What does a pine tree plantation have in common with a commercial office building? Both are real estate investments, use land or real property to generate sustainable cash flows, and appreciate in value.
Yet, commercial timberland and commercial real estate investments fall under two separate asset classes. Timberland is classified as an alternative investment vehicle — part real estate, part commodity and part fixed income — explains Charlie Daniel, president and CIO of Atlanta-based RMK Timberland Group, which buys, sells and manages timber assets for large institutions.
RMK is one of 20 Timber Investment Management Organizations, or TIMOs, that have emerged over the last 25 years. Unlike real estate investment trusts, TIMOs are not publicly traded. They function like private-equity firms, creating pooled funds for multiple investors but also manage separate accounts for larger clients.
Timberland provides excellent diversification, and inflation-hedging attributes to mixed-asset portfolios. The investment moves inversely to stocks and bonds with little correlation to commercial real estate. The returns also tend to keep up with the rate of inflation, which suggests it is an effective vehicle for the preservation of capital during inflationary times.
According to Kendall Thomas, a trustee with the Austin Police Retirement System in Austin, Texas, 10% of the $400 million pension fund is allocated to timberland. Although the fund previously had 30% to 40% of its portfolio invested in domestic bonds, it reduced that exposure to only 11% and diversified into other investments, one of which is timberland.
“It's hard to put your arms around timberland at first, but it doesn't take long to see that it is a good investment,” says Thomas. “Our returns have averaged 10% to 11% over the last 10 years.”
By the numbers
Although timberland is one of the oldest forms of investments, the National Council of Real Estate Investment Fiduciaries (NCREIF) didn't start tracking timberland returns until 1987. The number of properties included in the Timberland Index has grown substantially due to the unprecedented growth in the number of timber funds, especially in the last 10 years. There were only 95 properties included in the index in 1994, but by 2005 that number had grown to 235.
Since its inception in 1987, the Timberland Index has posted an average annual return of 15.3%, compared with 11.6% for the S&P 500 during the same period. But many industry insiders say the 10-year annualized return of 8.3% is probably more indicative of future return potential (see chart on page 100). Rising interest rates and a slowdown in residential construction are likely to impact timberland returns in the near term.
However, Mark Wilde, an analyst with Deutsche Bank, doesn't foresee a dramatic decrease in lumber prices. “Housing demand may ease, but we don't see housing falling off the table,” says Wilde.
The real concern among many industry insiders is the enormous amount of capital pouring into the asset class. Current bidding wars for timber tracts continue to push transaction prices upward, making it difficult to generate higher returns. Wilde refers to timberland as the “asset du jour.”
Timberland returns are derived from net operating income and capital appreciation. Timber sales drive net operating income while land value and the growth of the trees contribute to capital appreciation. Historically, two-thirds of the timberland yields stemmed from capital appreciation due to the large increases in historical valuations.
With inflated acquisition prices, investors are likely to see a subtle shift in the make-up of their timberland returns. “In the future, we are likely to see the income component increase to 30% to 40%, with capital appreciation accounting for 50% to 70%, given lower expectations for future returns,” says Kurt Akers, director of research for Global Forest Partners, a New Hampshire-based TIMO.
Roots of timberland investment
Many pension funds started investing in timberland after passage of the Employee Retirement Income Security Act (ERISA) in 1974. To comply with ERISA's then new fiduciary requirements to maximize portfolio returns, pension fund managers diversified by investing in equities, commercial real estate, oil and gas and timberland. They identified timberland as a steady, relatively safe long-term investment, delivering equity-like returns with bond-like risk.
Today, institutions own approximately $22 billion in timberland. The bulk of this amount, $15 billion to $17 billion, is managed by TIMOs. The real estate investment trusts control the balance. Dr. Mike Clutter, a professor at The Warnell School of Forestry at the University of Georgia, says that institutions are lining up to sink another $5 billion into the asset class. “There is a lot of capital chasing timberland right now,” he says.
Due to the long-term nature of timberland investments, most TIMO funds require at least a 10-year commitment with options to extend. Also, access to these funds is not cheap. Minimum investments for separate accounts range from $20 million to $100 million.
Commingled funds often require a minimum investment between $2 million and $5 million, although a few require as little as $250,000. In general, management fees run around 1% of assets. Also, managers typically take a percentage of profits, usually based on a performance hurdle.
RMK Timberland Group is one of the largest TIMOs in the country, managing more than $1.4 billion in timberland assets for institutional investors. RMK and other TIMOs have stepped up their acquisition strategy to buy large tracts of timberland from forest product companies such as Bowater, Weyerhaeuser and International Paper. In the last decade, millions of acres have transferred from industrial to institutional ownership.
The Manomet Center for Conservation Sciences, one of the nation's oldest environmental research organizations, recently compiled a study that focuses on the impact of the massive turnover of timberland ownership in the Northeast. According to the study, forest product companies sold 23.5 million acres in the Northeast over the last 25 years.
On a national scale, the disposition trend is even more dramatic. In 1981, forest product companies owned approximately 58 million acres of U.S. timberland. By 2005, they owned less than 21 million acres, more than a 60% reduction. The disposition trend continues today with International Paper's recent announcement that it will sell 5.1 million acres to two separate investor groups, and another 287,000 acres to conservation groups.
Dr. Lloyd Irland, a forest economist and one of the authors of the Manomet study, says it is difficult to predict to what extent forest product companies will sell timberland in the next 10 to 20 years. “Ten years ago, anyone predicting the industry would sell this much land in such a short period of time would have been laughed out of the room,” says Irland.
Why has there been such a pronounced shift in ownership of timberland from industrial to institutional investors? For decades, the publicly owned forest product companies operated under a production-driven philosophy, constantly harvesting timber to feed their capital-intensive paper mills. These vertically integrated businesses were more concerned with subsidizing their mill operations than maximizing the potential of their timber holdings.
Selling their timber holdings to institutional investors appears to have been a win/win scenario for paper companies. Many have used sale proceeds to pay down debt obligations and to make capital investments while retaining long-term wood fiber supply contracts with the new institutional owners.
In such an arrangement, the paper companies negotiate to buy a certain amount of timber each year from the new owners. Essentially, they eliminate the day-to-day responsibilities of managing timberland assets without cutting access to raw materials.
Managing timberland is a highly sophisticated business. Intensive forestry management involves maintaining and rebuilding timber inventories over time. Timberland management is also affected by supply and demand on a local and regional basis. As a result, TIMOs employ teams of foresters and consultants from around the country to manage their timberland holdings.
Robin Jolley, the CEO with American Forest Management, works with several TIMOs in the Southeast. While TIMOs are concerned with maximizing returns for their investors, Jolley says that they also put a strong emphasis on stewardship.
Many of the properties are certified under the Sustainable Forestry Initiative (SFI), Forest Stewardship Council and/or Tree Farmers Program. “The common thread found in these certifications,” explains Jolley, “is that sustainable and sound environmental practices are employed and recognized.”
TIMOs and their institutional investors have distinct advantages over industrial owners. First, the new ownership structure is more tax efficient. Institutions are not subject to the same tax burdens as corporations that own timber. Pension funds such as the Austin Police Retirement System pay no income taxes on their timberland holdings.
Secondly, institutions gain the full benefits of cash flows and value appreciation, while public companies are required to carry long-term timberland assets at book value on their balance sheets.
Another advantage is the lack of pressure from Wall Street. Forest product companies may have been compelled to harvest timber prematurely just to meet short-term quarterly earnings goals. TIMOs have no immediate performance hurdles. Their goal is to produce sustainable long-term revenues rather than a short-term return on capital. Therefore, it is not uncommon for TIMOs to warehouse timber assets during periods of low market prices. They simply delay cutting their trees until market prices improve.
The flexibility to time harvesting according to market conditions is what makes timberland stand out from other investments. Trees grow regardless of fluctuations in the economy. “The biological component is what is truly amazing about timberland as an investment,” says Daniel of RMK Timberland Group. “You can recognize a healthy return without actually harvesting any timber. Also, as trees grow and mature, they graduate to more valuable product classes.”
According to the USDA's Forest Products Laboratory, the forest products industries generate more than $240 billion per year. They also contribute 7% of the manufacturing portion of GDP. Timber products range from toilet paper and packaging to lumber. Over the long term, total U.S. forest product consumption is projected to increase by 38% by 2050, according to a USDA study.
To meet demand for the wide array of forest products and to enhance their risk-adjusted returns, TIMOs diversify on a broad geographical scale. Many funds own natural forests and timber plantations throughout the United States. The three largest areas of ownership concentration are the Northeast, Southeast and the Pacific Northwest.
Timber inventories include multiple age classes and a variety of tree species. These diversification methods mitigate market risks as well as physical risks such as fire, disease and pest infestation.
Future growth prospects
TIMOs generate income from sources other than timber harvests. Hunting leases and conservation easements contribute to timberland's bottom line and often cover real estate taxes and insurance expenses. Federal incentives to combat global warming are also in the works. Basically, landowners will be paid to grow trees since forests absorb carbon dioxide.
Interest among individual investors in timberland is on the rise. Although institutions are still the main investors in timberland funds (see chart on page 99), Bill Boden, chief investment officer with Timbervest, an Atlanta-based TIMO, says his firm has observed increased interest from individuals seeking to round out their portfolios with timberland. “Approximately 10% to 15% of our last commingled fund came from high-net-worth individuals,” says Boden.
For the individual investor, the tax benefits to holding timberland are attractive. According to Boden, the revenue from the actual sale of timber qualifies for capital gains treatment. The tax code also gives timberland owners a tax deduction, known as depletion, which is the annual cost assigned to harvested timber. Unlike land, the timber cost basis is recovered more quickly using a depletion allowance.
As demand grows, Timbervest continues to scout the country for investment-grade properties. Other TIMOs have taken a more global approach, focusing on emerging markets. Currently, Global Forest Partners has investments in Argentina, Brazil, Chili, Uruguay, Australia and New Zealand, in addition to its domestic holdings in the Southeast.
The Austin Police Retirement System has positions in three timberland funds, two domestic and one international. “Land has always been a hedge against inflation,” says Thomas, “and if you get paid an 8% to 10% return to grow trees while your land continues to appreciate in value, then it makes sense to invest in timberland.”
Toccoa Switzer is based in Charlotte, N.C.
Flap over spotted owl hit forest industry hard
It's hard to believe that a 16-inch bird weighing one and a half pounds could turn an entire industry on its head. But that's exactly what occurred in 1990. The northern spotted owl was thrust into the national spotlight when the Department of Interior listed it as “threatened” under the Endangered Species Act of 1973.
Under this provision, timber companies on federal lands were required to restrict logging on those acres where it might jeopardize the continued existence of the spotted owl or adversely modify their habitat. Private landowners were also required to avoid action that would harm, kill or interfere with the reproduction of the species.
Although it was a victory for environmentalists at the time, this decision virtually shut down 80% of logging operations in national forests throughout the Pacific Northwest. It is estimated that timber production on federal land in the region dropped from 5 billion board feet per year to approximately 1 billion board feet per year. With the reduction in domestic supply, timber prices soared as did the value of privately owned timberland unaffected by the restrictions. The chain of events resulted in record-breaking timberland returns in the early 1990s. Eventually, prices and returns inched downward as production capacity shifted to the southern United States.
Despite ongoing protection, the spotted owl population is still on the decline. According to Joan Jewett, spokesperson for the U.S. Fish & Wildlife Service, there were 5,000 to 8,000 pairs of spotted owls in California, Oregon and Washington in the late 1980s. Today, the population is estimated at half that total. Recently, the barred owl has also been identified as a major contributor to declining spotted owl numbers. No word yet on how the government will resolve that issue.
— Toccoa Switzer