More Tax Efficient Than Other Portfolio Diversifiers

Like stock gains, timber gains are generally taxed at the capital gains rate (usually 15%) rather than the ordinary rate (typically 25%), so investors in taxable accounts take home a greater proportion of gains. By contrast, much of the typical returns from bonds, non-timber real estate investment trusts (REITs), and commodities futures contracts are taxed at ordinary rates.

Risks

Physical risks—such as damage from fire or insects—can inflict significant losses, but not to the extent that many investors fear. Such losses usually erode returns by 0.1% annually, for timberland holdings that are well-diversified by geography, age, and species.[4]

In my view, the greatest risks are: 1) overpaying for timber assets, and 2) illiquidity (inability to readily sell assets).

Overpayment/Valuation Risk

No longer a "well-kept secret," timber has been attracting plenty of assets from large institutions and ultra-wealthy investors.

This influx of money is chasing after a limited number of forests. This is particularly the case in the U.S.—American forest-product conglomerates largely finished divesting millions of acres of forests in the past decade. Thus, investors are increasingly looking overseas for deals.

Steve Holland, portfolio manager for the Campbell Group, told me in an e-mail interview that while there are opportunities overseas, they involve "political, currency, and tax risks." Holland, who also serves as the NCREIF Timberland committee chair, says that currently "the U.S. is still the best place to invest, but over time institutional ownership of timberland on a global basis will become more prevalent."[5]

Illiquidity Risk

Timber is strictly an asset class for long-term investors rather than speculators seeking a quick buck. Trees generate most of their returns through steady biological growth, and harvesting cycles are typically 15 to 40 years. Also, timber assets are difficult to sell quickly. As I'll explain in my next article, some pure-play timber investment vehicles limit the timing or amount of sales by shareholders.

References

1. Real Estate Finance, "Timberland Return Drivers and Investing Styles for an Asset that has Come of Age," Winter 1998.

2. I would caution investors that timber returns from the late-1980s to the early-1990s were inflated by supply shocks from federal conservation efforts to protect the spotted owl. So, the 1987-2006 graph highlights abnormally high returns, while the 1992-2006 graph seems a bit more realistic.

3. Pre-1987 returns were extrapolated for the John Hancock Timber Index, as explained in this 2003 white paper (PDF) from Hancock Timber Resource Group.

4. However, a dramatic infestation of mountain pine beetles is killing entire forests in Western Canada and the Western U.S., primarily old lodgepole pines. This underscores the importance of diversifying by geography, age, and species.

5. E-mail interview excerpt, June 16, 2008, reprinted with permission.

George Nichols is a private research analyst who specializes in monitoring market trends regarding institutional ownership of alternative investments. He was formerly a stock analyst for Morningstar and holds degrees in accounting and library science.

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