In his March 22 Others' Views commentary, "Timberland market more challenging, conflicted," Richard Smith raises some interesting points -- but there are also some problems with the conclusions he draws.
While many new investors recently have entered timberland markets, and timber and timberland prices did enter a period of rapid growth in the early 1990s, the conclusion that these markets are now "overheated and overpriced" is incorrect. Moreover, it is wrong to attribute the price increase to new investors in the marketplace.
Institutional investors hold between 6 million and 7 million acres of timberland in the United States, out of a total forestland area of about 490 million acres. This is perhaps as much as 1.4%, half or more of which was acquired before 1995. Institutions are clearly a minor ownership category.
Timber prices, and by extension land prices, changed for the same reasons they always change: there was an imbalance in the supply and demand for industrial wood.
Mr. Smith correctly notes that on the supply side, timber harvests from public lands in the West were sharply restricted because of the Endangered Species Act. There also were timber supply "shocks" from other regions, but for reasons that varied by locale. For instance, the former Soviet Union traditionally was a major timber producer, but its timber production declined 70% since 1990 because of the economic turmoil taking place there. Timber harvests in Europe also have dropped in the face of an increasingly politically powerful green movement.
On the demand side, declining interest rates combined with strong economic growth led to rising housing starts and a significant increase in the size of the average home. Domestic paper markets, following a sharp downturn that coincided with the 1990 recession, entered a period of dramatic growth during the decade. And offshore, the phenomenal gross domestic product growth rates taking place in Asia until mid-1997 led to unprecedented increases in demand for most wood products.
Simply put, when timber availability was restricted and the demand for forest products rose, timber prices increased accordingly, and land prices followed. Although astute institutional timberland investors recognized and increasingly participated in this series of events, they did not cause them.
More recently, we saw timberland markets can go down as well as up. And they did so for the same reasons. Timber prices hit peaks in the West between 1994 and 1996. In the South, prices hit an all-time high in early 1998. Western sawtimber prices recently declined to levels last seen in 1992, and in the South, prices are returning toward long-term trend levels.
Why? Because the timber supply and demand imbalance has shifted once again. The Asian economic crisis in general, and the Japanese recession in particular, hurt timber markets in the West, which depend heavily on Pacific Rim exports. This put incremental lumber supplies into other U.S. markets, putting downward pressure on prices in those regions.
In addition, rainfall has greatly affected timber prices in the South. Timberland investors caused neither the resulting price spikes, nor their recent declines -- nor the variation in rainfall, for that matter.
I also disagree with Mr. Smith's point that traditional timber investment management companies have become "conflicted" in their dealings with institutional clients, which is resulting in a "dilemma." TIMCOs normally function as fiduciaries and take on the responsibility for holding or administering property owned by its client, and the self-interests of the fiduciary must not conflict with the interests of the beneficiary.
This is not to say a beneficiary and fiduciary cannot agree to strategies that more completely align their respective interests. In addition to an annual management fee, a TIMCO typically receives an incentive fee upon the planned liquidation of a closed-end timberland fund or separate account, which can represent the largest cashflow to a TIMCO from a client account.
It therefore makes no sense for TIMCOs to buy timberland to simply "retain and gather assets so they can generate consistent management fees." First, this means properties would be acquired that sell at premiums to true market value, so the TIMCO would be in violation of its fiduciary obligation. Moreover, it would defeat the ability to realize an incentive fee, because when a high-cost property eventually is sold, it would generate a below-average return.
Finally, Mr. Smith proposes timberland assets be securitized to avoid the above "dilemma." While there are factors that argue for securitized timberland investments, there also are questions that remain unanswered. While private equity timberland benchmarks have low or negative correlations with traditional financial asset benchmarks, securitizing timberland will introduce some systematic market risk. Existing timberland U.S. master limited partnerships have correlations with the Standard & Poor's 500 index that range from 0.6 to 0.9.
Also, unlike traditional securitized real estate investments like real estate investment trusts -- where distributions mainly come from rents -- securitized timberland distributions will come from timber sales. Timber prices vary in response to supply and demand conditions and can be quite volatile. But owners of securitized timberland, like the owner of any REIT, will expect regular dividend payments, which will require ongoing timber harvests.
When timber prices rise, fewer acres need be cut to pay the dividend, which does not create a problem. But when prices decline, more acres must be cut to support the same dividend. Cutting more timber is exactly the opposite course of action that would be employed by a private equity timberland investor in a down market. The private equity investor would instead "store the timber on the stump" until prices turn back up, which is one of timberland's most appealing features.
But the biggest flaw in Mr. Smith's argument for securitization is he ignores the obvious potential conflicts of interests that can arise when a forest products company securitizes its timberland. Unlike a traditional TIMCO, a forest products company does not act as a fiduciary and may securitize timberland simply to access low-cost capital to feed existing lumber or paper conversion facilities. It is no secret the woodlands divisions of many forest products companies have long subsidized low-margin mills by using transfer prices that are far below open-market prices.
Institutional investors require their interests to be aligned with those of the investment manager. Therefore, the manager must provide the highest risk-adjusted returns possible. To consistently achieve this objective, timber must be sold at the highest possible price. The highest prices almost always come from a sealed-bid sale process. This argues for a securitized timberland asset to be a stand-alone entity.
Mr. Smith does make one point with which I completely agree: "The introduction of the operating company concept would have a profound effect on the timberland asset class." Unless securitized timberland investments are structured to best serve investor interests, the effect on the timberland asset class will be profound indeed. The fiduciary relationship between TIMCO and beneficiary not only has the potential to be damaged, but also to evaporate completely.
