The Perspective of James Nicol,
Director of Investment Strategy
Forest Systems
The comments below were excerpted from a recent interview in which timberland investment market dynamics were discussed.
Q: You were recently quoted in the Wall Street Journal as suggesting that timberland may be over-priced and that a bubble may be forming. Were you suggesting the market is over-heated?A: Nicol: We think the dial has moved past “warm” and is closing in on “hot.” That suggests to us that anyone who is thinking about getting into the asset class should be cautious about how, when and where.
A: Nicol: There is just too much cash flowing into the asset class from too many sources relative to the supply of investment grade forestland. There are several factors driving this interest, including declining returns across all investment markets, an exploding interest in real assets, and the fact that there is a swarm of new firms out there promoting themselves as forest investment experts.
A: Nicol: I don't think so. It appears that a lot of the newer investors don't have a good handle on what has happened in the market over the last two decades, or even during the last couple of years. Many TIMOs (timberland investment management organizations) are promoting the asset class by pointing to its historical performance as is reflected by the NCREIF Timberland Property Index. Unfortunately, the index offers a very narrow and incomplete picture of the asset class' true risk and return profile relative to prevailing market conditions. Because of that, we think it is a mistake for investors to assume their future performance will approximate the big numbers they see in the NCREIF index. This is a long-term asset class and the market is just very different today. There are a lot of new variables that need to be considered.
A: Nicol: That's a complicated discussion, but it really starts with what's happening on the sell-side. When investors first started buying timberland 15 or 20 years ago, forest products companies only were selling their non-strategic forest assets. They were doing this to raise capital – primarily so they could manage quarterly and year-end earnings and fund equipment purchases that were necessary to comply with federally mandated clean water and air requirements. Some also were interested in funding capacity expansion. During this period, forest products companies typically looked at timberland as a production asset, so when they sold it, in many cases, very little financial analysis was done. They simply assessed whether they absolutely needed a piece of land to meet the fiber needs of their mills, and if they didn't, they'd sell it to whoever was willing to give them what they felt was a reasonable price. At that time, there were only five or six TIMOs that had begun to really establish themselves as buyers of such assets. They had capital to invest, they weren't competitors in that they didn't manufacture paper and wood products, and they were willing to work closely with industry sellers on deal structuring. In short, they were the perfect buyers from the industry's perspective. As a result, they often were able to negotiate very strong acquisition pricing on behalf of their clients. Through time, this ability to buy right came to be reflected in the NCREIF Timberland Property Index.
A: Nicol: Everything. The dynamic I just described doesn't exist anymore. Today there are at least 23 TIMOs competing against each other for capital allocations and acquisition opportunities and all of them face the same pressure to get assets under management so they can charge fees and make money. In some ways, they are generating demand for the asset class by virtue of their numbers. There are so many people out there promoting timberland it has created a buzz in financial markets and in the press. This is making it much more difficult to source and circle deals because there are just so many more buyers willing to pay any price to get in. Furthermore, forest products companies aren't just selling non-strategic lands any more. They are selling timberland to get out of the land ownership arena all together, and given the magnitude of the transactions they are initiating, they have become much more sophisticated about the process. In the past, deals like the ones I just described were negotiated directly between buyers and sellers as one-off transactions. Today, forest products companies are retaining investment bankers to run highly competitive timberland auctions that pit TIMO bidders and REITs against each other. Because of these factors, it just isn't as easy to generate premium returns. An additional implication of the capital glut is that historical wholesale purchase discounts have largely vanished. In the old days, you would generally get better pricing the bigger the deal. Today, TIMOs and REITs are buying hundreds of thousands of acres, and even millions, for the same per acre value you'd pay to buy less than a thousand acres. This new reality isn't reflected in what you see in the NCREIF Timberland Property Index. Those numbers were largely generated under a very different market paradigm.
A: Nicol: We think some TIMOs are either making aggressive assumptions in their future timber price and volume projections, or they're loading up their acquisition models with high valuations for HBU sales (higher and better use – land that will not be used to grow trees, but rather will be sold for development purposes). In some cases, they are probably doing both. This means that with any particular acquisition, you could be looking at a best-case scenario of having razor thin risk coverage for the fundamental uncertainties attributable to forestland investments. You also could be looking at a riskier investment scenario than you anticipated because a bigger portion of the purchase price is tied to realizing the investment's speculative HBU potential. The real question to us is whether the managers who are doing these things are telling their clients to adjust their risk and return expectations correspondingly because the firms are essentially investing in an asset class hybrid on their behalf.
A: Nicol: We believe the flush of capital is a by-product of the explosive growth in liquidity that we are seeing across all capital markets. In the face of lowered expectations for equity market returns, and what appears to be a diminished sensitivity to risk, investors need to put their money to work somewhere. This makes them very receptive to an asset class that has timberland's return history and that offers diversification and inflation hedging attributes.
A: Nicol: It is hard to know because the investor base is becoming more and more fluid and diverse. However, by some estimates, there is $10 billion in equity waiting on the sidelines – and that is before one begins to factor in the private equity pools and hedge funds. However, we would argue that some of this is “contingent capital” – money that only will be brought to bear for funding specific acquisitions under very specific criteria. It isn't necessarily capital that has been committed to a TIMO-sponsored separate account, or to one of the several new commingled, blind funds that are being aggressively marketed at present.
A: Because that's what TIMOs want to sell. It is also the kind of product that can provide smaller investors with access to the asset class. You can't do a $5 million separate account and it is the smaller investors who are increasingly clamoring to gain access to the asset class. It used to be that TIMOs preferred to do business with larger, separate account investors, like jumbo pension funds and endowments, but that isn't always the case any more. The commingled fund model gives TIMOs more control over their business. If you're marketing a large, blind pool to a host of smaller investors, you have a revenue stream during the acquisition-sourcing period because you're collecting management fees on money that hasn't even been invested. That's a nice deal. On top of that, when you have a group of smaller clients tied up in a ten-year fund, you don't have to worry about them suddenly deciding to sell out and move on like you do with clients who are investing through dedicated separate accounts. In short, the commingled fund model allows TIMOs to have a smooth and controllable revenue stream that can remain predictably constant for as much as ten years. The question commingled fund investors should ask themselves, however, is: “What are my options for getting out if market conditions change dramatically for the worse?” An additional factor contributing to the growing popularity of the commingled fund vehicle may be TIMOs increasing use of external intermediaries, such as investment banks, for fundraising. With all of the hype about timber, these kinds of financial intermediaries are hungry to provide their network of clients with access to the asset class and being affiliated with a manager that is offering a commingled fund allows them to sell a pre-packaged product.
A: Nicol: Good question. Low interests rates during the last three years have provided investors with access to deep pools of relatively inexpensive debt, which is one reason the size of deals has increased exponentially since the late 1990s – when a large transaction was $50 million to $100 million. Today, deals that are over $200 million in size are routinely being done, and several billion-dollar transactions have been completed in the past few years. Additionally, banks are more willing to underwrite higher debt levels; a 75 percent loan to value ratio is not unheard of in this market.
A: Nicol: Potentially, yes. Particularly those who are only recently gaining exposure to the asset class at the higher per acre values and lower indicated acquisition cap rates we've been seeing during the last couple of years.
A: Nicol: Again, I don't believe they are. The NCREIF Timberland Property Index is the only proxy for private timberland returns and it is far from a clean benchmark. If you look at it on a static basis, without considering what's currently going on in the market, it appears the asset class has generated a 15.3 percent total return since its inception in 1987 – and the income component of that return has averaged close to an impressive 7.0 percent. However, if you look at the index's recent history, you'll see that total returns in some years have dropped into the 4.0-to-8.0 percent-range. Even the more modest returns reported over the past several years for the composite universe of properties in the index may well overstate the potential performance on many of the acquisitions closed in the past 24 months.
A: Nicol: Obviously, the reasons are complex, but one of the major factors was the listing of the “spotted owl” as an endangered species in the Pacific Northwest and Northern California in the late 1980s. When the U.S. government listed the owl, public lands (those owned and managed by the U.S. Forest Service and the Department of the Interior's Bureau of Land Management) came out of timber production, which created a significant wood fiber supply crunch. Consequently, private timberland values in that region and around the country shot through the roof and stayed high for several years because the fiber growing in privately-owned working forests automatically became a lot more valuable. That value bump has gradually worked itself through the system and we're reverting back to a prospective equity return scenario that is more in line with the investment fundamentals of the asset class.
A: Nicol: Again, not in light of the purchase prices we're seeing. Timberland investment fundamentals just aren't likely to generate sustainable real equity returns at that level in the near future for investors without their taking on additional land speculation risk. Unfortunately, it appears that the 8.0-to-12.0-percent expected rate of return is still how the asset class is being sold in some circles. Just to emphasize the point I made earlier: We haven't seen a deal done in the last four years that could legitimately generate a timber products oriented, real equity return above 6.5 percent – and we have looked at virtually every major transaction that has been done in North America. Now some of the these deals may well exceed 7.0 percent, but they most likely will get there on the strength of the manager's ability to successfully play in the more speculative real estate conversion and development business, which, as I've said, is an investment arena that typically is much more risky than timberland investing and that historically has commanded much higher rates of return as a result.
A: Nicol: We believe that asset allocation – and specifically the pressing need to get capital invested in a diversified mix of assets – is a major factor in the decisions of many investors to pursue exposure to the timberland asset class. They need to get the money out and they see that timberland is a long-term, hard asset with solid diversification and inflation hedging attributes. It also has a history of excellent performance. I think many investors make the decision to move forward, or to maintain their positions, on that basis.
A: Nicol: Fundamentally, no. However, you need to realistically assess the current market pricing environment and weigh the potential benefits against the fact that timberland values are at very high levels and price to cash flow multiples are at all time highs. If you already have a large portfolio of well-diversified assets that was purchased more than four-or-five years ago, and you plan to hold it for a long time, you should be fine regardless of how the market behaves in the coming months and years. Clearly, you may lose an opportunity to sell into a brisk and highly valued market, but you'll still have the benefit of timberland's diversification and inflation hedging potential. However, if you're just getting into timberland, you really need to recognize the changing market dynamics we've been discussing here and assess your risk tolerance. That's because if your advisor pays inflated prices up front for your acquisitions, it is going to be extraordinarily difficult to generate the 6.0-to-9.0 percent real-return that you should be targeting over an extended holding period.
A: Nicol: I could see a scenario where interest rates rise and bond yields increase, drawing capital away from the asset class to more liquid, less risky investments like treasuries. This would also undermine the ready availability of low cost debt, which has been one of the contributors to the run-up in forestland transaction prices. Both changes would diminish the excess demand that is pushing up timberland values as well as mortgage rates. In all likelihood, a material increase in mortgage rates also would have a significant negative impact on housing starts, triggering a reduction in demand for lumber, which would drive down sawtimber stumpage prices.
A: Nicol: Just that timberland is a great asset class that has a place in most portfolios. I would only suggest that it is very important, especially right now, to keep your eyes open and to understand how the market is evolving before you invest. The risk and return assumptions you may be making on the front end – assumptions that might be influenced by data like the NCREIF Timberland Property Index – may not hold up in the long run. We have never had a scenario in the timberland investment world where there has been so much excess capital available to fund acquisitions. We just need to be aware of the fact that such circumstances can create real challenges if those doing the investing have greater financial incentives to make and hold investments than they do to make and hold good investments. All one has to do is look at the factors that led to the real estate crunch in the early 1990s to see what can happen under these circumstances. There are a lot of parallels between what happened there and what we're seeing in our market today.