DR.CHENJIAZI ZHONG

Investments in natural resources, such as oil and gas, farmland, timberland, and metals and mining provide protection against unanticipated inflation, high and visible cash flow, and opportunities to exploit inefficiencies. At the portfolio level, natural resources investments provide attractive return prospects and significant diversification. Moreover, superior natural resources investment managers’ skills have demonstrated their ability to generate excess returns over a market cycle. The inception-to-date return of Yale’s endowment fund, oil and gas (1986), timber (1996), and mining (2011) portfolio has realized an impressive 16.0 percent per annum.

The core objections to real assets investing are two folds: 1) real assets do not generate current income; 2) real assets lose value in deflationary times. However, timber, as a real asset, does provide inflation protection, and it also generates annual income with a minimal amount of current investment, maintenance, or management, and it helps in deflationary periods.

Some investors classify timberland investments as private equity because many of the commercial timberland deals have been made through private equity investment structures and managed by a timberland investment management organization (TIMO). Some consider timberland a specialized form of long-term fixed income as it generates cash flow each year through harvest and sale of timber. Some may also view timberland as real property or real estate, but the major difference is that traditional commercial real estate investments realize income primarily from leasing, whereas timberland derives its income from periodic timber sales, recreation, and value added. In addition, the source of return of timberland investments also comes from land appreciation and biological growth.

Institutional investors worldwide own approximately $60 billion worth of timberland, of which two thirds is invested in the U.S.; nevertheless, the principal owners of timberland are private, non-industrial landowners, with about $150 billion. Since 1995, over 60 million acres have changed hands.

The NCREIF Timberland Index is the benchmark for evaluating institutional timberland investment performance. The index was incepted in 1987; it is a quarterly index. To qualify for the index, a property must be held in a fiduciary environment and marked to market at least once a year.

Ten years ending 2012, the NCREIF Timberland Index had achieved an annualized return of 8.17 percent. According to NCREIF, as of the second quarter 2013, the index had 442 properties worth $24.7 billion and over 14 million acres included in the index. Within the index, there are 32 co-mingled funds with $7.9 billion in property and 70 separate accounts with $8.6 billion in assets. The lack of quarterly appraisals for many properties in this index makes the annual return series more reflective of changes in the market than the quarterly series.

Major Benefits of Timberland Investments

1. The U.S. timberland investments have delivered superior returns over the past decades relative to its risk profile. The calendar year 2008 performance proves that private timber offers good downside protection.
2. Timber as an asset class offers a level of price stability over the long term, and its biological and investment growth cycles are steady and predictable.
3. The correlation profile of timberland to other major asset classes indicates that it offers excellent diversification benefit, and hedges against inflation and market downturns.
4. Timber is a renewable, natural resource that provides ecosystems with clean air, water, wildlife habitat, and carbon sequestration.
5. For individual investors, timberland ownership offers tax advantages where income from timberland can generally be treated as capital gains.

Final Thoughts

• The total return of timberland investments can be enhanced by the biological growth of the assets, product class jumps, and active management.
• Timberland investments have the versatility to be shaped because a portfolio of timber assets 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. Alternatively, if long-term gains, as opposed to regular cash flow, matter more to the investor, he can consider young pine plantations with high growth rates. In another case, if the investor’s investment goal is to seek a balance of intermittent cash flows with an emphasis on long-term appreciation, he can incorporate various timber age classes into his portfolio.
• Historically, demand for wood products has tracked closely with worldwide population growth; the rapid growth of investment in timberland among U.S. institutional investors will ultimately push the price of timberland higher as buyers compete for available land.
• Physical risks can vary across different regions as a result of events such as fire, tornado, hurricane, and forest pests.
• The demand for timber can be impacted by factors such as a decline in housing starts, substitution of other finished products and materials. Beyond that, many areas with expansive timberland have few production markets nearby, which means, overhead costs in transporting timber to mills will negatively impact profits.
• Substantial turnover in timberland assets to financially oriented investors has caused compression in their returns. Many institutional investors are looking toward non-U.S. resources, which offer the prospect of higher returns but also involve currency and legal risks.

References:

1. NCREIF Research Corner, September 2013
2. A Brief History of Timberland Ownership in the U.S. by The Campbell Group