not simply a statistical accident of two rising time series, the claim for inflation sensitivity appears uncontroversial. But where does it come from?
"There are three main components to timberland returns," says Jack Lutz, director of global research and valuations at FourWinds Capital Management, which has an exchange-listed timberland fund among its products. "The small trees, the big trees and the land the trees grow on."
Research suggests that roughly 15% of timberland returns come from changes in the price of timber (the stuff you sell), 15% from changes in the value of land (the place you grow the stuff you sell) and 70% from growth (the naturally increasing volume of the stuff you sell).
The inflation link in land value is hardly news, but realising an inflation-linked cash flow on it is not easy: you could sell a ground lease or generate revenue from recreational users or property developers, none of which benefits from any inflation exposure associated with growing trees.
And, again, that exposure does appear to exist. It would be surprising if it did not, given that unique natural growth characteristic. This is interesting, because the thing that grows is the thing that forest owners sell, which suggests that that growth might be turned into cash flow. Surely making that a regular cash flow is just a matter of buying the fastest growing species in the best conditions for growing them? While Nordic forests grow at a rate of about 1% per year, in New Zealand it is more like 16%. A fast-growing species like eucalyptus can be sold at different stages of maturity for paper pulp, biomass pellets or fencing, achieving a complete rotation every seven years. Diversify across age-class and it becomes possible to imagine quite a regular cash flow from those rotations.
Unfortunately it's not that simple. First of all, that strategy would probably concentrate political risk. Perhaps more pertinently, if an investor wants to hedge the inflation sensitivity of its liabilities, it is not clear that a forest selling timber halfway around the world will do it. "New Zealand timber is by-and-large sold to Asia, and so it hedges Asian inflation," reasons Hugh Humfrey, managing director at Timberland Investment Resources Europe. "Brazil's timber is sold into the domestic market, so it hedges Brazilian inflation."
Then there is the question of whether you want a high inflation-protected return or a low inflation-protected return. While a Nordic or North American forest will be on the doorstep of the world's biggest forestry-industry businesses, not to mention their end consumers, even the core markets for New Zealand's timber, in Asia, are an expensive ship ride away. Brazil and Africa can grow trees very quickly indeed, but they are also big landmasses with poor infrastructure. "Shipping logs can be very expensive, so you have to factor in the costs of shipping the end product," says Roland Pfeuti of SAM Private Equity. Those costs eat into a return that is already relatively low, because faster-growing species do not produce wood with the density required for structural building materials - where the big money is.
"To maximise your inflation hedge you would overweight high-value, larger-diameter species like Douglas fir for export to Asia," suggests Christoph Butz, a sustainability expert with an MSc in forest engineering at Pictet Asset Management.
Of course, you do not have to sit around for 50 years waiting for a Douglas fir to reach maturity. You can buy a mature forest and harvest it next year - if you can find one for sale and bear to pay the premium for it. "The market is thinner for a forest that isn't quite ready for a current yield - and that's where long-term investors like pension funds can exercise a competitive advantage," says Eva Greger, managing director at GMO Renewable Resources.
That trade-off between maximising the inflation hedge and regularising the cash flow is important with regard to exposure to timber prices, too. At about 0.60, timber's rolling 10-year correlation with inflation is much stronger than that of other commodities. Wood products turn up in everything from houses and chairs to packaging, drugs, biomass fuel and babies' nappies, so it would be astonishing not to see a relation with consumer prices. Figure 2 might suggest that timber prices are quite volatile around that inflation-linked mean, but as Lutz points out, US housing starts are the lowest they have ever been at one-third of their long-term average, which makes current timber prices at two-thirds of their long-term average seem pretty resilient.
Some of that is a diversification benefit: construction timber prices have dropped, but pulp prices have risen; and while US housebuilders are in recession, Chinese housebuilders are not. However, most of the volatility-smoothing comes because when timber prices are low, forest managers simply choose not to take their trees to market. NCREIF figures suggest that income returns fell to 2.1% in 2008 and again to 1.5% in 2009, after 10 years steady at around 4.5%. "We did very little harvesting because prices were pretty miserable," Humfrey confirms. Known as ‘storing on the stump', the beauty of this is that the longer trees stay out of the market, the more value they add through natural growth.
But there is the trade-off. "You have an optimisation decision to make," says Lutz. "In some regions and with some species you can store for as long as 10 years to maintain the value of your trees - but that messes up your cash flow."
So timberland can act as a call option on timber prices, unless you are forcing yourself to market to maintain a steady cash flow - a strategy that will eventually eat fatally into the crop that you had allocated for the next year and the year after. That's not a theoretical problem: plenty of managers found themselves in difficulty because they'd taken on too much debt or signed overly-ambitious supply contracts, having convinced themselves that they could churn out sufficient wood at sufficiently consistent prices to meet repayments and demand.
"They thought there were plenty of cash flows associated with forests - and there are not," warns Marc Hempel, CEO of Re-Invest Partners, which is currently fundraising for a timberland vehicle. "Trees simply cannot grow that fast." Hempel says that his fund will aim for the broadest possible diversification of regions, species, age classes and end-markets, with a view to start felling (and therefore generating cash flow) in year two. "But we won't say when, exactly, or how much," he insists. "We don't want to promise something that we mightn't be able to deliver."
This is the way it is articulated across the industry: forests are a cash-flow asset, but only so far. "We strongly believe in the benefit of a fund of funds for this asset class," says Pfeuti. "Just as in private equity, diversification always pays off. A TIMO is usually structured to generate an annual cash flow - and you can improve that again by further diversification." But the SAM fund of funds, like the Re-Invest fund, will be structured to return cash to investors over a series of years, like a standard private equity vehicle, rather than generate immediate and steady dividends like a bond fund.
"What we're trying to do is have a regulated forest from which you can cut x% per year to provide a cash flow," says Liane Luke, FourWinds' head of timber investments. "But we typically understate that cash flow potential precisely so that we can manage the volatility and not end up having to cut into next year's real value to fund this year's dividend." Greger at GMO agrees. "It's hard to get that idealised forest where you can cut the same amount every year," she says. "Pension funds that need a lot of current cash flow are self-deselecting - we don't see them. The asset class is perceived as a long-term investment for those who can bear the illiquidity."
So while the inflation sensitivity of timberland is undoubtedly real, and the promise of inflation-linked cash flows is not entirely an empty one, investors must be prepared to compromise on that demand to get the best out of the asset class. As Hempel puts it: "You have to be able to take forestry as it is - don't try to turn it into something else."