How do timberland investments work?

Over the years, timberland investments have gained popularity with institutional investors seeking long-term inflation-linked returns that are not correlated with share and bond markets. For example, major pension and endowment funds, such as the Harvard University endowment fund, Ontario Teachers Pension Plan and the NZ Superannuation Fund own substantial timberland assets in New Zealand. The returns on these timberland investments come from biological tree growth, timber price appreciation, land price appreciation and more recently the sale of carbon credits. Timberland investments have also traditionally provided high returns with a low level of risk.

Timberland investments differ from the tax-driven tree plantation schemes which were heavily promoted in Australia to retail investors. These schemes typically involved borrowing money to plant trees, which would take many years to mature, with large tax deductions able to be claimed up-front. The key differences with timberland investments are they usually also include ownership of the land as well as the trees, they include mature trees - which provide a source of income from the start of the investment - and timberland investments have typically been made on an ungeared basis by tax-free investors who aren’t looking for tax benefits.

Since the early 1990s, major manufacturers of timber-related products, decided to sell their trees along with the associated management and farming of them, to investors and management companies with the financial and forest management skills to optimise production and yields. Manufacturers ensured access to tree supply by entering into long-term supply contracts with the timberland owners. These supply contracts are often made at pre-negotiated prices, allowing manufacturers to hedge movements and volatility in timber prices.

While individual trees can take 15-30 years to fully mature and harvest, timberland managers diversify the maturity profile by planting and harvesting different groups of trees each year so that there are always trees ready to harvest. Additionally, the timber can be used for different purposes depending on demand and prices at different times in the economic cycle. For example, during a building downturn, when the price and demand for building products is low, timber can be used for pulp and paper. Trees used for pulp and paper can also be harvested earlier than trees used for wood products, which also creates a timber yield curve that allows the timber manager to work out whether it is better to harvest today for pulp, or wait several years and harvest for building products. This ability to diversify, optimise the portfolio and sell the timber into different markets helps provide a more stable investment return and dividend profile to the investors.

In addition to the income from selling trees, timberland investors can generate capital gains from selling parts of the land on which the trees are standing if there are better uses for the land – for example for housing developments. Another more recent source of income is from government incentives and the sale of carbon offsets or credits which are gained from planting and owning trees.

Historically timberland investments have outperformed equities with less volatility. The NCREIF US Timberland Index, which measures the investment returns achieved by a range of institutional investors, returned 12.1% per annum compound from December 1986 to June 2016, with about half the volatility of the US share market (see below). As a commodity, timber is also a good inflation hedge. According to investor, Jeremy Grantham, from 1905 to 2005 timber returns exceeded inflation by around 3% per annum.

However, timberland investments are not riskless. There are risks of overpaying for the investments, which can depress returns, natural disasters such as bushfires can destroy the timber and there are risks associated with the price of trees and the land.