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Forestry Investment – An Attractive Alternative

Forestry as an Investment Class

by Frank Quin

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The investor seeking both heightened portfolio efficiency and mid- to long-term stability could do worse than cast an eye over investment products that offer exposure to the forestry industry. Forestry investment represents an alternative real estate investment and a potential diversification to stocks and bonds. The inherent features of forestry land and products, examined below, afford good complementarity to traditional financial assets. In particular, forestry products offer historically lower volatility than debt and equity securities, have shown equal or better returns over the long run and, importantly in fiscally turbulent times like the present, a low to negative correlation with most other asset categories. Additionally, as a commodity in daily trade and consumption, timber correlates well with inflation, making it attractive for hedging against inflationary risk.

A Background to Forestry Investments

In the past, say, until the 1980s in developed economies, commercial forest properties tended to be owned and exploited by vertically integrated forest products companies. Thus, the company owned or leased long-term – typically from the state - the forest land, husbanded and harvested the trees and operated the mills which produced the primary outputs in the form of logs, lumber and wood pulp. But the wave of economic restructurings during and since the 1980s, typified by ‘Reagonomics’ in the United States and the UK’s ‘Thatcherism’, saw many forests hived off into private ownership as the forest products companies focused on their core, downstream operations. Generally speaking the process was encouraged at government level with favourable tax treatment for forestry investments and fiscal incentives for incoming forest owners.

Forest ownership diversification has also been a feature of transitional measures in some – though not all – of the formerly communist countries of central and eastern Europe, via restitution from state-owned enterprises to pre-communism ownership, and in the settlement of indigenous claims by appropriation of forests in a number of countries globally. Such measures have at least allowed for the possibility of downstream third-party forestry investment.

The upshot of this changed environment is that, compared with 30 years ago, there now exist a range of investment options in relation to forestry and forestry products. These extend from the acquisition of direct ownership interests in a standing or newly-established forest through to indirect investment in REITs or other funds with exposure to forestry investments to speculative or hedge investment in timber futures. The players in forestry investment products are equally diverse – funds in particular, hedge, pension and sovereign, have increasingly turned to timber along with the traditional market participants and private investors. Specialist investment vehicles have emerged – so-called TIMOs (timber investment management organisations) – to bring cohesion to the mass of forestry investment opportunities which started to enter the market. Today in the US, some 20 TIMOs are thought to control, by one estimate, between $60 and $70 billion in private sector forestry investment, with roughly 70 percent of that investment in the United States (Timberland Investment – An AIMCo Perspective, Alberta Investment Management Corp, September 2011).

There is nevertheless ample room for smaller-scale innovation in forestry investment, with a raft of promoters having emerged to offer managed participation in forest ownership via both traditional corporate structures and tax-oriented limited partnerships. Depending on the investment project, there may or may not be the prospect of immediate or short-term cash-flow.

Forestry Investment Products in a Nutshell

However structured, an investment choice in forestry basically breaks down to a consideration of product type and of location. In product terms, the broad division is between hardwoods and softwoods. Hardwoods are deciduous species which grow in both temperate and tropical regions but to a very large extent the commercial harvesting of hardwoods involves tropical and sub-tropical natural and plantation forests, in countries such as Brazil and Indonesia. Increasingly, the commercial exploitation of temperate hardwood stands – old forests of oak, beech and the like – is being restricted or prohibited by governments worldwide, sometimes with and sometimes without appropriate compensation to the forest owner.

Softwoods are evergreens –primarily coniferous - and typically grow naturally in temperate regions of North America and Europe. Global attention to forestry conservation since recognition of climate change in the early 1990s has seen a growing focus on the commercial establishment of softwood plantation forests in a number of countries, notably the US, Canada, Australia, New Zealand and South Africa. Softwoods are increasingly displacing hardwoods in building timber and wood pulp production, with the permitted uses of hardwoods being confined to high-end products such as furniture, sports equipment and craftworks.

In terms of geography, an forestry investments will either be home-based – where ‘home’ is the UK or the US, for example – or offshore in either a developed country with a strong, well-managed forestry sector or a developing country with, typically, a lot of forest but degraded management and attendant investment risk. In the first category can be placed Australia and New Zealand, in the latter would be, say, the Russian Federation and other formerly communist countries of Europe, along with a number of emerging economies in Asia, Central and South America and in Africa.

Sources of Forestry Investment Returns

In understanding a forestry investment, an appreciation is critical of the fundamental components that comprise returns. Essentially there are three factors – biological growth, forest product pricing and land value.

As living organisms, trees grow and can be regenerated, making a forest a renewable resource which, if managed well, will increase in value as it matures. For trees grow not only in volume but also in value, with older and therefore larger logs typically having a higher value than smaller ones. This growth-related accretion in the value of a standing forest makes timber a unique form of investment asset – value added occurs regardless of macroeconomic conditions or financial market performance. With biological tree growth accounting for approximately 65-75 percent of the return on a forestry investment, competent husbandry – ensuring healthy and optimal growth – is obviously critical to the return on that investment.

The second key factor is price change for timber and other forestry products. Price fluctuation is inherent in the commodity nature of such products, constantly influenced by macroeconomic factors such as area-specific population growth/contraction, levels of construction activity, costs of borrowing and the overall level of economic activity in a given market. But unlike most other commodities, timber need not be harvested by virtue of having reached the end of its growing season. Timber can be "stored on the stump" if prices are unfavourable and will continue to grow and increase in value for a number of years following a first commercial harvest year. Minimal extra cost will be incurred in implementing this decision, compared with the warehousing of, say, butter or milk-powder. This ability to manage the market entry point of any given timber product, so as to optimise its selling price, is an important contributor – as much as 25-30 percent – to the forestry investment return.

Finally there is land value. Typically, the value of the land represents a very small portion (two-five percent) of the total value of a forestry investment, contributing least to the return on the investment. But well-chosen land, for example land which is capable of growing other crops or pasturing livestock, will add lustre to the overall value of an investment, providing indirect fiscal benefit in, for example, the ease which that investment might be liquidated on a secondary market.

A mention could be made in passing of other potential returns on a forestry investment. For example, a timber or conservation-related easement under which forest owners are compensated for taking an agreed portion out of commercial exploitation. Alternatively, there may be hunting rights for which an annual fee is paid.

Low Volatility

Relative to rate of return, forestry investments enjoy low volatility, principally because, as noted earlier, of biological tree growth. Thus, with the introduction of timberland into a diversified portfolio, long-run returns tend to smooth over time, reducing the overall portfolio's risk level.

This is not to say that timber products are immune from dramatic price movement – as commodities traded in international markets they are subject to shifts influenced by economic conditions. Foremost at the present time is the continuing slump in the US new-build housing market – a major determinant of softwood prices globally - which began with the sub-prime mortgage market collapse in 2007 and has yet to recover. Indeed 2011 was the fourth straight year in which new US housing starts remained around the half-million mark, half the volume of 2005 and representing a negative persistence not previously experienced in the post-war years. In consequence, the average price of lumber futures approaching the middle of 2012, at around $245 MBF (thousand board feet), is roughly two-thirds of 2005 pricing (at $380 MBF). Increasing demand from developing economies – with China leading the way – has yet to take up the shortfall in US demand for building lumber.

Yet the observation holds – relative to other, and especially financial, investment products, timber is insulated from major and sudden price fluctuations.

Diversification Benefits

In addition to solid and durable risk-adjusted returns and low volatility, forestry investments enjoy low correlations with other asset classes. Over the period 1987 – 2009, timber had a positive correlation of less than five percent with the market price of small cap equities (source – Ibbotson Associates / Lutz), becoming around eight percent negative in the decade 2000-09. Combining forestry investments into a well-diversified portfolio thus has been shown to lead to a more efficient portfolio (higher return, lower risk). Through 1987-2009, there was a 40 percent positive correlation between US building lumber prices and the consumer price index, indicating high correlation with inflation and justifying the perception of forestry products as an inflationary hedge.

Risks

There are, needless to say, risks with forestry investments as with every investment product. First, there are economic risks with pulp and lumber prices impacted by movement in supply and demand - the US housing slump mentioned above a major case in point - as well as cyclical and seasonal fluctuations. This risk can be muted to a degree because of the ability, noted earlier, to "store on the stump" and harvest when prices trend upward. Investment vehicles using hedge or other private funds have more leeway here, whereas publicly-traded companies are driven to achieve dividend targets. REITs with forestry investment holdings will predominantly be simply forestry land owners rather than operators, deriving income from concessions paid by whoever is actually harvesting the timber. The rules governing REITs are such that the majority of their income must be generated by rent paid and will thus be less tied to short-term fluctuations in timber prices.

Then there are physical risks, including fire, weather, insects and disease. These risks vary to a large extent across geographic regions and climates, with their mitigation strongly influenced by forest management competency.

Third, the flipside to relative lack of volatility in forestry investments is risk inherent in lack of liquidity. A direct investment in a forest is relatively illiquid, with like-for-like comparisons difficult to achieve and a consequent lack of market price discipline. There is a risk for investors in, for example, overestimating either or both present-day inventory and future growth from a given piece of land. The long-term investment horizons for forest land – 10 or more years typically - should bring clearly into focus the importance of effective due diligence and objective, hard-nosed pricing at the outset.

Finally, a forestry investment may be adversely impacted by environmental action. For example, in the early 1990s the United States government imposed harvesting restrictions on forestry land to protect threatened or endangered wildlife species (read – the spotted owl). More recently, a growing number of countries have introduced partial, and in some regions total, logging bans to conserve existing natural forest inventories. Increasingly, environmental restrictions - as well as the loss of land to development pressures - will reduce the availability of global forest land that can be commercially exploited. The well-informed investor will avoid being caught up in such risk.

Conclusion

Both private and institutional investors should consider an allocation to forestry investment. Despite the potential risks, forestry provides equity returns with fixed income volatility. The diversification benefits are equally attractive.

In the present uncertain times, the focus of most plan managers is on maintenance of a healthy funded status for their pension plans. Forestry investments typically call for a ten to fifteen year investment horizon, making them an attractive matching asset for the long-term nature of pension liabilities and for meeting endowment and foundation spending requirements.

Despite the currently gloomy market for US building lumber, future global demand for timber is projected to be favourable on account of population growth and improved living standards worldwide. With shrinking natural timber supply and long lead-times for replacement plantation timber, it’s hard to foresee supply outstripping demand any time soon. This demand/supply imbalance would appear to provide pricing support for forestry investments for the foreseeable future.

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