Why Invest In Land And Timber?

 

Overview

A timberland investment is one whose primary source of return is derived from the growth and harvest of timber. As an asset class, it offers particularly attractive benefits to the long-term investor. They are:

• Timberland investments have historically provided competitive returns relative to its risk profile. Such returns hold up well against many traditional asset classes, including stocks, bonds and real estate.
• Because of its unique nature, timberland often performs differently from securities or other investment assets. As such, it can offer an excellent opportunity for diversification when added to a broad portfolio of investments.
• Timberland-a renewable and biologically growing asset-represents an array of advantages among alternative investments.

How are timberland investments characterized?

There are a variety of ways to approach timberland as an investment. Some would classify it as private equity. An argument for this classification could be made because many of the purchases of commercial timberland for investment purposes have been made through private equity investments structured and managed by a timberland investment management organization (TIMO).

Another way to view timberland investment is a specialized form of long-term bond. A forest that holds mature timber will generate cash each year through the harvest and sale of timber. These harvests can be modeled and forecasted with a reasonable degree of accuracy over many years, even decades. Since timber growth and subsequent harvests are not affected by the movement of financial markets, the forest investment could be structured to act and behave in many respects like a long-term bond.

Aside from private equity and fixed income, timberland is real property and can be classified as an investment in real estate. While traditional commercial real estate generates income from leasing, timberland derives its income from the periodic sale of timber.

What is the invested universe of commercial timberland?

It is estimated that institutional investors globally now own about $35 billion worth of timberland. Of that amount, about $25 billion is invested in the United States, which represents the world’s largest producer and user of timber products. Over the last 20 years, timberland has emerged as a viable institutional asset class among almost 100 private pension, foundation, and endowment funds. Even with these commitments, institutional owners own approximately 8% of the investable timberland in the U.S. The principal owners of timberland are private, non-industrial landowners ($150 billion). This large investable timberland base represents continued opportunity for institutional investors, particularly as private landowners and forest products companies continue to sell off their timber holdings.

Risk and return

A key attraction of investing in timberland is the competitive returns it offers compared to other asset classes on a risk-to-return basis. Historically, the performance of timberland as an investment is most often measured by the Timberland Index, published by the National Council of Real Estate Investment Fiduciaries, or NCREIF. The index is analogous to the Property Index that NCREIF also publishes for the commercial real estate market.
Returns from timberland investments – as measured by the NCREIF Timberland Index – exceeded the Standard and Poor’s 500 Index for 9 of the past 16 years from 1990 through 2005. In that period of time, the NCREIF Timberland Index annual compounded return was 12.56% versus 10.85% for the S&P500 (Table 1). Yet, the returns from timberland offered lower volatility (standard deviation) of 9.49% against the equity market’s 17.35%.

Table 1. Comparison of returns from the NCREIF Timberland Index against the Standard & Poor 500 Index (1990 – 2007

Source: NCREIF, Ibbotson Associates

Timberland, as represented by the NCREIF index, has performed well against other asset classes (Figure 1). This performance has been achieved without the tradeoff of higher risk. As an asset class from 1989 through 2007, timberland investment lies above the capital market line, as shown in Figure 2.

Figure 2. Capital market line, showing the returns and volatility among asset classes. Timberland returns are represented by NCREIF Timberland Index (1990-2007).

Source: NCREIF, Ibbotson Associates

Portfolio-Diversification

The opportunity for an attractive risk-adjusted return is not the only persuasive argument for adding commercial grade timberland to an investment portfolio. Another key benefit of holding timberland as an investment is to provide portfolio diversification. Commercial timberland, by its nature, is affected by a different set of macroeconomic and market factors than other asset classes. As a result, there will be limited correlation between returns from timberland and other asset classes such as stocks, bonds, and real estate. The addition of a low correlation timberland asset can expand the efficient frontier of the risk-to-return profile of the total portfolio. NCREIF Timberland Index returns from 1990 through 2007 showed moderate to weak correlation against the major indices for publicly traded equities and fixed income securities (see Figure 3). In the case of commercial real estate, it is negatively correlated.
Figure 3 Correlation of the NCREIF Timber Index annual returns against inflation (CPI) and major market benchmark indices from 1990 through 2007.

The benefits of diversification with timberland are to boost returns for a given target risk tolerance, or to reduce risk for a given target return. In other words, timberland can expand the efficient frontier, as shown in Figure 4. This efficient frontier represents a hypothetical portfolio consisting of large and small cap stocks, corporate bonds, long-term government bonds, US treasury bills, and commercial real estate and is based on the last 18 years of returns with and without timberland investments. Timberland is held in the portfolio at no more than 20% of asset value. As the chart indicates, timberland, even when held as a small portion of the total portfolio, can still impart a measurable reduction in the overall volatility of a portfolio while increasing the overall return.
Figure 4 Risk-to-return efficient frontier of a portfolio with and without timberland.

Unique-Characteristics

Aside from offering competitive risk adjusted returns and portfolio diversification, timberland is endowed with several unique characteristics that institutional investors may find attractive. These characteristics are (a) continued accretion of value due to the biological growth of trees, (b) long-run adaptability to a range of investor needs and circumstances, and (c) tax advantages for certain individuals.

Benefit of biological growth

A unique advantage of timber is that as an asset it growsquite literally. Trees grow in volume, size, and ultimately into increasingly higher-valued products. For example, in the US South individual trees begin as lower-value pulpwood, grow into a combination pulpwood/sawtimber tree (9 to 12 inches in diameter), normally referred in the timber trade as chip-and-saw, and then into sawtimber (trees that are generally greater than 12 inches in diameter and of a high quality) for lumber products. As a tree grows into these larger and higher product classes, the monetary value of the tree increases as well. The negative impact of the time value of money and the risk of negative returns can be offset by the increasing volume and value of the asset. In short, the effect on investment return by possible downward movement in timber prices is mitigated by volume growth; the effect of upward price movement is compounded by volume growth. In addition, over the life of the investment, timber continues to grow although at a slower rate as trees mature. This allows the investor to warehouse timber on the stump, giving the investor greater opportunity to time the sale, or harvest when prices are high and delay harvest when prices are low.

Timberland portfolio structuring to produce specific investment objectives

Timberland investment portfolios can be structured to meet different investment objectives. For example, higher cash flows can be achieved by including a higher proportion of more mature timber holdings. If long-term gains are more important than regular cash flow, then this goal can be achieved by acquiring young pine plantations with high growth rates and enhancing the benefits of biological growth through intensive management techniques. If the investors’ objective is a balance of intermittent cash flows with an emphasis on long-term appreciation, various timber age classes can be included in the portfolio to achieve this goal. In addition, investment returns can be improved with a variety of structuring and management options including the use of leverage, selling selected properties that have real estate development potential or recreational use value, or possibly using the asset to support the issuance of asset-backed securities. In short, timberland investments have the versatility to be shaped through financial engineering to meet a variety of goals for the sophisticated investor.

The tax advantage of timberland for individuals

For individual investors, timberland ownership offers tax advantages where income from timber and timberland sales can generally be treated as capital gains. In addition, there are specialized tax deductions and credits that can be utilized for conservation easements, reforestation, and timberland management practices.