Does It (Still) Pay to Own Timber?

In its August 10, 2009 issue, Barron’s ran an article about “Trouble in the Forest.” It concluded that timber is overvalued, and “could decline by as much as 50% in coming years.” We have a very different view.

The underlying diversification logic for investing in timber is quite simple: the key return driver is biological growth, which has essentially no correlation with factors driving returns on other asset classes. That said, the correlation of timber returns with other asset classes should be different from zero, as it also depends on the price of timber products (which depends, in part, on GDP growth) as well as changes in real interest rates and investor behavior – factors affect returns on other asset classes as well as timber.

However, in valuing timber as a global asset class, we face a number of significant challenges.

First, the underlying assets are not uniform – they are divided between softwoods and hardwoods, at different stages of maturity, located in different countries, face different supply conditions (e.g., development, harvesting, and environmental regulations and pest risks), and different demand conditions in end-user markets.

Second, the majority of investment vehicles containing these assets are illiquid limited partnerships, and the few publicly traded timber investment vehicles (e.g., timber REITs) provide insufficient liquidity to serve as the basis for indexed investment products.

Finally, the two indexes that attempt to measure returns from timberland investing (the NCREIF Index in North America, and IPD Index in Europe) are regional in coverage and utilize an appraisal based valuation methodology based on timber limited partnerships, which tends to understate the volatility of returns and their correlation with other asset classes.

Given these challenges, the result of any valuation estimate for timber as a global asset class must be regarded as, at best, a rough approximation.

Our valuation approach is based on two timber REITs that are traded in the United States: Plum Creek (PCL) and Rayonier (RYN). We chose this approach because both of these REITs are liquid, publicly traded vehicles, and both derive most of their revenues from their timberland operations. This avoids many of the problems created by appraisal based approaches such as the NCREIF and IPD indexes. That said, tor the reasons noted above, this approach is still far from a perfect solution to the asset class valuation problem presented by timber.

As in the case of equities, we compare the returns that a weighted mix of PCL and RYN are expected to supply (defined as their current dividend yield plus the expected growth rate of those dividends) to the equilibrium return investors should rationally demand for holding timber assets (defined as the current yield on real return bonds plus an appropriate risk premium for this asset class). We note that since PCL and RYN are listed securities, investors should not demand a liquidity premium for holding them, as they would in the case of an investment in a TIMO Limited Partnership (Timber Management Organization).

Two of the variables we use in our valuation analysis are readily available: the dividend yields on the timber REITS and the yield on real return bonds. The other two variables, the expected rate of growth and the appropriate risk premium, have to be estimated. The former presents a particularly difficult challenge.

In broad terms, the rate of dividend growth results from the interaction of physical, economic, and regulatory processes. Physically, trees grow, adding a certain amount of mass each year. The exact rate depends on the mix of trees (e.g., southern pine grows much faster than northern hardwoods), on silviculture techniques employed (e.g., fertilization, thinning, etc.), and weather and other natural factors (e.g., fires, drought, and beetle invasions).

Another aspect of the physical process is that a certain number of trees are harvested each year, and sold to provide revenue to the timber REIT. A third aspect of the physical process is that trees are exposed to certain risks, such as fire, drought, or disease (e.g., the mountain pine beetle in the northwest United States and Canada). And a fourth aspect of the physical process is that, through photosynthesis, trees sequester a portion of the carbon dioxide that would otherwise be added to the earth’s atmosphere.

In the economic area, three processes are important. First, as trees grow they can be harvested to make increasingly valuable products, starting with pulpwood when they are young, and saw timber when they reach full maturity. This value-increasing process is known as “in-growth.” The speed and extent to which in-growth occurs depends on the type of tree; in general, this process produces greater value growth for hardwoods (whose physical growth is slower) than it does for pines and other fast-growing softwoods.

At the level of individual timber investments, the rate of in-growth is a key driver of returns; however, at the asset class level, we have decided to assume a constant mix of grades over time. The second economic process (or, more accurately, processes) is the interaction of supply and demand that determines changes in real prices for different types and grades of timber.

As is true in the case of commodities, there is likely to be an asymmetry at work with respect to the impact of these processes, with prices reacting more quickly to more visible changes in demand, while changes in supply side factors (which only happen with a significant time delay) are more likely to generate surprises.

In North America., a good example of this may be the eventual supply side and price impact of the mountain pine beetle epidemic that has been spreading through the northwestern forests of the United States and Canada. The IMF produces a global timber price index that captures the net impact of demand and supply fluctuations, which is further broken down into hardwood and softwood.

The average annual change in real prices (derived by adjusting the IMF series for changes in U.S. inflation) between 1981 and 2007 are shown in the following table:

	Average	Standard Deviation
Hardwood	0.4%	11.8%
Softwood	1.7%	21.6%
All Timber	0.1%	9.2%

As you can see, over the long term, prices have been quite stable in real terms, though with a high degree of volatility from year to year (and additional volatility across different regional markets).

The third set of economic processes that affects the growth rate of dividends includes changes in a timber REIT’s cost structure, and in its non-timber related revenue streams (e.g., proceeds from selling timber land for real estate development or conservation easements).

For example, if wood prices decline, and non-timber sources of revenue dry up (as is happening during the current recession), a timber REIT (or timber LP) will have to either cut operating costs and/or distributions to investors, increase leverage, or increase the physical volume of trees that are harvested.

Regulatory processes also affect the future growth rate for timber REIT dividends. In the past, the most important of these included restrictions on harvesting or land development. In the future, the most important regulatory factor is likely to be the imposition of carbon taxes or a cap and trade systems to limit carbon emissions.

These new environmental regulations could provide an additional source of revenue for timber REITs in the future. For example, estimates of the amount of CO2 sequestered each year per acre of growing timberland range from 84 to 172 metric tons. Current forecasts call for CO2 emissions allowances and offsets to trade at between USD 25 and USD 50 per metric ton, depending on the final shape of a cap and trade system.

At this level of pricing per metric ton of sequestered CO2, the potential new revenues to owners of timberlands would be significant relative to their current revenue (for an early attempt at establishing the CO2 sequestration value of timberland, see “Economic Valuation of Forest Ecosystem Services” by Chiabai, Travisi, Ding, Markandya and Nunes.

For a review of similar studies, see “Estimates of Carbon Mitigation Potential from Agricultural and Forestry Activities” by the U.S. Congressional Research Service. Most recently, see “Forging the Climate Consensus: Domestic and International Offsets” by the National Commission on Energy Policy).

The following table summarizes the assumptions we make about these physical and economic variables in our valuation model:

Growth Driver	Assumption
Biological growth of trees	We assume 6% as the long term average for a diversified timberland portfolio. We stress that biological growth rates can vary widely for different types of timber investment (with softwoods and timber located in tropical countries delivering the highest growth, and hardwoods and timber in more temperate climates delivering the slowest growth rates). We have also changed our valuation model to assume a constant mix of product grades, to present a better approximation for timber as a global asset class.
Harvesting rate	As a long term average, we assume that 5% of tree volume is harvested each year. As a practical matter, this should vary with timber prices and the REITs prevailing dividend level. So 5% is a “noisy” long-term estimate for timber as a global asset class.
Change in prices of timber products	In line with IMF data, we assume that over the long term, average timber prices will just keep pace with inflation. Again, this is a “noisy” estimate, because the IMF data also shows that real prices are highly volatile. Moreover, there are indications that climate change is causing increasing tree deaths in some areas, which should lead to future real price increases (see “Western U.S. Forests Suffer Death by Degrees” by E. Pennisi, Science, 23Jan09). Hence we believe our long term price change assumption is conservative.
Carbon credits	Until more comprehensive regulations are enacted, we assume no additional return to timberland owners from the CO2 sequestration service they provide. Again, given the high level of global concern with limiting the increase in atmospheric CO2 levels, we believe this is a conservative assumption.

This leaves the question of the appropriate return premium that investors should demand to compensate them for bearing the risk of investing in timber as an asset class. Historically, the difference between returns on the NCRIEF timberland index and those on real return bonds has averaged around six percent. However, since the timber REITS are much more liquid than the properties included in the NCRIEF index, and since timber has displayed a very low correlation with returns on other asset classes (particularly during the worst of the 2008 crisis, even in the case of liquid timber vehicles), we use three percent as the required return premium for investing in liquid timberland assets.

Given these assumptions, our assessment of the valuation of the timber asset class at 31 August 2009 is shown in the following table. We use the dividend discount model approach to produce our estimate of whether timber is over, under, or fairly valued today. The specific formula is (Current Dividend Yield x 100) x (1+ Forecast Dividend Growth) divided by (Current Yield on Real Return Bonds + Timber Risk Premium - Forecast Dividend Growth). A value greater than 100% implies overvaluation, and less than 100% implies undervaluation.

Average Dividend Yield (70% PCL + 30% RYN)	5.10%
Plus Long Term Annual Biological Growth	6.00%
Less Percent of Physical Timber Stock Harvested Each Year	(5.00%)
Plus Long Term Real Annual Price Change	0.00%
Plus Other Sources of Annual Value Increase (e.g., Carbon Credits)	0.00%
Equals Average Annual Real Return Supplied	6.10%
Real Bond Yield	1.95%
Plus Risk Premium for Timber	3.00%
Equals Average Annual Real Return Demanded	4.95%
Ratio of Returns Demanded/Returns Supplied Equals Valuation Ratio (less than 100% implies undervaluation)	77%

We stress that this is a long-term valuation estimate that contains a higher degree of uncertainty that valuation estimates for larger and more liquid asset classes. Over a one year time horizon, you could easily reach a different valuation conclusion. For example, if you believe that real timber prices will decline over the next year, and/or that physical harvesting rates will increase to cover costs and dividends, then you could argue that, in so far as PCL and RYN are roughly accurate proxies for the asset class as a whole, timber is likely overvalued today.

On the other hand, whether looking over a short or long-term time horizon, if you believe that new revenues from timber’s CO2 sequestration service are likely to be significant, and/or that three percent is too high a risk premium to use, then you could argue that timber is actually undervalued today on a medium term view, and possibly on a short-term view, depending on your outlook for cap and trade legislation.

Finally, you could also argue (as Robert Hagler does in “Re-Allocating Timber Investment Portfolios for the Decade Ahead”) that timber remains a relatively inefficient asset class in which it is still possible for active managers to generate significant additional returns.

In sum, timber valuation is an issue upon which reasonable people can and do disagree, in no small measure because of their different time horizons and the different underlying assumptions and methodologies they use to reach their conclusions.

On balance, taking a long-term view, we continue to believe that timberland is likely undervalued today, for two reasons:

1. Future revenue growth related to CO2 sequestration is likely to be significant;
2. The negative impact on timber prices caused by the recession and long-term slowdown in North American housing construction will be moderated or offset by the impact of supply side changes, such as the mountain pine beetle problem, and by rising demand for wood products that will accompany rising incomes in China.

On a one year view, however, we are neutral, with downward price risk balanced against the upside potential inherent in pending environmental legislation.

Disclosure: No positions

Comments

[jbfiacco]

Two points.
1. On the demand side, you have missed the very important woody biomass market (being driven by renewable fuels, global warming and energy self sufficiency issues) and its evolving impact on stumpage prices.
2. Historical timber prices have risen at a real rate of about 2%. You appear to have a mathematical miscalculation on your chart. Your data shows a 1% real increase not a 0.1%.

2009 Oct 02 05:21 PM

[Index Investor]

Point taken about potential biomass related revenues (e.g., cellulosic ethanol). However, we chose to err on the side of conservatism here, as we did with the treatment of revenues from CO2 sequestration. On the real price change point, we accept that 1% to 2% real has been a North American TIMO rule of thumb. However, in trying to construct a valuation framework for timber as a broad global asset class, we chose to use the IMF's data for the historical evolution of global softwood and hardwood prices. Clearly, it is possible to take issue with their methodology, from weighting to quality adjustments; to cite just one recent example, new technologies that make softwood more durable should expand the range of its potential uses, and thus add to demand and upward price pressure. Again, we took the most conservative approach. The bottom line remains the same: any attempt to value timber as a global asset class is unavoidably "noisy" and uncertain; however, even a conservative approach leads to the conclusion that timber is likely undervalued over a medium term time horizon.


On Oct 02 05:21 PM jbfiacco wrote:

> Two points.
> 1. On the demand side, you have missed the very important woody biomass
> market (being driven by renewable fuels, global warming and energy
> self sufficiency issues) and its evolving impact on stumpage prices.
>
> 2. Historical timber prices have risen at a real rate of about 2%.
> You appear to have a mathematical miscalculation on your chart. Your
> data shows a 1% real increase not a 0.1%.

2009 Oct 03 01:23 PM

[Dopamine]

In the tourist resort Grindelwald Switzerland, they just ripped out the oil central heating to the mainstreet and replaced it with locally supplied wood fueled water heat,piped from the furnace through to 1000 homes and business establishments.
Your lengthy article was informative and, worthy of a second read, good job, and cheers to investing in trees.

2009 Oct 24 05:38 AM