Forestry and Commercial Real Estate - Twins
but not identical
Where does forestry fit into a traditional asset allocation
matrix? It is after all an unusual asset which grows
regardless of the economic cycle. Some classify it in the
“alternative assets” catch-all category, covering
everything from private equity to hedge funds. Some
have a stand alone natural resources weighting. For me
the closest parallel is with commercial real estate – both
are real assets that have a positive correlation with
inflation, generate cash and are not realisable overnight!
However, there are many differences that investors need
to be aware of that illustrate the benefits of having both
in a diversified portfolio.
Trees grow – One of the most unique aspects of
investing in forestry is that trees grow regardless of what
the economy or the FTSE100 are doing. The mild and
wet climate of the British Isles makes it one of the best
softwood conifer growing areas in the world. In an
average year, a Sitka Spruce (the main softwood timber
species grown in the UK) will add 4-5% of timber
volume. This ability to grow without the need to harvest
annually means that value can continue to compound “on
the stump” especially in years of weak product prices. In
contrast, while commercial real estate returns do not
correlate highly with the stock market, GDP growth and
job creation are undoubtedly key driving factors in the
demand profile for space.
David and Goliath. The UK has one of the lower
levels of forest cover in Europe at just 13%. With
roughly half owned by the state through the
Forestry Commission*, the value of the commercial
private sector resource is around £4bn. In contrast,
according to IPF, the value of UK commercial
property is £ 683bn, with roughly 60% of that being
“investable”. This gap is enormous, but it doesn’t
mean building scale in UK forestry is impossible.
In 2015 around £150m of forests changed hands in
the UK with additional turnover in farms for
conversion to forestry.
Both assets correlate positively with inflation but
to a limited degree with each other.
Commercial property and real assets both correlate
positively with inflation. Where the two differ is in
periods of economic weakness, where property has
more of a link to GDP and unemployment. There is
also a disconnect in asset specific periods of
investor disinterest – e.g. 2009 in property or the
late 1990s in forestry.
Restricted supply in both but forestry takes a much
longer time to come online. Going from virgin land to
having a functioning office block or shopping centre takes
several years but that is a blink of an eye compared to the
35-40 year cycle of planting a new forest and getting it to
the harvest stage. Even getting permission to plant a forest
today is taking around 2 years. The impact this has is a
much more visible domestic supply picture in forestry, that
is highly favourable to the grower. All the sawlogs that will
be available within the UK until well into the 2040s are
already growing and the FC’s projections for softwood
timber show a significant drop-off in availability from the
mid 2020s – at a time of growing demand.
Product price volatility. Timber is a commodity product
with all the price volatility that brings. In contrast, Property
is an investment where pricing is more about steady
compounding with occasional big chops in recession. This
contrast would often favour property, however, UK timber
price volatility risk is to the upside. Over the next 15 years,
UK timber supplies are forecast to peak and fall by over
one third in the following 20 years. At a time when
demand for wood products in construction and for biomass
is growing, this should put upwards pressure on UK timber
prices, which today are still only half what they were in the
late 1980s in real terms.
Regular and Irregular yields. At a time when low
interest rates have dragged down yields in bonds and
stocks, investors have turned to the higher and steady yield
offered by commercial property – the IPD All Property
Index initial yield currently stands at just under 5%.
Forests too offer a cash yield in the form of harvesting
income – it’s just more irregular and requires portfolio
management to be smoothed out on an average 35-40 year
cycle, felling is executed in 5 year phases.
The cash flow is lumpy and is dependent on timber prices.
However, having a spread of different aged forests (and
sometimes different qualities) can significantly smooth the
cash flows to the degree that we would argue a 2-4% annual
yield could be paid from UK forestry.
A premium for illiquidity in both! Higher risk should
equal higher return – it doesn’t always happen but the
theory is sound. One such risk is illiquidity which forestry
and commercial real estate share. All transactions are
individual, non screen based and subject to marketing and
legal processes that can take several months. However, that
backs up the common sense of an appropriate weighting
within a diversified portfolio and makes both assets suitable
for long term investors. Looking at total returns over the 5
years to the end of 2014, UK forestry and commercial
property have returned 21.0% and 10.9%respectively p.a.
against 7-8% for stocks and bonds. Over the longer 22 year
period since the creation of the IPD’s UK forestry index,
the two less liquid assets have returned 1.5-2.0% p.a. more
than stocks and bonds.
Conclusion
The benefits of timberland investments are also well known
in parts of the world such as the US. The UK forestry
market is smaller but the reasons to diversify a portion of
real estate or real asset allocations into this asset class are
sound, especially for UK investors. A well structured
forestry portfolio can add an uncorrelated, real asset that
delivers yield and inflation protection.
Richard Davidson
Fund Manager
Rupert Robinson
[email protected]
T. 020 3837 6270
E. [email protected]
W. www.greshamhouse.com