JULY 2010                                                                           Download PDF Version

Timber - An Asset Class Coming Home

Family offices are in the business of delivering safe, uncorrelated returns with a strategy which preserves the wealth of their principal. Many North American pension funds have spent the last two decades getting just that by investing in timber. This research piece argues that timber and the funds that invest in it should now be considered a portfolio staple for family offices which are the natural home for this asset class.

We view timber funds as capital growth investments (occasionally blended with some income) with a far time horizon of 10-15 years.

  1. The current global investable timber universe is $300bn

  2. Approximately two thirds of this is in the USA with most of the rest in Latin America

  3. Current institutional investment is estimated to be approximately $18-20bn

  4. Timber funds as an investment grade asset class date from the early 1980s

Not all institutional investors allocate to timber but those that do may allocate 2-3% and often consider it alongside other ‘real asset’ investments (although a small number of North American pension funds have taken considerably larger positions over the years). Timber investors have historically been attracted by:

  1. Demonstrable steady returns with extremely low volatility

  2. Very low correlation to other asset classes

  3. And an intrinsic hedge against inflation.

However, although these benefits might seem a good fit for family offices, those investors have historically been reluctant to adopt the asset class, possibly because they perceived it be immature and/or they could get better risk-adjusted returns from elsewhere.

Given the performance of portfolios in 2008/9, we are re-examining the asset class with particular regard to its suitability to family offices and high net worths.

Return and Risk
The primary sources of return and risk are generally considered to be:

  1. Biological growth of the physical trees

  2. Timber price fluctuations

  3. Land values

  4. Geographical location of the plantation

Biological growth can account for as much as two thirds of the returns. Consequently the management and harvesting of the physical asset is of paramount importance. Considerable skill and experience is required for managing a plantation correctly for maximum profit: a good timber team will divide a forest into early stage trees to be sold for pulp and paper (low price and volatility), and an established stage which will generate lumber for construction (high price and volatility).

The risks for Biological growth stem from biological factors such as infestation, fire, weather and disease. These risks, though important, are straightforward to manage by a competent team through regional diversification. Data shows that 0.5% per annum of return is lost to these risks.

Timber prices are generally considered to be a leading economic indicator and, although volatile in the short term, have grown over the long term at an annual rate of 2%. Timber prices have historically been driven by demand for housing in the USA, but recently are strongly influenced by demand from China and India, who have emerged as the larger importers of timber. As has often been  noted, timber is a unique investment that ‘pays an investor to wait’ since, should timber prices be at a low point, the trees can  simply be left standing.

Land appreciation has traditionally not accounted for a significant proportion of the return of timber indices. However, this is largely due to timber teams being inexpert in spotting the associated real estate opportunity. The current view is that a timber investment should overlay returns from a well executed real estate transaction on top of a well managed timber play.

The geographies which are optimal for timber growth are also those with greater political risk. As a general rule investors have received 9-11% raw return from Latin America, compared to 6-7% from North America. The extra yield may or may not compensate investors for the additional geographical (largely political) risk and will be a matter of individual preference. However, it is worth noting that many current US-based timber funds are now targeting higher returns due to land appreciation opportunities, which are not so obviously available in Latin America.

Fund Considerations
In common with our general investment principles we would recommend that any investor wishing to invest in timber did so via a fund, rather than attempting a direct investment. There are therefore a number of further considerations:

  1. 1.Manager selection

  2. 2.Fund governance and operational risk

  3. 3.Deployment and dormancy

It has often been noted that there are two types of timber fund: those run by forestry experts; and those run by financial/fund experts. Due the sophistication of the asset management requirement we strongly prefer the former (notwithstanding fund governance and operation considerations below). A good manager should have a demonstrated track record in the relevant geography and timber type and should be an established team, even if operating in the context of a first time fund. Investors should be wary of managers who might seek to stretch their competence beyond their direct experience, perhaps by expanding into new geographical areas or types of timber.

Timber funds run by ‘forestry guys’, whilst preferable to those run by ‘finance guys’ are not always the best at governance and operational risk. In particular it can be difficult for investors to be certain that the team is adhering to the investment process detailed in the investment memorandum, rather than taking a freer rein. In our view key governance roles (in particular valuation) must be outsourced. Ideally, therefore, the fund should be constructed as a hybrid between a well established fund manager and a suitably experienced timber team.

We see significant variations in the timeframes forecast by different timber funds for deployment investors’ assets. This can range from as little as three months to as much as four years. Since dormancy of cash materially impacts an investor’s rate of return, investors should favour shorter deployment terms and, ideally, request evidence of pipeline deals before committing to a fund.

Since timber is an intrinsically illiquid asset, investors pay a heavy price for early redemption from a timber position. Therefore we recommend the asset to a family office only if the investor is certain it can comfortably tie up its capital for the duration of the proposed investment period.

Timber has matured as an asset class and has now come of age. The benefits of investing in timber come into sharper focus when placed next to the disappointing performance enjoyed by a large number of hedge funds, funds-of-funds and private equity funds through 2008, 2009 and 2010.

The outlook for equity and bond markets for the next 5-10 years promises to be volatile and not necessarily rewarding. Furthermore, inflation is likely to significantly further erode market values over this same period. Therefore timber does have a number of very attractive attributes to protect while also delivering real returns.

There are no good liquid investment opportunities in timber and investors must be ready and willing to lock their money up for a prolonged period of time. This means that for the majority of investors timber will remain a smaller allocation in the 5-7% range. However, if a suitable fund can be found then this would be a very sensible allocation to make.


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