Timberland Investments: A Portfolio Perspective

"Timberland Investments" is more interesting than useful. Written in 1992 before timberland investing had become as mainstream as it is today among pension funds and endowments, Zinkhan's book offers a perspective from an interesting point in time. However, the landscape has become significantly more crowded and the world more globalized. People are exporting logs from all over the US to China these days and there is ferocious competition among TIMOs and REITs. Overall, the book is clear although severely dry. There are some interesting stats and a few practical pointers. But I wouldn't recommend this book to anyone who doesn't do this for a living!

My highlights below.

Foreword

To my knowledge, this is the first book that expresses forestry terminology in terms meaningful to financial investors; conversely, it translates investment concepts into silvicultural or management terms meaningful to the professional forester.

1 - Introduction

Nonindustrial private forest landowners (NIPFs) control approximately 57% of the commercial forest lands in the United States. Forest industry and government own 15% and 27%, respectively.

One study focusing on individual timberland owners in West Virginia, for example, discovered that almost 40% owned timberland simply because it happened to be part of their residence or farm.

The biological growth of timber, resulting in bigger and more valuable trees, is not sensitive to the financial and economic factors that influence common stocks and bonds... timberland returns' minimal, or possibly countercyclical, reltaionship with the returns of financial assets.

One estimate of the value of the nation's 700 million acres of timberland is $280 billion. Approximately 482 million of these acres are of commercial quality. One report estimates the value of the commercial-quality acreage to be $200 billion... a rough estimate of privately held commercial timberland would be $180 billion... We guess that the privately held timberland that is accessible and that has the potential to offer respectable returns from forestry has a value equal to roughly 1/2 of the $180 billion estimate.

The forest products industry... accounts for about 6% of America's gross national product.

The US forestry industry supplies 1/4 of the world's solid wood products... US industry maintains the lowest delivered cost for softwood fiber in the world.

Both the Soviet Union and Brazil... control 26% and 14%, respectively, of the world's total timber reserves, while the US has less than 7%.

Forest product firms obtain 48% of their timber supply from farmers and other NIPFs, 22% from government lands, and 30% from their own lands.

While 90% of timberland in the South is in private ownership, private entities control only 42% of the timberland in the West. NIPFs posess 73% of the privately held timberland in the South, but only 50% of such land in the West.

The 1989 year-end book value of Weyerhaeuser Company's timberland was approximately $612 million, in comparison to a market value of perhaps $5.5 billion.

Some of the major players in this field are Forest Investment Associates, John Hancock Mutual Life Insurance Company, Prudential Timber Investments, Resource Investments, Inc, The Travelers Corporation, and Wachovia Investment Management.

2 - An Overview of Timberland's Investment Characteristics

The timber standing on a tract of land has a rare characteristic: it represents both inventory and capital.

Western softwood timberland generally offers less inflation protection than southern pine timberland.

However, on average, losses stemming from wildfire and other natural hazards such as storms, disease, and insects exceed normal timber mortality by less than 1%. Based on 15 years of experience with 700,000 acres in the Southeast, Weyerhaeuser Company experienced losses to insects of 0.3% of total timber volume per year.

The value of timber allocated to remodeling is only 14% less than that used in new housing. By relying to a greater extent on the remodeling market, Georgia-Pacific Corporation's building products group was able to increase sales by 21% during 1988 despite a 21% decline in housing starts.

In regard to output price volatility... timberland possesses an important advantage over farmland: timber sales can generally be deferred if prices are currently perceived to be inadequate.

It is doubtful that any given institutional investor will ever allocate more than 5% of total assets to timberland.

The approximately 2,000 forestry consultants in the US derive the largest portion of their gross incomes by providing the following services: timber marking and help with timber sales, timber inventory and appraisal, timber volume estimates, forestland appraisal, management planning, and coordination of timber harvesting.

Ignoring taxes, the return on investment from owning timberland is a function of at least six factors: growth of the trees, changes in stumpage prices, changes in land values, operating expenses, exogenous revenues (such as pine straw harvesting), and damage caused by natural hazards.

The strength of future stumpage prices will be determined more by supply-side impacts than in the past... Numerous factors affect short-term and long-term timber supply, including the amount of land area allocated to timber growing, the age distribution of timber, timber inventory levels, the level of management intensity, public timber policies, and many others.

They anticipate price stabilization or decline in the subsequent 25-year period because of the supply contribution by the large acreage planted during the 1980's... one positive timber supply force is represented by government programs such as the Conservation Reserve Program.

Timber supply is also constrained from a global perspective...:

• Scandinavia - already producing at a level approaching its legislated limit
• Soviet Union - inadequate road and rail infrastructure in its vast forests east of the Ural Mountains
• Canada - huge capital investments are required to tap its northern forests
• China - competition between forestry and other uses for land is severe
• Brazil - also faces infrastructure problems

Some averages per acre for the South in 1990 are reported here:

• Mechanical site prep - $87.45
• Planting - $34.33
• Prescribed burning - $8.10
• Fertilization - $29.29
• Fire protection - $1.57
• Timber cruising - $2.02
• Mechanical precommercial thinning - $55.43
• Removing undesirable trees with chemicals - $63.70

Frequently in the South, however, it is possible to offset all or part of the annual property taxes from fees for hunting rights.

3 - Fundamental Forest Management Concepts for the Timberland Investor

Land values can rise a great deal because of changes in use. [NOTE: land speculation!]

The average annual growth rate of Douglas-fir, the dominant commercial species in the West, was 1.5%. The comparable rate for southern pines was 7.9%.

The West is the nation's only region with a major log export trade.

For the West as a whole, the softwood controlled by NIPFs has an average annual growth rate of 2.4% per year compared with only 0.9% per year for federal government-controlled softwood.

[In the PNW] The large forest products companies would probably be very reluctant to sell their timberland since they would then have to rely more heavily on government timber.

About 166 million acres of commercial forestland are located in the North. Approximately 90% of this land is owned by forest industry or private individuals... approximately 60% of the region's harvest volume is pulpwood.

There are 188 million acres of commercial forestland in the South, the majority owned by individuals... on those properties owned by NIPFs, an average annual growth rate of 6% has been reported for the South, compared with only 2.4% for the West and 3.4% for the North.

Alternative markets are often more readily available in the South than in the PNW because of land ownership patterns and relatively flat terrain in the prime timber growing sites. In the South, markets may be available in all four primary directions, while in the Northwest one must generally follow the creeks downhill to the converting mills.

Almost everyone who has bought or sold timber or timberland can recount cases in which they suffered losses because they erred in making conversions.

The heirs' basis in the timberland is the fair market value at the date of the transfer, not the original cost.

A simple analysis of Weyerhaeuser's situation shows that the company's initial investment in this mill probably exceeded the value of the timberland needed to supply it with fiber.

A pulp mill with a planned output of 425,000 air-dry tons requires approximately 790,000 cords of softwood per year. The USFS estimates that an average acre of southern pine can produce approximately one cord per year when managed under fully stocked stand conditions. Since an average acre currently costs approximately $500 for the land and timber, the 790,000 acres of land base required to furnish the raw material for this ($500 million) facility would cost approximately $395 million, or 79% of the cost of the facility.

Forest products companies rely on their timberland to help stabilize earnings... when fee timber is harvested, this will usually result in a net gain - even in a poor stumpage market. Thus, a possible incentive to harvest fee timber during periods of low stumpage prices is to prop up earnings when they are otherwise depressed.

Institutional owners have advantages... their financial strength should allow them to buy timberland advantageously. Forest products companies often buy land when profits are high. Often high profits mean that the end products, timber prices, and timberland prices are also high. Institutional investors should be able to buy when the market is on a downswing.

Most timberland investment management firms arrange for the properties they manage to be valued annually by independent appraisers, complemented by quarterly in-house updates.

USFS researchers have estimated that in the South almost 82 million acres of timberland need silvicultural treatments to improve current productivity. The application of such treatments on approximately 36 million of these acres is expected to yield a real return of at least 10% with an average cost per acre of $80. Examples of treatments include (in decreasing rank according to millions of acres with the potential for such application): clearcutting mature stands and then replanting them; preparing non-stocked or cutover sites for planting; controlling undesirable trees with chemical or mechanical methods so that desirable, overtopped trees can survive and grow more rapidly; and thinning densely stocked poletimber stands once the trees are merchantable.

The biological gain expected form first-generation southern pine stock is a 5-10% increase in height and a 10-15% increment in volume after the orchard has been "rogued" of the poor performers. These gains... have been reported ton increase the value per acre of harvested timber by more than 30%. Another 10-15% increase in volume is expected from second-generation stock.

Manual precommercial thinning may cost two to three times more than machine precommercial thinning, but it allows for individual tree selection as well as control of undesirable species.

Denser stands can produce relatively high levels of cubic volume per acre, but the trees will likely have narrow growth rings, small average DBHs, less vigor, and be more susceptible to insect and disease attacks.

Large forest products companies which own or control millions of forest acres have very complex and expensive inventory systems. The degree of the owner's need to accurately project volumes and incomes influences how much effort and funds are allocated to inventory systems.

In the South foresters consider loblolly pine sites below site index 50 (base age 25 years) to be marginal for timber production. For good southern pine land, the site index for large loblolly pine tracts will generally average between 55 and 65 (base age 25 years).

Small rotation age changes do not influence timberland value estimates to the same degree as stumpage market conditions.

In an environmentally sensitive society, increases in the scope and intensity of forestry-practice regulation are probably inevitable.

Chapter 4 - Timberland as a Portfolio Asset

Timberland's correlation with government bonds, common stock, and corporate bonds was negative.

Even with these constraints, timberland still accounted for as much as 18% of an efficient portfolio.

Chapter 5 - Timberland and the Capital Asset Pricing Model

Unique risk consists of that portion of total risk which is particular to a specific holding in the portfolio... in forestry, examples are fire and wind damage, regional reductions in stumpage prices, overestimation of the intrinsic value of an acquired tract, and poor silvicultural judgment and practice by a forestry consultant.

Alpha represents an indication of an investment's excess or deficit return relative to the degree of market risk involved. The alpha parameter is estimated using a regression equation which is consistent with the CAPM:
R_it - R_ft = a_i + B_i(R_mt - R_ft) + u_it
where:
R_it = the actual return on investment i during time t
R_ft = the actual return on a riskless investment during time t
a_i = alpha associated with investment i; it represents the y-intercept in the regression equation
B_i = the beta associated with investment i
R_mt = the actual return on the market portfolio during time t
u_it = the random error associated with investment i during time t

6 - Timber and Timberland Markets

Since the large life insurance company's managers are required to be fully informed about their loan collateral, someone in the organization would be knowledgeable about trends in timber and land values and how such trends applied to the land and timber serving as the company's collateral.

Ownership classes that have important motivations other than return on investment include forest products industry (wood supply), utility firms (watershed protection), state and federal governments (public policy), and US Dept of Defense (military reservations).

Timberland investment management firms can financially benefit their customers - mostly pension funds - by behaving in a predatory fashion.

Private timber owners do not utilize standard provisions in conveyances. Disagreements over the provisions in the conveyance often contribute to closing problems. Examples of provisions in a timber sale include: the maximum time period for logging the property, the penalty for harvesting unmarked trees, the percentage down payment at closing, and procedures for handling debris.

The USFS publishes "Volume and Value of Sawtimber Stumpage Sold from National Forests by Selected Species and Regions."

The lesson that leaps out from this chronology - and this chapter - is that timing is of the essence, both from the standpoint of markets and the health of the forest... an owner wishing to maximize return must be continually in contact with the market and continually aware of the physical condition of his or her forest.

8 - Timberland Investment Strategies and Tactics

The biggest jump in timber value is when the timber in one category jumps to the next highest category. For example, the best time to buy timberland is when the trees in a stand are about to become merchantable pulpwood. Another good time to buy is when the trees in a stand are about to become chip-n-saw... this is hard to do, obviously, because entire stands don't move from one category to the next in two years. But in general, this is how to time a purchase.

Eric Oddleifson, president and chief investment officer of Resource Investments, Inc. labels the timberland market as perhaps the ultimate imperfect private market. To take advantage of this characteristic, the timberland buyer needs to know more about a given tract than the seller. This might enable the buyer to purchase a tract with an expected present value greater than the purchase price.

Informational asymmetries, Oddleifson claims, sometimes can be tilted in favor of the buyer.

Charles M. Tarver, director of acquisitions with Forest Investment Associates, does not believe that a wholesale/retail strategy is feasible for institutional investors: Very large industrial tracts generally are poorly suited for division and resale. Logical buyers for such properties are limited to forest products companies (which have been the primary sellers of such tracts in the first place) and other institutional investors. This would imply that, for the strategy to work, properties would have to be sold back to the forest products companies or to another institutional investor ("the greater fool theory"), and that there by a reversal in the market discount to a premium for large properties.

An expected widening of the deficit between softwood timber growth and removals in Georgia might suggest that investors evaluate pine stands in that state.

In relationship to short-term stumpage price movements, many practitioners have observed that stumpage prices tend to follow a seasonal pattern in some regions. Prices during winter often reflect the premium paid for the limited number of winter harvesting areas.

Investors cannot ignore supply-side influences when projecting long-term timber price trends. Three indicators of supply-side impacts are:

• the ratio of removals (of timber) to inventory (of timber),
• the ratio of growth to removals,
• and the ratio of forest products companies' inventory relative to removals.

Flexibility to coordinate silvicultural practices with changing market conditions is an important characteristic of active forest management.

Pensions funds represent the primary institutional investor with an interest in allocating portfolio funds to timberland.

9 - Timberland Investing Comes of Age

Timberland is a tangible asset that, over the long run, should generally provide respectable - but not spectacular - returns. The primary engine producing these returns is biological growth - not financial sleight of hand or speculation.

Forest products companies have huge investments in conversion facilities to protect.

As in most investment opportunities, the greatest returns are reserved for the pioneers.