Investing in timberland

Nikki Matthews

Senior Consultant

The bottom line:

Timberland investment can add diversification to a portfolio and generate attractive returns. It can also provide positive ESG characteristics when done well.

Money doesn’t grow on trees - or does it?

Timberland investment, i.e. buying and operating commercial forestry (this could be an established forest or involve planting new trees), continues to expand and is currently estimated to be a market worth between $200-$300bn. Key forestry regions include North America, Australia, New Zealand and parts of Latin America and Europe.

What are the key characteristics?

Timber offers attractive risk-adjusted returns, low volatility and low correlations with traditional asset classes, inflation linkage and positive ESG characteristics. Timber has the additional benefit of providing an income yield. Timber is an illiquid asset (most funds have lock in periods of around 7-12 years), and is therefore appropriate for investors that have long-term investment horizons, with the potential to offer attractive returns to compensate for the lack of liquidity.

Timber’s return drivers

Tree growth rates are typically predictable. This provides diversification benefits, as trees are unaware of market downturns and grow independent of trends in financial markets – this growth is expected to account for the majority of total return.

Over the long term, timber prices are expected to increase and therefore offer a hedge against inflation.

Timber is mostly used in construction/housing, furniture, paper and packaging - all relatively basic consumption needs. It is also used as biomass. Demand for these goods is predicted to increase due to global population and GDP growth as well as increasing urbanisation in emerging economies.

Whilst recessions may have a negative impact on timber prices, this can be mitigated by delaying harvesting.

Land value - as a finite resource land value is expected to increase over time, land can also be repurposed for other uses should timberland fall in value.

Most funds offer total returns between 6-10% net of fees and charge around 1% pa.

10 year risk/return chart to 30 September 2022

Source: Bloomberg

NCREIF Timber index correlations

Source: National Council of Real Estate Investment Fiduciaries (NCREIF)

Risk

Losses from natural hazards such as fire and insect infestation have historically had a very minor (<1%) impact on returns. Climate change has perhaps recently increased fire risk in certain regions, however, it is worth noting that good forestry management helps to reduce fire risk significantly. Some funds have insurance policies in place against fire, although this is sometimes not cost-effective.

Timberland investing in developing countries may offer potential higher returns however it comes with greater political and regulatory risk. In some cases, it is possible to insure against political risk.

We prefer global funds, as this approach offers additional diversification which mitigates the impact of any particular area being negatively affected by the risks described. We also favour funds that allocate to countries with strong governance and institutions.

How to invest in timber

The main options are:

Invest via a pooled fund
Own forests directly
Invest in timber REITS (companies that own timberland or timber products such as paper) – returns and correlations are closer to equity markets

ESG

Trees remove carbon dioxide from the atmosphere, (carbon sequestration) and so there are significant positive environmental benefits in allocating to timberland when done correctly. Timber products (such as a wooden table) also lock up carbon (assuming there is no fire). With the UK’s ambitious plans to achieve net zero by 2050, this should provide additional demand for timberland (and support pricing) longer term.

Careful consideration must be given to protecting biodiversity and ecosystems when investing in timber. Good planting and harvesting techniques are also important; overharvesting for example could lead to deforestation and poor techniques could impact soil quality.

Furthermore, land rights and relationships with local communities should be managed appropriately by timber managers.

There are certification standards such as the Forest Stewardship Council (FSC) and the Programme for the Endorsement of Forest Certification (PEFC) that are dedicated to promoting sustainable forestry management through third-party certification to support long-term forestry growth – typically, institutional investors purchase forestry that have at least one of these certifications, further encouraging forestry management teams to comply with the certification standards.

Carbon credits

Some funds issue carbon credits although this is a relatively recent innovation. Funds will generate additional returns from selling the carbon credits, thereby providing additional income to investors (without the need to wait until trees are harvested). In some instances, the credits can be distributed to investors to use in offsetting their own carbon emissions or for holding as an investment. Caution must be exercised should an investor decide to own the credits as regulation and pricing in carbon markets are fast evolving.

Conclusion

Timberland has proved itself to be an asset class that can provide powerful diversification benefits due to its historically low correlation to traditional asset classes while also having positive ESG characteristics when done well – making it an attractive asset class for those investors with long enough time horizons! We will be producing a white paper expanding on the characteristics of the asset class.