Investors see the forest for the trees

Timber is increasingly attractive for institutional investors as part of an alternatives exposure, with benefits including diversification and inflation-hedging. To date most of the investments have been in the US, but a new report predicts this will move to emerging countries including those in Asia, with consultants advising investors spread their timber exposures to capture growth opportunities.

Timber investments offer the lure of returns uncorrelated to other financial assets and also play into several attractive potential thematic opportunities such as population growth and resource scarcity, climate change and the growing consumer-base in emerging markets.

While timber has previously been the domain of the endowments – with investors such as Harvard Management Corporation allocating 14 per cent to commodities exposures – pension funds have also been looking at these assets both for their risk diversification potential and as a hedge against inflation.

Sovereign wealth funds, including Australia’s FutureFund, and the Alaska Permanent Fund  are among investors which have been vocal about increasing their timberland investments.

In 2008, CalPERS announced it would more than double its investment in timber to $2.4 billion or 1 per cent of total assets. Timber investments fall under CalPERS’ “inflation-linked” asset class, which also includes commodities, inflation-linked bonds and infrastructure.

As of this year, inflation-linked assets made up 3.5 per cent or $7.9 billion of CalPERS total asset allocation and California’s biggest public pension fund aims to increase this to 5 per cent.

Other public pension funds to move into timber include two Canadian pension funds that this week paid more than $1.03 billion in a shareholder approved buy-out of publically listed timber company, TimberWest.

British Columbia Investment Management Corporation and the federal Public Sector Pension Investment Board purchased TimberWest, Western Canada’s largest private timber and land management company.

Despite having more than 327,000 hectares of private land, TimberWest was hit by the downturn in the US housing market, making it an attractive acquisition target for the two long-term investors.

The general trend by institutional investors into timber assets can be seen in the context of a steady increase to alternatives among institutional investors. Cliffwater LLC’s recent Allocations to Alternative Assets 2011 survey found public pension funds on average allocated about 20 per cent and corporate pension funds 14 per cent to alternatives.

The survey of 97 state-wide pension funds in the US found that on average funds had 6 per cent of their alternatives’ allocation in real assets. The move is mostly coming from real estate exposures.

Principal in Mercer’s alternatives boutique within investment consulting, Simon Fox, says timber has been one of the best performing assets over the past two decades.

Taking the US NCREIF Timberland Index, timber assets have delivered an annual return of 14.1 per cent since the index was started 23 years ago.

A key diversification of risk comes from the biological growth cycle, which is uncorrelated to markets generally. As the trees grow they increase the value and the ultimate volume of wood available for sale.

Trees also mature through a number of so-called “life stages” which are suitable for different products, each providing a higher price per ton.

Mercer also says young trees are typically harvested for pulp, more established trees for chip ‘n’ saw, and mature trees for sawtimber.

There is also a growing market in trees with ongoing cashflows such as rubber trees where the latex can be harvested on an ongoing basis while the trees grow.

An attractive element of investment is also that trees can be left “on stump” during a timber price downturn and harvested when prices pick up.

Fox said Mercer is recommending the asset class from a strategic perspective for institutional investors with a 10-year-plus time horizon, describing it as “a beneficial time to enter the asset class”.

“What has been interesting for us has been the expansion of the timber opportunity into a global context and that opportunity is still maturing,” he says.

“You do potentially have risks when you move away from very mature markets like the US but it also creates opportunities as well particularly in areas such as South America and Asia now.”

The investment manager, Timberland Investment Resources LLC estimated this year that total global timber assets amounted to somewhere around the $300 billion mark.

Of this, institutional investors make up about 16 per cent only, meaning strong future demand is expected for quality forestry assets.

In recent times several funds have shown confidence in a sector that is maturing quickly on the back of growing institutional interest.

To date, more than 70 per cent of the timberland investments by institutional investors is located in forests in the US. But that is predicted to change in the coming years.

In a report released this year Timberland Investment Resources economist Chung-Hong Fu looked at global timber assets, breaking them down into established, broad and potential markets.

Established markets with a track record of investment were Australia, Brazil, Canada, Chile, New Zealand, the United States and Uruguay.

Of the non-US markets Brazil was the biggest with timber assets of more than $14.82 billion followed by Australia ($7.02 billion).

The remaining broad timber market – where investment returns are not yet proven – and more established elements of the potential timber market have about $44.5 billion in assets.

Timberland Investment Resources LLC estimates that more than 86 per cent of the global timber market is the United States.

Because housing starts at historic low levels, timber seems cheap, and many institutional funds with a long-term outlook have seen buying opportunities in US timber assets.

However, with soft demand in the US construction industry, and a realigning of demand for timber to emerging markets, particularly China and India, others are seeing that timber production will inevitably shift to emerging markets across the globe.

While housing starts in the United States have almost halved from their peak of 1.6 million units in 2006, in China housing starts were estimated at 10 million units last year.

A major beneficiary of this realignment of timber demand to Asia has been New Zealand foresters, with New Zealand timber exports growing four fold since 2008.

Canadian David Brand is the managing director of New Forests, a timber advisory company that is riding high on the back of landing the management contract for the biggest ever timber investment in Australia.

A joint venture between Alberta Investment Management Company (AIMCO) and the Australia New Zealand Forest Fund announced it would purchase more than $481 million in forest assets in Australia in January this year.

In addition, New Forest also runs a $700 million fund of established timber assets mainly in Australia and New Zealand that has attracted seven institutional investors.

Brand says more than 40 per cent of the world’s timber supply now comes from high yield plantations and to meet growing expected demand, investors will increasingly look to Asia’s attractive timber business models.

“All the emerging markets are areas where you can invest capital in growing trees and make a return but in the US you can buy an existing forest but the return on capital for new plantings would not be sufficient to attract new capital,” Brand says.

In a recently released New Forest five-year outlook for timber investment released in January, Brand says he expected that over the coming decades that the bulk of investment capital would be directed to assets in Latin America, Australia, New Zealand, African and Asian.

With investors in timber looking at 10- to 15-year time horizons, structuring timber portfolios should also look at both diversifying risk across regions and where future growth in the industry would come from, says Brand.

New Forest recommends a general portfolio that has 30-40 per cent of its timber assets in Canada and the US, 25 per cent in Latin America, 15 per cent in Australia and New Zealand and 15 per cent emerging markets such as Asia, Africa and Eastern Europe.

While the regulatory landscape is still unclear, Brand also recommends putting between 5 to 10 per cent of a portfolio in so-called “ecosystem services” that target potential carbon markets or biomass energy opportunities.

Both Fox and Brand say that timber can be part of a hedging strategy for climate change risk, with attractive potential opportunities in construction and as carbon sinks.

But the unknowns in terms of the shape and regulatory framework of any potential future global market carbon market make this a very difficult potential return to quantify.