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Timberland Investments Can Diversify Portfolio

Ever since the stock market’s downturn early this decade, many investors have been searching for alternative sources of return and stability. Are timberlands a good place to look?

Timber as an investable asset class has sprouted on many investment professionals’ radar screens recently. Indeed, timber has desirable traits because it possesses an expected return in line with that of the public equity markets, but tends not to move in step with the stock market, thus smoothing out the returns of an investment portfolio.

Investors with substantial assets can invest in timber through limited partnerships or other commingled funds, which can provide pure, diversified exposure. Smaller investors must use less direct, but adequate, alternatives.

How Timber Investments Work

Funds that invest in timber achieve their returns by buying tracts of timberland in either natural-growth forests or plantations, then harvesting the timber or selling the property for a gain. The major attraction of timber investments is their biological growth component, known as in-growth. In time, trees are going to grow, regardless of market fluctuations or the price for lumber. This built-in appreciation is bolstered by the fact that large trees can be sold as sawtimber to mills, where they are processed into lumber and plywood. Sawtimber fetches a substantially higher price per cubic meter compared with smaller-diameter trees, which are usually sold to pulp and paper mills.

The rate of in-growth varies with the type of tree and the region in which it grows. Hardwood trees such as oak and maple in the eastern United States might grow at 4 percent annually, while softwoods such as pine and fir in the Pacific Northwest may grow at 9 percent annually.

Timber’s consistent biological appreciation gives it a negative correlation to other asset classes. Timber funds in particular, which employ professional forest managers, can use strategies to minimize the effect of volatility in the price of lumber. Lumber prices depend on the housing market, which in turn depends on the health of the economy. When prices are low, managers can simply hold on to the trees and let them grow. When prices are high, managers can capitalize by harvesting more. Professional managers also can add value by seeking out timber properties that are undervalued.

Although timber is an attractive asset class, finding a quality vehicle through which to invest can challenge investors who don’t have substantial assets or who are not willing to allocate large portions of their portfolios to timber. Only a handful of timber investment management companies offer funds, and their minimums are often steep at $250,000 to $1 million or more. However, clients of financial advisors may be able to access timber funds for a lower minimum if the management company is willing to aggregate the advisor’s clients’ commitments to satisfy the larger minimum.

A more attractive option for some investors may be to invest in a real estate investment trust (REIT) that owns and manages timber properties such as Plum Creek Timber Company (NYSE: PCL). Plum Creek is one of the largest land and timber owners in the nation, with 8 million acres over every significant timber region of the country. According to its Web site, Plum Creek employs professional foresters and support personnel who enhance and manage the company's forestlands for maximum timber growth and financial returns.

Timber As A Diversifier

The degree to which two assets move together is known as the correlation coefficient, and is based on a scale of –1.0 to 1.0. A correlation of 1.0, or perfect correlation, means that two assets move exactly together. Based on information from the John Hancock Timber Index and the National Council of Real Estate Investment Fiduciaries (NCREIF) Timberland Property Index, timberland returns have a negative correlation with the S&P 500 Index of -0.17. The research also shows that timber is negatively correlated with U.S. small-cap equities, international equities and long-term corporate bonds, and has no correlation with Treasury bills.

Timber is a hard asset, a tangible commodity that tends to keep up with the rate of inflation. This makes it a hedge against investments in the public equity markets. Inflation tends to be bad for both equities and fixed-income investments, but can be good for hard assets such as timber. Based on information from the John Hancock Timber Index and the NCREIF Timberland Property Index, timberland returns have a positive correlation with inflation of 0.39. Data from Ibbotson Associates Inc. for the same time period used by NCREIF, 1960-2002, show that the S&P 500 Index has a negative correlation of -0.14 with inflation.

John Hancock and NCREIF calculate that a regionally diversified timber portfolio has an annual expected rate of return of about 13 percent. This compares with U.S. large-caps’ annual expected return of 12 percent, international equities’ of 13 percent and U.S. small-cap equities’ of 18 percent, according to Ibbotson Associates Inc. To create an efficiently diversified portfolio, one seeks to add assets that have low correlations with each other and positive expected returns. Modern portfolio theory would indicate that a portfolio with an allocation to timberland investments receives the benefits of diversification, namely higher expected return, lower risk, or both.

But is there more to timberland investing than the statistics show? There must be, or many more high-net-worth and institutional investors would have timber in their portfolios. A major risk factor with timberland investments is illiquidity. Most timber investment management companies run their funds as limited partnerships, which typically have terms of 10 years or more during which the investor has no power to demand a return of capital. This illiquidity risk definitely detracts from investing a large portion of a portfolio in timber. However, investors with sufficient capital often tolerate illiquidity to invest in private equity, venture capital and hedge fund partnerships. Yet they continue to ignore timber.

Another risk potential investors quickly identify is that of the destruction of the timberland properties through fire, disease, pests and other natural disasters. While an obvious risk, these perils are immaterial for most diversified timber funds, as the risks average less than half a percent a year and are usually netted against a tract’s estimate of biological growth.

When evaluating a timber fund, it is important to consider whether it is diversified both geographically and by type of tree. Otherwise, the risk factors cited above could have a more damaging effect than average. Insects, for example, can substantially damage key commercial species over wide areas. An investor should also look at the fee structure before investing in a timber fund, as the manager of most limited partnerships will take a percentage of the profits in addition to an annual management fee.

Timber is an asset class not often included in the traditional mix of a diversified portfolio. With its attractive risk/return characteristics and negative correlation to stocks, it may be appropriate to consider an allocation to timber if you can find an appropriate vehicle through which to invest.

Vice President Eric Meeermann, who is based in our Stamford, Connecticut office, is the author of Chapter 8, “Buying A Home,” in our firm’s most recent book, The High Achiever’s Guide To Wealth. He was also among the authors of the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.