Timber Fundamentals and Attributes
Institutional investors began to place capital in timberland in the early 1980s as a way to diversify their portfolios. Today timberland has grown into an accepted alternative asset class with over $12 billion currently under the management of timberland investment management organizations (TIMOs). FLI estimates that up to $3 billion is invested by high net worth investors, with the remaining capital being provided by institutional investors such universities and pension funds.
Timberland offers unique opportunities to investors, such as high net worth individuals and family offices, pension funds, and university endowments. Timberland is especially well-suited for long-term investors and offers attributes such as:
• Strong risk-adjusted returns
• Attractive portfolio diversification benefits
• Multi-generational wealth preservation benefits
• Short and long-term tax efficiency
Strong Risk-Adjusted Returns
Timberland has historically outperformed other asset classes, such as common stocks and commercial real estate, while having lower risk. Figure 1 shows a basket of assets from 1974 to 2003, the 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 compared with other assets sectors over a 30-year period is attractive. The Sharpe ratio is illustrated by the slope of the security market line linking timberland to the risk free rate in Figure 1 and is listed by rank in Table 1. 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. FLI estimates that the future expected Sharpe ratio for FLI managed funds will be 0.97. This compares very favorably to historical measures and reflects the fact that FLI timberland investments, while targeting 7%-9% IRR, are not subject to risks arising from the traditional exit strategy.
Figure 1. Risk and Return of Traditional Asset Classes, 1974-2003
The Sharpe Ratio, also called the reward-to-variability measure, corresponds to the excess return per unit of standard deviation. It is written as, . Where, average return of security, average return of risk-free rate, and standard deviation of security.
Table 1. Sharpe Ratio, 1974-2003
Attractive Portfolio Diversification Benefits
The fact that timberland's performance characteristics differ from other asset classes is ultimately the primary reason to invest in timber. Timberland investments cannot be easily duplicated using commonly available investment instruments. Timberland is a good diversifier, as illustrated in Figure 2. Correlations to the other asset classes are the key to diversification benefits. Timberland is negatively correlated to most other asset classes and positively correlated to inflation. The presence of timberland in a multi-asset portfolio should reduce risk without sacrificing overall portfolio return, or conversely, increase return without adding more risk.
Figure 2. Correlation Coefficients, 1974-2003
One way to examine the benefits of timberland in a multi-asset portfolio is to compare efficient frontiers with and without timberland. The efficient frontier represents the group of portfolios that offer the minimum expected risk for a given level of return. All other portfolios and even single assets will exist below the efficient frontier and will be inferior from a risk/return standpoint. Figure 3 depicts two efficient frontiers calculated from historical returns from 1974 – 2003. One efficient frontier is calculated with timberland included the other is not. The figure helps show that portfolios with similar target rates of return will have less risk with timber included.
Figure 3. Efficient Frontiers, 1974-2003
Multi-Generational Wealth Preservation and Tax Efficiency
Timberland offers the unique opportunity to “store value in the trees” 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. The biological growth of timber provides consistent volume and value growth through time. However, the growth of timber adds value without generating near-term tax liability. In addition, income generated by harvesting timber held in a flow through ownership vehicle such as an LLC enjoys preferential capital gains tax treatment.
Risks of Investing in Timber
Several factors quantified in the risk shown in Figure 1 can be attributed to specific risks associated with timberland. The most often cited risk associated with timberland is illiquidity. Illiquidity can vary by the age of timber, the size of the property, and geographical region. However, three factors have created an increasingly more liquid asset class in recent years.
• Timber has earned a greater acceptance by the investment community. As the asset class has grown to over $12 billion, a much wider range of investors have either invested in timberland or researched the asset class and increased their knowledge of the asset class.
• Integrated forest product companies are continuing to monetize their timberland assets, thereby increasing the number of transactions in the marketplace.
• A greater number of publicly traded “pure play” timber equities have increased the number of transactions in the marketplace and increased investor familiarity with timberland investments.
Additional risks to investing in timberland also include cyclical markets and environmental risk. Market fluctuations in timber and timberland prices can often be mitigated by opportunistically harvesting timber when prices are favorable. When timber markets are soft, on-going biological growth allows for “storing value in the trees” and harvesting when timber prices improve. Environmental risks include both natural hazards (such as fire), and increased regulatory constraints. Fire is generally not considered a significant risk of investing in private forestland. Historically, less than 0.5% of commercial timberland owned by institutional investors is damaged by fire, insects, disease, and other natural hazards. The active management of timberland investments greatly increases monitoring, access, and available mitigation opportunities. Diversification by timber species and ages also helps mitigate these risks.
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