"You think I should invest where?" We hear that question a lot these days.
U.S. institutions now own timberland worth more than $8 billion. The returns on these investments generally have been excellent, averaging 19.8% per year since the National Council of Real Estate Investment Fiduciaries first started keeping statistics in 1987. Investors now are comfortable with the risks associated with holding timberland (no, the trees don't burn up every summer) and now are seeking greater diversification of their portfolios and higher returns. This search logically takes us offshore.
While the investible universe for timberland in the United States exceeds $200 billion, there is perhaps $100 billion of desirable timberland elsewhere in the world in countries such as Canada, New Zealand, Australia, Chile and Brazil. International diversification can provide meaningful improvements in the performance of timberland portfolios. We now believe that investment in selected offshore regions totaling 10% to 20% of an otherwise well-diversified timberland portfolio can make sense.
International trade in forest products has been important since the Phoenicians sold cedar timbers to the Greeks for their triemes. Yet only recently has the industry followed the lead of automobile, chemical and metal industries and become truly global, with firms manufacturing products in many locations for consumption in many locations. Globalization of the industry makes global timberland strategies highly desirable.
Logs are commodities and are reasonably costly to transport, especially over land. As a result, the markets for logs tend to be weakly correlated with one another. Changes in domestic demand for radiata pine timber in Australia, for example, have little influence on the prices of pine trees in the United States (See Figure 1).
Our research suggests that returns for international investments are more variable than returns for U.S. timberland. However, because of the weak correlation, an investor can add international properties to a domestic timberland portfolio without causing any substantial increase - and perhaps even a decrease - in the volatility of portfolio returns.
The Hancock Timber Resource Group regularly participates in acquisitions in all of the world's investible timberland regions. As a result, we price most major deals using a consistent set of assumptions about timber markets. Of course the results are highly dependent on individual transactions and the particulars of the current state of markets. As a result of this work, however, we believe that most timberland investments outside the United States appear to be priced to yield about 100 basis points to 400 basis points above U.S. domestic ones. Why is this so?
Some argue that the higher returns from international investments - particularly those in the Southern Hemisphere - arise as a result of higher biological growth rates in those regions. This is faulty logic because markets generally reflect the discounted value of cash flows available from a property. Higher growth rates mean higher cash flows, and these cash flows already are priced into the deals.
Instead, we believe that the higher returns result in large part from the same kinds of market inefficiencies that occurred in the United States in the late 1970s and early 1980s. In particular, forest products companies (which currently own most of the investible timberland) systematically undervalue their timberland as a result of inefficient timber processing facilities and unimaginative timber procurement strategies.
So, international timberland investments produce higher returns and greater - but uncorrelated - price volatility. Figure 2 shows the net effect of these two factors, assuming a 20% allocation of international timberland to an otherwise well-diversified domestic timberland portfolio.
International exposure expands the risk-efficient frontier for timberland investments.
The economic case for investing in offshore timberland is compelling. However, even in stable, developed countries outside the United States, international timberland investments carry some risks not experienced with domestic ones.
Downsides down under?
Offshore timberland investments share many risks with domestic timberland investments. Various physical risks - fire, windstorms and pests - tend to be minor and can be readily controlled through good forest management practices and geographic diversification within a region. And, of course, timber prices fluctuate and timberland tends to be illiquid. What are the unique risks of international timberland investments? The two biggest are taxes and currency risk.
TAX CONSIDERATIONS. Many foreign jurisdictions do not extend tax-exempt status to U.S. institutions that enjoy that status at home. Hence, payment of income taxes can wreck what otherwise would be attractive investments. There are two main ways of mitigating this risk. The first is to employ sophisticated investment structures. The nature of these is highly dependent on the specific jurisdiction and investor involved, so no general conclusions are possible (except that good legal advice can generate an exceptional IRR). The second is to include relatively large amounts of debt in the capital structure of the investment entity because debt payments generally are excluded from taxation in many jurisdictions. Stapled debt/equity investment structures - a combination of equity and internal debt in which the equity holder is both the borrower and the lender - can be particularly effective in this context.
CURRENCY RISK. Of course, most U.S. institutions have U.S. dollar obligations. As a consequence, fluctuations in currency exchange rates may add volatility to an international investment.
Three considerations are important here. First, most international trade in forest products takes place in U.S. dollars. Hence, a timberland investment in a location such as New Zealand, where a large fraction of the logs will be exported, suffers only the currency risk associated with changes in local harvest, delivery and forest management costs. If these local costs are a small fraction of the overall cash flow, then the currency risk will be minimal. Second, timberland investors can create a "natural hedge" by matching the currency of any external debt with the currency of revenue. In that case, any rise or fall in the exchange rates exactly offsets itself in the revenue and debt-related cost streams. While the net return will still be subject to exchange-rate risk, some of the most pernicious problems of foreign investment will be avoided. Finally, currency risks can be laid off in ordinary currency hedges, especially when investment cash flows are predictable, as they can be with certain investment structures. In our experience, the cost of such a hedge is not high.
Globalization of the forest products industry has opened the door for institutional investment in timberland outside of the United States. Such investments carry some substantial advantages for U.S. institutional investors in the form of higher returns and deeper diversification. We believe that a core allocation in the 10% to 20% range makes sense; higher allocations are advisable if pure returns are of interest and volatility is less of an issue. While additional risks attend offshore timberland investments, careful management can mitigate the worst of these.
Clark S. Binkley is chief investment officer, Courtland L. Washburn is director of economic research and investment strategy and Mary Ellen Aronow is forest economist at Hancock Timber Resource Group, Boston.