Looking for an nontraditional way to diversify your traditional stock and fixed-income portfolio? If so, try thinking outside the typical realm of investable assets. Don’t know where to start? How about going against the “grain” and investing in timber?
Investing in timber can yield a number of benefits. The main draw of having timber in your portfolio is its low, long-term correlation to traditional investments such as stocks and bonds. Low correlation means the returns generated by timber investments are not connected to stock or bond returns. A low correlation results in improved diversification and decreased overall portfolio risk.
U.S. timberland investment performance is measured by the NCREIF Timberland Index, a composite of a large pool of individual private timber investment properties. Over the past 15 years, the NCREIF Timberland Index has averaged an annual 7 percent+ return while providing a low correlation to equities.
Timber is a commodity. Often a linkage exists between the commodity price and investment returns. Like any commodity, timber prices can fluctuate. If you’re forced to sell when prices are low, the return on your investment is likely to be relatively unfavorable.
On the plus side, since your investment is literally comprised of trees, it will continue to grow until you sell. In addition, the quality of wood increases as it matures, much like a good bottle of wine ages. That also increases the value of your investment. With a timber investment in your portfolio you can wait out periods when prices are less favorable, then harvest when prices become more attractive.
The most basic risk of growing trees for investment is Mother Nature. You don’t have to be an expert to understand that the value of your investment can decrease, sometimes sharply, if the trees are damaged or destroyed. Droughts, fires, and infestation are the enemies of timber investments. The professionals managing the investment need to create a growth/harvest plan that includes a blueprint for dealing with those risks.
Another issue is timber pricing. Prices may fluctuate based on the timber’s geographic location and the type of the trees grown. For the first quarter of 2019, a report by Forest Investment Associates found that demand for sawtimber increased in the south, where it is grown, while Pacific Northwest timber markets experienced price declines. Why? The markets in the Pacific Northwest were impacted by decreased Japanese and Chinese demand. As an investor, if you purchase land in just one region, it will be more difficult, if not impossible, to smooth out the impact from these types of movements.
Don’t Bark Up the Wrong Tree!
Time horizon and liquidity are two additional factors to consider before investing in timber. Because it takes years for trees to grow large enough to harvest, you can expect a long-time horizon (typically 10-15 years) and a low level of liquidity with your investment.
The illiquid nature of the investment has its own pros and cons. On one hand, you can expect to receive a premium to compensate for the lack of liquidity. On the other hand, it may take 15+ years before you receive the full benefit of your investment. And, if you are forced to liquidate your position prematurely, the penalties can be significant, potentially causing losses that negatively impact your portfolio.
What I have described above is considered a “direct” timber investment. In this scenario, an investment management company pools investor dollars to buy either the land on which the timber grows or the timber that is planted and harvested—or a combination of both. Direct timber investment correlates (slightly) with the broader economy. The housing market is a good example. An increase in housing means more demand for lumber, and vice versa. However, the stream of returns should be far different from traditional asset classes. Direct timber investments can require significant up-front capital and may be limited to only accredited investors or qualified purchasers.
Another option is to buy publicly traded companies that specialize in timber or ETFs that own such companies. While this option provides you with more liquidity and doesn’t require a lock-up period or significant up-front capital, it is more closely linked to the stock market. That can lead to more volatility than a direct investment in the land or trees. These effects may work against your original desire to add a less-correlated source of returns to your portfolio.
While the barriers to entry are high for a direct timber investment, this type of investment can provide compelling, long-term growth that is unrelated to traditional asset classes. When considering whether to invest in timber, keep two things in mind: the objective of a timber investment and its role in your portfolio’s diversification.