“We’re simply talking about the land and the trees,” says Tim Cayen, director of business development at Hancock Timber Resources Group. He was in Toronto recently to talk to the Canadian chapter of the Chartered Alternative Investment Analyst Association. “We’re really trying to capitalize on tree growth and timber markets.”
Timber investing is not about integrated forest product companies, though they are the customers of the wood. Instead, there are two components: the land value, and the price of the timber. Land is valued like commercial real estate. The price of timber will fluctuate, but if log prices fall, owners can withhold production. As the trees continue to grow, they will fetch a higher value when harvested.
Timberland is a very young asset class, with the first investments in 1985. And it has benefited landowners and forestry companies alike. When forestry companies owned their own land, the focus was on volume to feed the mills, rather than getting the best lumber. New owners, Cayen explains, might let the trees grow three years longer. Bigger logs can be used to create higher-value-added products, 2×4’s to frame houses instead of pulp to be turned into paper.
While the data on timber returns is relatively short, compared to that for equity market returns, timberland comes out in the middle: a higher return than everything but small-cap equities, at about 12%, with a volatility between corporate bonds and large-cap equities, at about 12%. It is most correlated with inflation and commercial real estate, and negatively correlated with bonds, and oddly, publicly traded forest product companies. The class has lost money money only twice in the past two decades.
“Over the long term, we’ve seen timberland generate relatively strong returns. We’ve seen relatively low correlation with other asset classes. It tends to be positively correlated with unanticipated inflation,” Cayen says. “So it’s a nice diversifier.”
Still, it’s only a small diversifier. Hancock’s 293 clients have exposure to timberland ranging from 1% to 13%, but it averages 2%.
The investable universe of timberland for institutional investors is estimated at US$120 billion to $150 billion, the vast majority in the U.S. There is some in Canada, but most of the forests are owned by the Crown. Other investment areas include Australasia and Latin America. Still, there has been increased selling of corporate timberlands in recent years, adding to the investment opportunity set.
Cayen defines investable using a number of criteria. First, “You have to be able to buy it.” In addition, there has to be deep infrastructure – roads and mills – to get the timber to market or to process it for the market. Then there are political factors, namely legal title. While Russia has the world’s largest supply of softwood, it is not investable. Europe is also excluded, by reason of market depth. But it also has very low risk-adjusted returns, since land is very expensive. “You have too much money tied up in the dirt and not enough in the trees,” he says.
On the risk side, timber price fluctuations account for 80 to 90% of the downside. “I know what timber prices are today,” he explains. “ I don’t know what they’re going to be in three years, five years or 10 years down the road.” There are short-term weather fluctuations, such as wet weather that prevents loggers from getting into the woods. There could also be technological innovation. For example, instead of waiting for a tree to grow straight and with few limbs over 30 years to make plywood, smaller trees, limbs and all, can be chipped up, pressed with glue and turned into plywood. “Now you’ve created a whole new value structure,” Cayen says.
Biofuel is a potential future use too, though Cayen thinks pulp manufacturers will always pay a better price for low-value lumber unless oil is significantly above $100 a barrel.
A second risk is harvest risk – mostly that of fire. But it’s a minimal risk, he says, that can easily be diversified away by using high-quality management and by owning parcels that are not contiguous. In last year’s fires in Australia, Hancock had 15,000 hectares that were affected, but suffered a loss in value of only 2%.
Finally, there is liquidity risk. It may be hard to sell when an investor needs the cash. But Cayen says this was a much greater risk 10 years ago than it is now.
Geographical diversification plays a key role. Different regions grow different types of trees, and in turn, offer different types of products that are not highly correlated to each other. In the U.S. northeast and eastern Canada, there are 35 commercial species of trees that can be used for paper, furniture, railway ties, even tongue depressors. In the U.S. south, the two types of pine are used for pulp and 2×4’s. On the west coast, five species of trees are used in construction and also for exports. “There’s typically a market for some product from some tree species, despite the economic cycle.”
Timberland may not be just about trees. Some areas of the land may find a higher and better use, for example, as recreational property or as a conservation easement.
Which brings stewardship to the fore. The definition of sustainable forest lands, Cayen says, means “as you cut your trees, you plant trees.” The last thing an institutional investor wants is “to be on the front page of the Financial Times” for poor stewardship.