Wood you buy this investment?

Have your clients considered investing in timberland? If your answer’s no, that’s not a surprise.

Most investors are unaware of the asset class, which involves investing in either tree farms or managed natural forests. The investment matures as the trees grow or appreciate in price.

The lack of interest in the class is surprising in a country born of hewers of wood, and also since the sector remained strong during the recession, helping those investors who did buy in diversify their portfolios.

In terms of returns, timberland investments exceeded the S&P 500 for 11 of the 21 years from 1990 to 2010; its compounded return was 11.15% versus the S&P’s 8.52%, and its returns provided lower volatility of 9.81% versus the equity market’s 19.26% over the same period. The NCREIF Timberland Index measures the performance of the asset class.

In volatile 2008, the NCREIF Timberland Index gained 9.5% while the S&P 500 lost 38%, and timber demand has remained strong despite slumping housing markets in the U.S.

So timberland provides excellent portfolio diversification thanks to its low correlation to other assets—less than +0.1. It was named as one of the top asset classes of the next decade by GMO due its high potential returns and correlation with inflation—the group predicted returns would top 6% each year from 2011 to 2020, with an extra 1.5% possible with active management.

As of 2010, Canada had over 100 million hectares of public forests. There are countless managed timber farms across the country, as well as Timber Investment Management Organizations (TIMOs) that help investors find and manage their investments. In 2002, Yale’s Private Forest Certification study found $14.4 billion was managed by TIMOs.

Currently, timber demand remains high and the United Nations has predicted demand for wood will double in the next 30 years as demand from China increases. Exports from Canada are expected to reach record highs in 2011 and doubled in volume throughout the recession according to the 2011 timber trends report by Campbell Group.

Tim Cayen, head of business development for Hancock Natural Resource Group, a subsidiary of Manulife Financial, says timberland is similar to real estate. But, due to its unique ability to grow and replenish itself, investors aren’t subject to the same debt and leveraging challenges.

“If you have debt and need to service it, you can do that through proper harvesting,” he says. “You also have the flexibility of not cutting and waiting for prices to improve if your debt levels are low. Prices may fluctuate, but you have a long-term horizon and can maximize your investment through good management.”

With investors yearning for high-yield and low-risk investments, timberland seems an obvious choice; but no reward comes without risk.

“There are three main risks facing timberland investors,” says Cayen. “Price uncertainty is the main risk, but there is also volume risk and liquidity risk. The chance of volume loss is small, but regulatory changes and natural disasters can affect your investment. In terms of liquidity, land was worth more in the 1980s, but timber is more actively traded now and especially with larger scale holdings will be quite liquid.”

Average investors may consider timberland investing too challenging or out of their range—most investments come from large institutions or pension funds such as the Ontario Teachers’ Pension Plan, which holds a $10.8 billion investment in infrastructure and timberland.

“For institutional investors, allocation ranges from 1%-to-5% of their portfolio,” says Cayen. “It’s the same for individual investors, but is typically more skewed to 5% since most products in the private space require a minimum investment of $5 million.”

For example, those looking to purchase timberland in the state of Virginia must buy a minimum of ten contiguous wooded acres, and have a detailed management plan before harvesting profit. So clients looking to invest need substantial funds—even land loans usually require large down payments—as well as knowledge or the help of an expert.

Wait times are also a barrier for some investors. You have to wait at least 10-15 years for their investments to mature, which can be boring, and if a harvesting mistake or management mistake is made, that period can double.

As Carl Richards, director of investor education for Bam Advisor Services, says in The Behaviour Gap, “We choose complexity [over simplicity]. Slow and steady means exchanging the opportunity of making a killing for the assurance of never getting killed.” Most people have a hard time watching others get rich quick.

On the bright side, Cayen says, “People are curious about the asset class and it’s expanded at the institutional level. But there are hurdles in the retail market and a lack of products for the average market consumer.”

There are several ETFs, such as the Claymore Beacon Global Timber Index Fund, and several forest product companies with large timber holdings, but Cayen warns, “The characteristics of each vehicle are very different and public vehicles act like stocks. They have relatively low correlation with traditional timberland investments due to drive for yield in the public market.”

Looking to the future, he says, “There is potential. Timberland mirrors what you find in real estate to some degree but there are no open-ended funds at the moment. Future products could be similar to development funds but no work has been done on that frontier.”

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