Timber Fundamentals and Attributes
Investors began to acquire timberland in the early 1980s as a way to
diversify their portfolios. Today timberland has grown into a widely
accepted alternative asset class with an estimated $35 to $40 billion
(according to a recent Merrill Lynch Timber Survey) currently under
the management of timberland investment management organizations
(TIMOs). Timberland investors range from affluent families to
institutional investors such as university endowments, pension funds,
and foundations.
Competitive Returns
Timberland has historically outperformed other asset classes such as
common stocks and commercial real estate, while also having lower
risk. A return comparison over five different time periods is
presented in Figure 1.
Figure1. Timberland Asset Class Return Comparison
Figure 2 depicts various asset classes from 1988 to 2007 by their
average return, standard deviation, and security market line or Sharpe
ratio (a measure of the excess return per unit of risk). The Sharpe
ratio indicates that timberland's risk-adjusted return over
the previous 20-years is attractive. The Sharpe ratio is illustrated
by the slope of the security market line linking timberland to the
risk free rate. The steeper the security market line or the higher
the Sharpe ratio, the more an investor is rewarded for adding
additional risk beyond the risk-free rate.
Figure 2. Risk and Return of Traditional Asset Classes, 1988-2007
Diversification Benefits
The fact that timberland's periodic performance differs from other
asset classes is a primary reason many investors choose to invest in
timberland. Timberland investments cannot be easily duplicated using
commonly available financial instruments. Timberland is a good
diversifier, as illustrated in Figure 3. The lack of correlation to
other asset classes is the key to the diversification benefits of
timberland. The presence of timberland in a multi-asset portfolio
reduces risk without sacrificing overall portfolio return or
conversely, increases return without adding more risk.
Figure 3. Timberland Correlation to Other Asset Classes, 1987-2006
Multi-Generational Wealth Preservation and Tax Efficiency
Timberland offers the unique ability to “store value on the
stump” (i.e., delay harvesting if log prices are unfavorable)
with low carrying costs and has proven to be a time-tested technique
for passing wealth on to future generations in a tax-efficient
manner. The long-term nature of timberland allows for capital
preservation strategies since new, physical tree growth adds value
without generating near-term tax liability, and timberland values tend
to be positively correlated with inflation.
Option Pricing Attributes
The ability of timberland to grow timber with a relatively long life
span bestows several interesting features on the asset class. Timber
can be “stored on the stump” with a very small risk of
loss. Unlike other products such as agricultural crops or some
consumer goods, timber does not perish quickly if it is not
consumed. The stored timber will continue to grow, adding volume and
product quality, thereby adding value. This biological growth of
timber reduces storage or holding costs significantly. Although other
goods can be stored in a warehouse and sold at a later date, the cost
of capital tied up in the unsold goods is substantial. In the case of
timber, the biological growth can more than offset this capital cost.
It is this growth that eliminates most of the risk of market timing
timber sales and allows for flexible management operations and the
opportunity to take advantage of cyclical markets by storing value
“on the stump” if short-term market conditions justify
it.
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