Down to the woods

Although everyone is talking about climate change and discussing investment possibilities from clean technology to carbon funds, few investors have seen the wood for the trees and turned to timberland as part of their SRI or sustainability portfolio.

According to a report published by Watson Wyatt last year, timberland is a subset of forestland, and in the US it is seen as being at least one acre with a minimum 10% tree cover. In addition, timberlands are defined as those forested areas that are capable of producing in excess of 20 cubic feet per acre per year of industrial wood crops under natural conditions.

But most institutional investors do not directly invest in timberland by buying land, according to Otto Reventlow, managing director of forest investment adviser, the International Woodland Company (IWC). Instead, they typically go through funds, he says.

They can either invest via the private market through segregated accounts, pooled vehicles called timberland investment management organisations (TIMOs) or via listed entities in timberland real estate investment trusts (REITs).

According to the Watson Wyatt report, TIMOs are usually highly illiquid closed-ended limited
partnership vehicles requiring a large account minimum, while REITs are more liquid and allow investment of smaller amounts but may negatively impact on the illiquidity premium associated with the asset class.

Reventlow says the main driver behind investments in forestry - and what attracts institutional investors to this asset class - is the stable, long-term return, historically of around a nominal 10-12% annually.

He says another advantage is the low correlation with other asset classes. Reventlow points out that based on statistics, negative returns from forest investments are rare, because if, for example, the paper market, looks bad, trees will not be felled until markets regain value, with older trees generally achieving a much higher price.

New Zealand-based forestry investment manager Greenplan puts the best rate of return at harvesting after 22-25 years of growth.

In 2006 PME, the Dutch industry-wide pension fund for metalworkers that has assets under management of more than €20bn, invested €440m, or around 2.2% of its portfolio, in two forestry projects.

Spokesman Bram van Els explains that PME was attracted by the long-term returns of woodland investments of 6-10% - currently around 7% - which are lower than equities but higher than bonds.

“Timberland investments are less affected by inflation than other asset classes, so they are a nice compensation investment for inflation due to the rising value of the land we own on top of the woods,” he says. “And because forestry has very little correlation with traditional asset classes such as fixed income, equities or commodities, it reduces the risk of the total portfolio; in short it is a good diversification asset class.”

Low correlation and portfolio diversification also spurred Sweden’s AP3, which is a buffer fund of the national pension system with assets under management of around SEK212.2bn (€23.2bn), to commit SEK1bn, or 0.5% of its portfolio, to forestry. Some SEK900m was invested by the end of 2006, primarily in international timberland funds.

“Our expectation is that timberland investments will generate attractive long-term stable risk adjusted returns,” says AP3 communications manager Christina Kusoffsky Hillesöy. “Studies have shown that a well-diversified timber portfolio will deliver a compound annual real return before fees of 5-7%.”

According to the Watson Wyatt report, return streams are split between income - the sale of wood from a plantation, rental income and recreational leases - and capital gains - the biological growth of trees as timber and land value - with income accounting for around one third and capital gains accounting for around two thirds of total returns.

But Reventlow argues that from a portfolio point of view, the low correlation benefits stem from the wood price, which can be influenced by choosing when to harvest.

“There are two ways of getting a return,” says Van Els. “First from the wood sold to the paper and construction industry as well as the hardwood - as opposed to softwood - required for furniture and luxury projects. And second from the land because if we sell after 15 or 20 years the land will be valued much higher.”

But timberland investments also have their downside. Among these, according to Watson Wyatt, are the large amount of governance required, the high concentration of the asset class in three US regions despite some large plantations and forestry projects in Scandinavia and the rest of Europe, a lack of liquidity, a limited number of available asset managers and a reasonably high investment minimum.

“We looked at different regions but investing in the US appeared safer than investing in developing countries because of the smaller geo-political risk involved,” explains Van Els. “And because of our size the projects needed to be quite large too and these are difficult to find. Fortunately for us, the US producer International Paper wanted to focus more on its core business and started selling its forests. And these parcels were big enough for us.”

PME has invested in nine US states: Texas, Louisiana, Mississippi, Alabama, Florida, South Carolina, North Carolina and Arkansas in the southeast of the US and Michigan in the north.

In addition to investments in North America AP3 has invested in forestry funds in South America, Oceania and in Swedish forest owner Bergvik Skog. Hillesöy says that AP3 has no fixed minimum ticket but admits that forestry investments are not worthwhile if they are too small relative to the overall portfolio.

Reventlow believes that the best areas for forestry investments are currently the US and South America. “The problem in Europe is that the returns have been poor due to smaller-scale investments and because historically, higher and immediate value from shooting rights, for example, has played a bigger role,” he says.

“On top of that, it is difficult to get large-scale investments because European forests are mainly held by private, small-scale owners.” He pegs the minimum amount of capital for an institutional investor participating in a fund at around $5m.

Pension funds often include their forestry investments in their SRI or sustainability portfolio. AP3 works with an external adviser with an SRI-compliance programme and forestry forms part of its due diligence process. And Reventlow says a few certificates exist, notably the Forest Stewardship Council (FSC) and pan-European forest certificate (PEFC).

Van Els says: “We negotiated a shift to a more sustainable management of the forests with the project managers on the ground in order to be able to include this investment in our sustainable portfolio. We agreed that the Michigan forest should apply for an FSC certificate within three years because it is a natural forest. The southern US plantations will take more time.”

There are other risks to forestry, including external negative impacts on biological growth, product and land prices. They might be caused by falling demand due to product substitution or increased supply due to governments selling their forests, for example, as well as physical risks such as fire, weather, insects, disease, animal damage and theft.

Reventlow adds that the biggest risk probably lies with investments in an area that lacks development of infrastructure and industry.

However, according to Watson Wyatt, the extent of physical risk has diminished over time on the back of improved technology.

PME has reduced the physical risks by scattering its forestry projects through various regions in nine US states, limiting the possibility of, for example, a hurricane or disease destroying several projects at once.

“For us it’s a very limited risk because it is a bigger project with a total of around 3,500 square kilometres,” says van Els. “But it presents a big risk to smaller or consumer investors in forestry who only possess a small amount of trees.”

He adds: “Another risk arising from forestry is the price of wood and paper. Because part of the wood is meant for construction there is a certain correlation between the housing market and the price of wood. But such economic risks exist in all asset classes. And we think the risk is actually smaller compared with other asset classes. The good thing about wood is that it keeps growing.”