In 1987 the US published its first national benchmark for private timberland investment returns, the NCRIEF index (where NCREIF stands for the National Council of Real Estate Investment Fiduciaries).
According to the index, if you had invested $1 in US timberland at the start of 1987, by the end of 2017 that would have been worth $31, or around $17 after adjusting for inflation.
That is a 12% annualised return.
But over the last 10 years, returns have fallen off dramatically, with annualised total returns down to 4.43%, behind the NCRIEF Property Index which yielded 6.08%, and the S&P 500 index, which returned 6.18%.
Whilst EBITDA returns from timber sales have held relatively constant over that period in percentage terms (at around 2.5%), it is the capital appreciation that has bottomed out, a consequence of sky-high asset prices.
Timberland can act as a great portfolio stabiliser, offering decent returns of 5-10% combined with low volatility, low or zero correlation with stocks and bonds, and a strong correlation with inflation. However, a decade of record low bond yields has fuelled massive inflows of institutional money into timberland, in particular the more established markets of the US, UK, Australia & New Zealand, and some parts of South America. At the same time “major landowners and governments have slowed the pace of offering assets to institutional investors throughout South America, Oceania, and Europe” according to leading sector expert Bob Hagler. As a result, the mature timberland markets are overbought, and total returns have declined significantly.
Today the timberland asset class is worth around $100bn. Approximately a third of that is in the form of listed REITs, which comprise large, vertically-integrated companies, and the rest is privately held timberland managed by TIMOs, or Timberland Investment Management Organisations, specialist forestry asset managers.
Over the last ten years even the REITs have outperformed the NCRIEF index, returning 5.64%, but the REITs don’t offer the low volatility, uncorrelated characteristics of the private timberland that the TIMOs offer. The vast majority of TIMO-managed capital is invested in the mature timberland markets. Where TIMOs have gone looking for assets in less developed, emerging timberland markets, they have often found that the risk premiums associated with doing business in those markets are simply too low, or there are very few established, cash-yielding assets available to buy, or both. That was my first-hand experience between 2011 and 2015 trying to deploy capital in Asia for one of the leading TIMOs.So, with mature markets overbought and emerging markets not offering attractive opportunities either, are we seeing institutions selling down their TIMO assets? In a recent article entitled “Should Investors be Leaving the Forest?”, Bob Hagler suggests that whilst institutional money is undoubtedly leaving, or trying to leave, the asset class, and TIMO capital raising has slowed significantly, rather than seeing a wholesale exit of the asset class, we are more likely to see ‘a realignment’ of capital, as an influx of impact investors, more tolerant of low investment returns, buy up the assets that the institutions are trying to sell. But I am not sure this is the case.
“A decade of record low bond yields has fuelled massive inflows of institutional money into timberland”
Whilst many TIMOs have recently taken to talking up their environmental and social credentials, and trees are undoubtedly a renewable resource of low carbon building materials, biomass energy and a range of biomaterials with exciting applications, impact investors are usually looking to catalyse some form of transformational change. Investing in a US southern pine plantation producing high grade sawlogs that are going to be turned into staircases, as they have been for over a hundred years, is more of an institutional play than an impact investment one. Given the lack of buyers for their overpriced assets, many TIMOs have also started to look at converting their convert closed-end funds into permanent capital structures.
Is there anywhere to go for institutional capital or family office investors interested in timberland? And are there any truly transformational investment strategies open to impact investors in the asset class? Well, sort of. SLM Partners, a boutique investment manager with offices in London and New York, specialises in commercial strategies in forestry and agriculture that are also transformational, or high impact. The company’s first forestry fund, the SLM Silva Fund, had its first close at the end of March this year, and is focussed exclusively on commercial forestry properties in Ireland.
Over the past few decades, with the help of generous EU grants and income payments, Irish farmers have doubled the size of the forest estate in the country, planting a range of conifers and broadleaves, but with a majority being Sitka spruce, a fast-growing conifer from the western seaboard of the US, that produces construction-grade timber with an excellent strength to weight ratio.
The Irish timber industry is world class and is a leading exporter of sawn timber and panel products to the UK, one of the largest timber importers in the world. The private Irish forest estate, planted in the 1990s and 2000s, is now reaching maturity and will soon overtake the public forest estate as the largest source of timber to the market making it a reliable source of income for the foreseeable future.
As the EU grants and income payments come to an end, the ageing Irish farmer is selling up, and with the timber processing industry’s costs of capital being too high for them to invest in purchasing forests, over the next decade or two we are likely to see a very significant transfer of ownership as the private timberland resource in Ireland moves into institutional ownership. But first, there needs to be an aggregation of small properties into institutional-scale portfolios. The fact that the average property available for sale today is so small has meant that, unlike in other developed countries, the asset class is simply not suited for direct investment by institutional investors and as a result asset prices have remained in check. This makes the private Irish forest estate an attractive capital gain opportunity also.
The aggregation of smaller forests is also coming at a good time to help Ireland meet its EU renewable energy targets. Energy producers in the country such as state-owned Bord Na Mona, which still runs its power stations on peat collected from the country’s peat bogs, need to source large volumes of biomass. Dealing with hundreds or thousands of small farmers makes raw material supply nightmarishly difficult. This has meant they are importing all sorts of exotic forms of biomass from around the world, including palm oil waste from Asia and Africa, which is an unintended consequence of demand outstripping domestic supply. Aggregation of forests however, enables the development of long-term supply agreements for industrial quantities of lower value timber from Irish forests. Some of this low value timber, which is unsuitable for sawing, is used in making panel products, but the surge in volumes from the private forest estate will also enable Ireland to move away from burning peat and instead switch to a truly renewable biomass resource.The final piece of the jigsaw is the direct environmental impact of forestry. The conventional approach to forestry in Ireland in the 1980s and 1990s was to plant monocultures of Sitka spruce and grow them for 30-40 years and then clearfell them and replant. Such forests have limited biological value and are dark and inhospitable places. Clearfelling can lead to soil erosion, causing a loss of soil fertility and structure, and this is accompanied by a pulse of carbon emissions from both from harvesting residues and the soil.
SLM Partners has adopted a forest management approach that has been piloted in Ireland over the past few decades on several thousands of hectares of commercial forest. This approach transforms conventionally-managed plantations to a more sustainable form of forest management called Continuous Cover Forestry, without any compromise to financial returns. Clearfelling is replaced with a regular thinning cycle that ensures that forest cover is maintained in perpetuity, whilst the canopy is opened up to a greater extent, allowing more light in, and encouraging natural regeneration. Soils are protected. Species and age diversity are encouraged. This makes the forests less vulnerable to climate change, building resilience to pest & diseases and storm damage, and it also makes the forests more profitable, as it reduces the need for costly replanting of bare ground after clearfelling. The resulting forests also have high amenity value, being more open, more diverse, and a permanent part of the landscape. The retention of permanent, diverse forest cover protects key water catchments and encourages the recovery of populations of rare or threatened species such as pine marten, lesser spotted woodpecker and crossbills. Together with the rewetting and rewilding of the many failed forestry plantations planted on deep peat, the adoption of Continuous Cover Forestry offers an effective and profitable way to transform an industry and reconcile the need for climate change mitigation and adaptation at the same time as meeting biodiversity, amenity and economic objectives across the country.
Darius Sarshar is Investment Director at SLM Partners.