Because of the dynamics now in the timberland acquisition market, it is difficult for timberland investors to be sure their investment managers are making buy, hold and sell decisions with their clients' needs in mind, or if they are operating, at least in part, in their own interests.
During the past three years, the timberland acquisition market has become overheated and overpriced. This is a result of continued interest in the asset class by pension funds and other institutional investors -- and new interest among a broader range of investors, including corporate and offshore players -- and ongoing concerns over access to wood fiber among forest products and paper companies.
Unfortunately, the more competitive and challenging the acquisition market has become, the more conflicted timberland investment firms have become.
On the one hand, meeting clients' investment objectives requires buying land at the lowest possible prices and selling it opportunistically based on the behavior of the market.
On the other hand, the growth and profitability objectives of timberland investment firms are based on their ability to retain and gather assets so they can generate consistent management fees.
Recognition of this dilemma is causing larger timberland investors to consider ways of increasing liquidity so they can have more control over market exposure. It also is causing them to investigate management and compensation structures that will enable them to better align their interests with those managing their forest investments.
This type of thinking is what led to the growth of the real estate investment trust market following the commercial real estate slide of the early 1990s. Over time, that movement has led to the creation of real estate operating companies specializing in every sector of the market -- from office buildings and apartment complexes to shopping malls and prisons. There is every reason to believe this model will be applied in the timberland investment arena.
Securitization has dramatically changed how institutional investors participate in most sectors of the commercial real estate market, and it is likely to change how they invest in timberland as well.
A major restructuring under way within the forest products and paper industry is providing momentum for the change.
And more timberland investors are studying securitization as a way of enhancing liquidity and creating greater alignment of financial interests among themselves and those managing their forest assets. Together these factors are likely to alter how forests are owned and managed in the future.
The recent mergers of industry giants such as Stone Container and Jefferson Smurfit, Bowater and Avenor, and International Paper and Union Camp indicate a major consolidation is just getting under way.
At a time of unprecedented value creation across the general economy, the forest and paper industry continues to underperform the market. From 1989 through 1998, a universe of 17 forestry companies returned, including dividends reinvested, an annualized 3.6%. By contrast, the Standard & Poor's 500 stock index returned 16.9%.
This underperformance means wood products and paper manufacturers are under intense pressure to revitalize their businesses, and monetization of forest assets is viewed increasingly as the logical way to capitalize this transformation.
For years, forest products and paper companies expended enormous amounts of capital, labor and energy to convert highly valuable trees into low margin, unprofitable products like market pulp and kraft bags. For the most part, their significant timberland holdings were buried in their balance sheets. In general, most of these companies viewed their forests as nothing more than sources of raw material, rather than as a marketable asset that could be managed profitably on a stand-alone basis.
In the mid-1980s, finance-savvy foresters recognized the significant investment opportunity this presented for large pension funds, and they began establishing timberland investment firms to capitalize on the situation.
This dynamic was in play for about a decade. During that time, investors in timberland not only benefited from easy access to attractive acquisitions; they also were positioned ideally to participate in a historic runup in private timberland values. The listing of the spotted owl as an endangered species on the West Coast caused public timber supplies to constrict significantly in the early 1990s as publicly owned forests in the region came out of timber production. The resultant supply shock drove private timberland values, and timber prices, skyward and allowed investors to see the overall value of their portfolios appreciate dramatically.
Since 1995, the broader investment community has taken note of the performance institutional investors have been generating with their timberland portfolios. In part because of the existence of the NCREIF Timberland index, other large investors now recognize timberland's investment attributes and want to participate in the asset class.
Shareholders, and analysts in particular, have been pressuring industry players to reduce the cost of capital devoted to their manufacturing assets and to unlock the underlying value of their forests by segregating their lands from the rest of their balance sheets and managing them independently.
So what does all of this mean?
It means securitization of timberland assets not only makes sense for institutional investors, it also makes sense for the forest products and paper industry.
Because scale and market presence will be critical to the growth and success of securitized timberland vehicles, savvy institutional investors, industry players and other large timberland owners are likely to combine their assets to form independent forest operating companies.
These companies will be in the business of managing and purchasing forests and selling timber and fiber to wood and paper manufacturers. They will be managed by experienced forest investment professionals who will be compensated not through annual management fees, but on the basis of company performance.
The introduction of the operating company concept would have a profound effect on the timberland asset class. Institutional investors and other large landowners would exchange direct ownership of land for shares in the companies. In return, they would benefit from enhanced liquidity -- greater alignment of interests with those managing their assets.
As for forest products and paper companies, contributing their lands to forest operating companies in exchange for shares in the companies would enable them to better satisfy their shareholders and to enhance their capital positions, which would allow them to compete more effectively in the global market. It also would help them address their fiber access concerns by creating an open market from which to purchase wood on as-needed basis.
Timberland securitization will happen because it will provide an elegant set of options for all those who have an interest in the asset class.
Richard N. Smith is president and chief executive officer of Forest Systems Inc., a timberland investment firm based in North Easton, Mass.