Over the course of the last six years, the Dow has gone crazy, rising from around 2,500 to where it now stands at more than 10,000. Yet along with this growth has come uncertainty about where an advisor can place clients’ money without fear of overpaying for an asset. For instance, notwithstanding any further erosion in corporate profits, the price/earnings ratio of the S&P 500 is 24, while its historical average from 1926 to the present is only 14.
For the past several years, Jeremy Grantham, investment strategist for the Boston-based money management firm Grantham, Mayo, Van Oterloo & Company (GMO), has been making just this point at various trade shows. Thirty-dollar stocks like Intel, he points out, are only set to earn 50 cents this year–and only marginally more in 2002. So what’s an advisor to do? Grantham suggests institutional investment in timberland.
Initially this might sound like a harebrained scheme. Why would anyone want to get involved in such an unknown asset class? Who wants to invest in trees? But timberland is worth a second look. Historical studies show that timberland has actually had a higher return than U.S. equities over the last 40 years–between 9% and 15% a year–while maintaining a very attractive dividend structure and much less volatility. To top it off, the asset class has a built-in natural advantage that allows it to continue to deliver solid returns even when the overall economy turns sour. So grab that plaid flannel shirt, pick up your saw, and start learning about this exciting asset class.
Investing in timberland is not as easy as just buying up tracts of land, cutting down the trees, and sending them off to market. This is the fundamental premise behind the asset class, but describing the intricacies of the equation that will at last determine an investor’s final return can be overwhelming. Understanding the market conditions that affect timberland is also no picnic. For instance, you may associate timberland with a sort of rustic, provincial persona, but the people involved are actually employing all manner of high technology to achieve the best possible return.
To start with the basics, after opening the funds and raising the necessary capital, timber fund managers buy tracts of timberland throughout the U.S. and abroad. It may surprise you to discover that a large percentage of our nation–468 million acres out of 2.25 billion–consists of timberland. Managers will scour the country in search of good deals and buy a number of tracts, often in a variety of regions.
The return on the investment is at least partly affected by the price of timber, but while the price may fall in one place, it will remain steady in another. “We try to get some geographic diversity to spread out risk,” says Cort Washburn, 42, director of economic research and investment strategy for John Hancock Renewable Resource Group, which manages $2.7 billion and three million acres.
Once the land is purchased, the main thing to do is wait, and wait, and wait. About 60% to 70% of the return in timberland is made through the actual growth of the trees. “You have to understand that a tree that is one size will bring a certain price at market while a much larger one will be worth a great deal more,” says Peter Mertz, 50, managing director for UBS Timber Investors, which has $1.5 billion under management. “So really you have to just wait for the trees to grow.” Deriving returns from tree growth sounds fairly safe, but there is a drawback: It takes a long time.
So most timberland funds have a 10- to 15-year holding period before they can start to sell off the assets and return principal to investors.
The Liquidity Issue
But if all that is required is to simply wait for the trees to grow, why would anyone agree to sell timberland in the first place? “In addition to the holding period, you have illiquidity,” says Mark Seaman, 49, whose Wachovia Timber Investors manages some $1.2 billion. Indeed, once invested in a fund, there really isn’t any way to get out. Why? Timberland funds (run by TIMOs, timberland investment management organizations) are set up like closed-end mutual funds whose shares cannot be redeemed for cash. As with closed-end mutual funds, you can sell your shares, but the problem is that no one has ever heard of an instance where a buyer has been found. “It just doesn’t happen,” says Seaman.
The reasons for this are fairly obvious. For one, TIMOs are able to buy timberland at a relative discount per acre because they are buying such enormous tracts. According to a 1999 John Hancock research note, fully 100 basis points in annual returns can be realized simply by buying larger pieces of timberland and then selling them off in smaller packages. “If we can do this, why would anyone want to miss out on that later markup?” asks Hancock’s Washburn.
Furthermore, in most instances an investor also must tie up a very large piece of capital. Historically, investment minimums for TIMOs have been in the neighborhood of $20 million for a separate account or between $2.5 and $5 million for a commingled fund. For the most part, the reason for this lies in the origins of the industry as a whole. TIMOs didn’t really exist until the mid-1980s, when pension fund managers began to feel the full brunt of the passage of the Employee Retirement Insurance Act of 1974, which established new and more prudent rules for the investment of pension funds. “Managers suddenly were very interested in alternative assets that would even out the risks posed by equities,” says Washburn. Conveniently, at the same time, many of the major forest product companies like International Paper were looking to liquidate their timberland to realize the appreciation the properties had experienced. “This created a dilemma, though,” adds Washburn. “The funds wanted to buy, but they couldn’t have their chief customers manage the land. There needed to be a middleman.”
Into this void stepped the insurance and banking institutions that had for years financed the purchase of timberland for forest product companies. John Hancock Insurance and First Atlanta Bank–which was later acquired by Wachovia–both set up TIMOs to manage timberland for the funds. “It took a few years to raise the money and actually purchase the properties, but the first funds were running by the mid-1980s,” Washburn says. “Really only now are individual investors expressing interest.”