Safe in the forest
Forestry investment has attracted increasing attention in recent years from pension fund managers looking for alternatives to the uncertainty and lower returns experienced with the major asset classes.
A key feature of Irish forestry investments has been the steady positive real rate of return, with the lowest volatility of any of the asset classes held by domestic fund managers. Most of the larger funded schemes in Ireland now have varying holdings of between 0.25% and 3% of their portfolios in unitised forestry investments.
Many other European countries, including the UK, Denmark and France, have pension forestry holdings, mostly through direct ownership of holdings in forest properties. New opportunities are also opening up in the market-based economies preparing for accession to the EU. US pension funds have also been increasing their appetite for ‘timberland’ which has been growing steadily since the mid-1980s.
Forestry is unlike other asset types though it is often grouped with property for comparison purposes. It is fundamentally different, however, in that its return comes from physical growth over a long timeframe. Its investment characteristics more closely resemble an index-linked bond with readily predictable volume output and long-term price trends that have kept pace with inflation. Timber markets are cyclical but the unique feature of this type of investment is the ability to manage the cycle, withholding timber sales until the market is on the upside while continuing to benefit from the physical growth and increase in value of the asset. Volume growth is complemented by a corresponding increase in value per unit volume of each tree. Smaller trees are used as lower value raw material for panel boards, larger trees are used in higher value sawn timber products. The higher value compensates the grower for the longer time taken to mature and the more intensive management input.
Forest crops can be readily insured against fire and storm damage, making this one of the lowest risk types of investment in real assets available.
Local factors can have major influences on investment returns. UK forestry investments have yielded lower and even negative returns in recent years, suffering first from tax changes that adversely affected capital values and second from falls in timber prices that have flowed through into forest valuations. In the US the National Council of Real Estate Investment Fiduciaries (NCREIF ) Timberland Property Index has shown returns in excess of the S&P 500 with a lower standard deviation and zero to slightly negative correlation to the major asset classes.
Including forestry in Irish investment portfolios has had obvious benefits. It has increased both nominal and risk-adjusted return. In addition, the low to negative correlation with other assets has further enhanced risk management. Irish forestry has significantly outperformed managed funds. It fits well into socially responsible investment (SRI) portfolios because of its renewable and sustainable nature. This has been in evidence through the increase in charity funds it has attracted in recent years. Forestry now also has the advantage of attracting carbon credits under the Kyoto Protocol to reduce global greenhouse gas emissions. While trading of these credits is not yet fully developed they offer additional future return potential.
Asset liability matching can be achieved through the proper age profile within a fund. The typical 40-year life cycle of commercial Irish plantations means that suitably aged crops can be targeted to match the remaining expected working life of pension fund members. Though it may not be practical to exactly achieve this match, forests near their felling age suit a more mature fund requiring strong income flow. Newer funds may opt for younger crops for future capital appreciation. A balanced portfolio has the advantage of allowing exploitation of price cycles to enhance return while at the same time it will be maturing to a sustained yield – effectively moving from a capital growth fund in its early stages to a sustainable income flow as it matures.
New investment opportunities are opening up in Europe, particularly the EU accession countries. A process of restitution of state-owned forest lands to private citizens has led to a new market in these countries, where the new owners are seeking to realise some of their recently acquired wealth. Companies like Scottish Woodlands in the UK and the International Woodland Company (IWC) in Denmark have been involved in evaluating these new markets in countries such as the Czech Republic, Slovakia and the Baltic states. Critical to reducing the risk inherent in these emerging forestry investment markets is reliable information and good local management and timber market experience. Forest regulation can differ in these countries, which can impact on the flexibility of future cashflows to optimise returns. Fragmentation directly arising from the restitution process is also a problem. This can be avoided by acquisition policies aimed at concentrating local forest holdings.
The more established timber producing countries, such as Sweden and Finland, do not appear as attractive because of relatively high land prices and forestry valuations – and consequently lower forecast rates of return.
South America has experienced expansion in fast-grown timber plantations while North America has a long-established forest products industry. The US has the world’s largest trade flows in forest products.
The privatisation of state commercial plantations in New Zealand has facilitated investment through quoted companies. Australia is also increasing.
The existence of different markets and conditions allows potential investors to choose their market according to their risk appetite.
Investment mechanisms differ globally. The most common form of ownership has historically been direct ownership of individual plantations or groups of plantations. Limited partnerships have also been a common form of forest investment in the US.
Unitised funds have become more common because they generally offer greater management efficiency and specialist forest management expertise while reducing specific risk associated with owning large single, even aged plantations. The grouping of investors in pooled funds also increases liquidity in what can be perceived as a bulky type of asset. Unitised funds can allow smaller pension funds to invest in what would otherwise require overweighting of the asset in their portfolios given the significant capital values of individual plantations.
Brendan Lacey is chief executive of the Irish Forestry Unit Trust (IFUT) in Dublin