We all use wood on a daily basis, in our homes, furniture, floors and ceilings. Institutional investors, hedge funds and pension funds have been investing in wood as a long-term growth asset and inflation hedge for decades. However, as more investors discover the little-known fact that timber investments have generally outperformed stocks, bonds, and commodities over the long term, there are now many opportunities for the smaller investor to participate in this alternative asset class.
The demand for timber is increasing in line with the ever-increasing population, as the human race multiplies in number, we need more timber for construction, but at the same time, the basic limits of natural forest supply limit the amount of timber that we can grow and harvest for our own use.
Deforestation has destroyed 1/5 of the world’s forests since 1950, and new global legislation is in place to protect forests that still play a vital role in carbon sequestration and the ecosystem.
This imbalance between supply and demand creates a fantastic opportunity for investors to acquire assets in short supply and profit from the undeniable underlying trends of population growth and resource scarcity.
investment performance
The vast majority of timber ROI is derived from biological growth in the size of the timber source, from seedling to seedling to the full tree. On average, the wood volume of a single tree will increase by between 2% and 8% each year depending on the species, age, and climate. On a very basic level, this gives the tree owner more timber to sell over time, thus generating a greater return in the long run.
Aside from this basic observation, there is more to consider, as trees produce a greater selling price as they grow into larger product categories. For example, a small tree would only be suitable for paper products or biomass for fuel, as a larger tree could be harvested for lumber which would fetch higher prices per ton and could be used for products such as plywood or telephone poles.
A study by Professor John Caulfield of the University of Georgia found that biological growth accounts for more than 60% of total financial returns, while increases in the price of timber, and capital increases account for land for the rest of the revenue generated from a timber farm.
This shows that it is an effective strategy to rent the land to grow wood on it, as well as to buy outright as only 6% of the profits are derived from the capital increase in the value of the land. This also shows that fluctuations in the price per cubic meter or ton of timber have limited impact on the overall performance of timber investments. The majority of the yield is generated from growth in the tree itself.
The benchmark for timber is the NCREIF Timber Index, which increased 18.4% in 2007, versus a 5.5% gain for the S&P 500. Over the long term, Timberland has outperformed all major asset classes including large-cap stocks, international equities and corporate bonds.
While small-cap stocks have outperformed timber over the long term, after accounting for risk (as reflected in the Sharpe ratio), timber has shown the highest risk-adjusted returns of any major asset class. When compared to the S&P 500, lumber showed a low-risk characteristic. Since its inception in 1987, the NCREIF Timber Index has fallen in just one year: -5.25% in 2001, meanwhile, the S&P 500 has fallen four times, including -22.10% in 2002.
One of the main reasons investors, especially large institutional investors, turn to timber is the fact that the asset shows low to zero correlation with other assets, especially those related to the financial markets. It has been shown over a long period of time that adding timber to an investment portfolio has the effect of improving total risk-adjusted returns. This low correlation reflects the fact that the primary driver of returns – biological growth – is not affected by economic cycles.
Institutional investor in timber
In 2007, Jeremy Grantham, chairman of Grantham Mayo & Van Otterloo, a Boston-based firm that oversees $60 billion in assets, predicted the impending financial crisis, one of very few investment managers to do so.
At a conference in June 2007 Mr. Grantham declared that stocks were so overvalued that the market was as risky as he had ever seen it. He warned, “The next few calendar years look like a black hole as expensive markets, risky leverage and hedge fund outsized business collide with the housebuilding phase of the US presidential cycle, as well as the deflationary phase of the long interest cycle.” expect it? He said he could see the S&P index falling 38% over the next two years.
He went on to say that investors should allocate capital to timber investments as a stable and predictable asset with low risk as the returns are made outside of any market. It is the only asset class in existence that rose in three out of four major market crashes in the 20th century. It should be noted that Jeremy Grantham owns 20% of his personal investment portfolio in wood assets.
Institutional investors have realized the benefits Timber investments For a time, pension funds like Calpers led the way in the 1980s, but it was major college endowment funds like Harvard and Yale that saw the real potential and invested heavily in a move to diversify their portfolios globally. In 2009, the Harvard Endowment Fund invested $500 million in forest and carbon credits in New Zealand.
PKA, the DKK 114 billion (€15.4 billion) Danish collective pension scheme for employees in the social and public health sectors, raised its investment in forestry to around €335 million by the end of 2007, raising its commitment to timber from 1.5 to 2% of total assets.
ABP, the €211 billion Dutch pension fund, made its first investment in timber in 2007 by allocating $60 million (€40 million) to the Global Solidarity Forest Fund (GSFF), which will develop three sustainable forestry projects in the Republic of Mozambique, in Southeast Africa, and Angola.
The UK’s £1.5bn (€2.1bn) Environment Agency Pension Fund, £31bn Universities Pensions Scheme and London Pension Fund Authority £3.6bn are all reviewing whether to put money into forest investments.
The European Investment Bank (EIB), the €26.3 billion cooperative mutual insurance company Ilmarinen, and seven medium-sized Finnish pension funds have invested in the timber industry via the Dassos Timberland fund.
The Massachusetts Pension Reserves Investment Board (Mass PRIM) has decided to invest $500 million in timber just three years after selling a $700 million portion of its timber portfolio.
Recently, there has been a flurry of new investments in timber by major asset managers, not least of which is the $1 billion acquisition of Canadian timber company TimberWest by two large asset management firms acting on behalf of institutional pension funds.
At the time of writing in December 2010, there was a possibility of a second round of quantitative easing (QE2) by both the US Federal Reserve and possibly the Bank of England as well.
QE2 should help support the US housing market. Construction accounts for nearly 70% of the total value of timber resources, and as the US real estate market recovers, inflation will rise as house prices increase again.
One such asset is timber which has a proven history as an excellent hedge against rising prices.
The US housing market (construction accounts for about 70% of the total value of timber resources) and QE2 should help ensure the stability of the US housing market. As the US real estate market recovers, inflation will rise, with house prices increasing again.
Timber as an asset class offers unique properties. The performance of forest assets is primarily driven by the natural growth rate of trees, independent of the overall economy. As the tree matures, its size and usefulness increase, and thus the price. In a difficult economic climate, lumber companies do not need to discount their crops because if they are left to grow, the value of the assets only increases.
This makes timber less volatile in the long run and more resilient in tough times than most other commodities as the investment is backed by the real asset value of the wood. Timber is recognized as a hedge against inflation as the trees grow in size, and therefore valuable each year. If inflation is 3% and your trees grow in size (value) by 5%, then your wealth has grown in real terms before inflation.
As the rate of inflation increases, so does the price of lumber and so does the amount of lumber you have to sell. This creates a double reserve for investors and makes investing in timber an ideal balancing tool for diversifying portfolios.
There are a number of different opportunities for retail investors to participate in timber investing in various forms. In this section we will focus on direct investing within commercial timber plantations, although the reader should be aware that there are other opportunities linked to the market such as forestry trusts and listed timber companies.
The basic premise of all investment offers from the various companies we researched remains relatively consistent, as investors are typically invited to purchase either a lease of a plot of land within a commercial timber plantation, thereby owning the rights to grow any wood produced within their plot or parcel of land. An alternative is to offer outright ownership of a fixed number of trees to investors.
The cost of plots varies from project to project between £5,000 to £22,500 depending on the size, location and types of timber being grown.
Sometimes an annual fee is required from the investor to service management costs on site, and of course the occasional mitigation that is always required within a commercial farm.
For other projects, an administration fee sufficient for the time period until the first harvest is paid in advance by the seller and held in escrow, and fees for future crops are deducted from the proceeds of each previous harvest, thus creating an investment where no further cash input is required from the investor.
With some projects, the land is leased by the forestry company and the investors enjoy a sub-lease, while others have the land wholly owned by the forestry business and the investors have a direct lease and the land is held for the benefit of the investors until the lease expires.