By Jim Nicol
Director of Investment Strategy
Forest Systems
Since 1984, when institutional first began investing in working forests, the forestland asset class has provided investors with a return that includes both a predictable income stream and consistent value growth through appreciation.
In general, the asset class continued to be viewed as having strong diversification attributes because it is not correlated with the performance of the stock market. It also is negatively correlated with other types of financial assets, including long-term bonds and commercial real estate. Finally, it is considered an excellent capital preservation tool because it is positively correlated with inflation.
All in all, forestland's investment attributes should make it a staple in any portfolio that is being managed for investors who have long-term, value orientations. This includes investment programs managed on behalf of:
Historically, the forestland asset class was the domain of large, tax-exempt institutional investors and high net worth investors capable of committing huge amounts of capital through the private equity market. However, in recent years, individuals have increasingly become active in the market through fund structures and participation in forest REITs.
At present, there are three large, forestland real estate investment trust (forest REITs) trading, Plum Creek Timber, Potlatch and Rayonier, but a number of other private forest REITs also are managed on behalf of institutional and high net worth investors.
Historically, forestland has outperformed both the S&P 500 and many other asset classes in which both individuals and institutions participate.
Total Return Comparison
Forestland vs. Other Asset Classes
Source: Forest Research Group
Investors make money investing in forests in two ways. First, income is generated from the sale of harvested timber; the sale of hunting and recreational leases; royalties generated from oil, gas and mineral extraction activities; and the sale of development rights, sensitive lands and conservation easements. These sources of income account for roughly one-third one-half of a forest investment's annual return. The balance is attributable to appreciation, which is heavily influenced by market conditions and forest management activities, like fertilization and timber thinning and enhancement regimes.
NCREIF Forestland Property Index Disaggregation of Total Return
(1987 - 2005)
Source: National Council of Real Estate Investment Fiduciaries
A working forest that is well managed tends to grow in value through time because it behaves like both a factory and a warehouse. It produces timber on an ongoing basis (like a factory) and increases in value as that timber continues to grow (storing more and more wood fiber as if it were a warehouse). Generally, the more trees a forest has, and the bigger they are, the more valuable the forest is. That is because larger trees can be used to produce higher value products – like furniture, high-grade lumber and fine veneers. This unique characteristic is one reason owning forests is an excellent way to preserve capital. In short, a forest's timber can be cut when market prices are favorable, but when they are not, it can be stored on the stump where it is likely to increase in value through time.
Forestland Relative to the Security Market Line
Source: Forest Research Group
Investing in forestland also is viewed as a highly effective way to reduce portfolio risk because the asset class tends to perform in a counter-cyclical fashion relative to fixed income instruments and commercial real estate and it seemingly has no correlation with the performance of the stock market. In fact, studies have shown that the more forestland that is included in a diversified investment portfolio, the better that portfolio will perform through time, and the lower its risk will be. Because of this, some might describe forestland as an indicator asset with respect to a portfolio's position on the risk-efficient frontier.
Forestland’s Correlation with Financial Assets
through 2005
Source: Forest Research Group
The long-term outlook for forestland investment performance remains strong. There are two fundamental reasons for this.
Forestland is the resource base for one of the largest economic sectors in the world - the global paper and forest products industry. However, despite its importance to the world economy, forestland is among the most under-invested segments of the commercial real estate market globally.
Here in the United States, there are roughly 350 million acres of privately-owned forestland that are managed, at least in part, for timber production. Collectively, these lands are valued at about $350 billion.
U.S. Private Forestland Ownership
Total - 350 million acres worth $350 billion
Private forest owners are normally placed in three categories. The smallest group is large, tax-exempt institutional investors, like pension funds, that engage timberland investment firms to acquire and operate forests on their behalf. Statistics vary on the extent of their holdings, but experts estimate such investors own about $25-$30 billion worth of forests worldwide. The second group is industrial forest owners. They have typically owned and managed land as production resources to support their core paper and wood product manufacturing businesses. In recent years, however, this group has been aggressively divesting of its forest assets to focus on core manufacturing processes and to improve corporate balance sheets in the face of increased global competition. The largest group of forest owners, by far, is small, non-industrial private landowners who tend to own smaller, more fragmented forest parcels. This group is diverse, but is normally thought to include individuals, families, estates and trusts.
One reason so little U.S. forestland has been available for investment through the public markets is that these three types of landowners have traditionally held their lands in private, illiquid vehicles. Furthermore, they have little need or incentive to help expand the universe of forest owners and investors. This has meant that, until just recently, the forest asset class has been mostly off-limits to smaller individual investors who may wish to participate in it through ownership of some type of liquid security. The emergence of forest REITs like Plum Creek, Rayonier and Potlatch are changing this paradigm and introducing the asset class to a broader array of investors of all sizes. Future changes in estate tax laws also could have a significant impact on the forest ownership practices of individuals.
In the early settlement and colonial days, families acquired forests from public agencies at little or no cost. This was meant to provide individuals with an incentive to establish homesteads and to convert forests for farming purposes. However, in the late 1700s and early 1800s, this dynamic began to change. Seafaring merchants from the New England states who had grown wealthy from their shipping and global trading businesses began to acquire vast areas of the Northern Forest from cash-strapped states and the U.S. federal government. These families soon became a major economic presence, particularly in Maine, Vermont, New Hampshire and Massachusetts, where their interests branched out to include timbering and shipbuilding.
As the country entered its period of western expansion, many of these families bought or otherwise acquired additional lands - first in the upper Midwest - and later in Washington, Oregon and California. There, they established communities anchored by saw-milling and shipbuilding. This westward movement, and the orientation to own and exploit forest resources, was the inspiration for the famous American folktale, "Paul Bunyan."
The introduction of the transcontinental railroads in the mid-1800s accelerated the process of forest consolidation in the United States because many of these same families became involved in the planning and financing of the railways. Through their involvement with the Union-Pacific, the Central-Pacific and other such ventures, they acquired even more forestland, as well as cutting rights on public lands, largely in exchange for the risks and costs they had assumed to build the railroads for the public's benefit.
As the country's population moved west and expanded, demand for construction materials followed suit. Those families and companies that owned forests and public land cutting rights were well positioned to further extend their wealth and influence in response to the growing market demand for wood. Eventually, in the wake of the Civil War, moneyed interests followed the railroads south, where they acquired more land and additional commercial influence. The onset of reconstruction, and the shift away from labor-intensive production agriculture, was a catalyst for this southward creep and the reason much of the region's land base has been devoted to timber production during the last century and a half. In fact, many of the vast hardwood forests and pine plantations of today's South were, in pre-Civil War days, farms and plantations devoted to the cultivation of cotton, peanuts and other row crops.
The railroad, timber and mining interests of the country's leading capitalist families of the 1800s were the foundation upon which today's U.S. paper and forest products industry was built. In fact, many of the most prominent names in that business sector, including Weyerhaeuser, Georgia -Pacific, Plum Creek, Longview Fiber, Simpson, Boise, Potlatch and International Paper, can trace their roots directly to the pioneering, entrepreneurial families of the 1800s.
Throughout the last century, the nation's private forests were owned almost exclusively by small, non-industrial landowners, especially wealthy families, and by large industrial concerns. The industrial owners bought and managed forestland primarily as production resources to keep their sawmills and paper manufacturing facilities stocked with fiber. However, starting in the 1930s and 1940s, some of these companies began to expose their forests to scrutiny of the banking and insurance worlds – using them to collateralize loans. In time, this would open the door to the forestland asset class for the institutional investment community.
Throughout much of the 1900s, insurance companies and regional banks became leading lenders to the paper and forest products industry. By the middle of the century, many of these institutions had become the reluctant owners of vast forestland portfolios - portfolios that had been created by the need to foreclose on non-performing loans. In most cases, these banks and insurers simply hired foresters to manage the properties as income-producing ventures – growing and selling wood to the paper and forest products industry until it was possible and prudent to sell the lands on the open market.
In the late 1970s, analysts associated with these financial institutions, including a few who had been trained as foresters, began to closely study the investment characteristics of forestland. By the early 1980s, they had concluded that, despite its lack of a quantifiable track record, forestland had the financial attributes to be an excellent tool for funding the future obligations of public and private pension funds.
Forestland Relative to the Capital Market Line
Source: Forest Research Group
These conclusions were well timed given prevailing market conditions. The growth and volatility of the stock market during this period meant that many large pension funds had excess cash to invest. They also had a pressing need to manage risk because of the passage of ERISA – the Employee Retirement Income Security Act of 1973. ERISA mandated that private/corporate pension funds had a fiduciary obligation to their pensioners to diversify and maximize the investment returns of their pension plans. By the early 1980s, pressure to comply with ERISA's requirements was causing many pension plans to diversify by investing in new and alternative asset classes, including real estate, oil and gas, venture capital and leveraged buyouts.
In addition to these conditions in the investment world, industrial landowners, including many of the largest paper and forest products companies in the United States, had incentives to sell non-strategic forest holdings. Most were facing pressure to boost sagging shareholder returns, while others needed to generate cash to fund new, federally-mandated water and air pollution abatement requirements arising from the implementation of the Clean Air and Water acts.
The combination of these factors – available cash and a mindset toward taking exposure within new and emerging asset classes among institutional investors – and the need to raise capital among forest industry concerns – set the stage for tax-exempt investors to become influential players in the private forest ownership arena – a transition that continues today with the accelerated consolidation of the global forest and paper industries.
By the mid-1980s, John Hancock Financial Services, Equitable Insurance, Wachovia Bank & Trust and a few smaller companies, had begun to canvas the institutional investment community to raise private equity capital for the acquisition of working forests and the construction of forest portfolios. Each organization achieved a measure of success in its own right. Some established notoriety for expertise in one particular region, while others became leaders in offshore investing. In short order, John Hancock's subsidiary, the Hancock Timber Resource Group, a strategic alliance between Hancock's investment operation and three, regional forest management firms – Resource Management Service in the South; The Campbell Group in the Pacific Northwest; Wagner Forest Management in the Northeast – emerged as the market leader. By 1987, Hancock had attracted substantial commitments from several large pension funds, including the State Teachers Retirement System of Ohio; the California Public Employees Retirement System; and, the GTE Pension Fund.
Relative Performance
Indexed Price Series (1991-2005)
Source: NCREIF, MS Investor, FS Research
Over time, the Hancock Timber Resource Group strategic alliance built nationally diversified forestland portfolios for these and other tax-exempt investors. By 1997, the company was the seventh largest manager of privately-owned, working forests in North America. It had more than 40 clients and oversaw nearly three million acres worth about $3 billion. It also had generated cumulative real returns of nearly 20 percent. This strong performance, coupled with the healthy returns generated by peer companies, attracted attention within the broader investment community, which began to track the forestland asset class through the National Council of Real Estate Investment Fiduciaries Timberland Property Index (NCREIF Timberland Index).
Total Return Comparison
Forestland vs. Other Asset Classes
Today, interest in forestland investment remains strong among institutional investors. The institutional market currently stands at between $23 billion and $30 billion in total invested assets.
Looking to the future, institutions are likely to continue accessing forestland investment opportunities through the private equity market, but demand for pure-play, publicly-traded forest investment vehicles also is likely to fuel strong growth within the forest REIT sector. In addition, increased interest in off-shore timberland investing is expected as is the emergence of sector specific investment opportunities that are designed to capitalize on new opportunities in areas like eco-systems services and carbon sequestration.