Stocks and bonds are the traditional investment choices for many institutional investors. But with equity markets now moving toward their previous peaks and fixed income yields near historic lows, institutional investors are returning to the land. Timberland and farmland (known as real assets—tangible assets with real intrinsic value) offer institutional investors some particular investment attributes:
- exposure to rising economic growth in the world’s emerging economies;
- lower volatility of return, on average, than other real assets such as real estate, energy and infrastructure;
- strong risk-adjusted total returns;
- a regular stream of cash yields;
- the capacity to improve the risk efficiency of a typical mixed asset portfolio dominated by stocks and bonds; and
- the ability to match the timing of the asset’s financial maturity with the duration and schedule of a pension plan’s liabilities.
An additional positive feature is their relatively high barriers to entry—a feature that limits competition from smaller investors and makes them particularly relevant for the institutional space.
Growing world demand
Strong economic growth in large emerging markets such as China, India and Brazil has resulted in a significant jump in global demand for agricultural commodities and timber products. And that increase in demand should continue over the long term. The United Nations (UN) estimates that the world’s current population of seven billion will rise to
9.2 billion by the year 2050, with most of this growth occurring in the developing world. The UN suggests the population of India will grow 33%, to 1.61 billion in 2050 from about 1.21 billion in 2010, while the population of sub-Saharan Africa will increase 103% to 1.75 billion from 0.86 billion over the same period.
According to the Food and Agriculture Organization’s World Agriculture Towards 2030/2050: The 2012 Revision, income per capita is also forecast to grow by 2050, particularly in developing countries where large rural populations will migrate to urban areas to improve their standard of living. Urbanization and income growth in the developing world will continue to increase the demand for processed foods and livestock products. Higher-protein diets require more resources to produce compared with traditional diets. For example, the United States Department of Agriculture reports that it takes two to five times as much grain to produce a pound of meat than to provide comparable nutrition by eating grain directly. Farmland investments, therefore, provide institutional investors with direct exposure to this growth opportunity in food production.
The growth in demand for timber in the emerging economies occurs across a wide range of sectors, including construction, furniture, flooring, paper, packaging and tissue. Global timber demand is also driven by the increased use of wood as a renewable alternative to fossil fuels in the production of heat and electrical power. Growth in global timber demand is led by continued development in the economies of Asia, Latin America and Africa. In addition, global timber demand in the coming decade will be supported by a recovery to levels of construction activity (both residential and commercial) in North America and western Europe that match underlying demographic demand.
Meeting this anticipated demand will require greater reliance on the world’s commercial plantation forests. The world’s native forests will be restricted in their ability to contribute to the need for industrial forest products, reflecting depleted inventories and increasing environmental restrictions. The percentage of industrial timber harvested from short-rotation managed plantation forests has been increasing, and it is estimated to represent almost half of the global industrial timber harvest, according to FAO’s 2012 State of the World Forests. This provides extensive opportunities for timberland investors.
Correlation with inflation
Actions taken to respond to the ongoing global economic downturn and stimulate economic growth have raised the possibility of resurgence in inflationary pressures. Aggressive fiscal policy has produced increased levels of public
debt, which, coupled with excessively accommodative monetary policy, could ignite an inflationary cycle. Under such a scenario, holding farmland and timberland has a strong appeal.
Inflation does not cause timberland and farmland returns to increase or decrease. Rather, the price of food rises during inflationary periods. Farmland investors reap the benefits both in increased income but also in gains in farmland value as farmers bid expectation of higher food prices tomorrow into the price of farmland today. The U.S. Department of Agriculture has a long history of farmland prices and incomes to observe this positive relationship.
The inherent nature of timberland and farmland values to move with rising inflation has many investors taking a closer look. Farmland generates income from the production of food and fibre products. Timberland strategically supplies growing economies that demand paper and forest products. These products from the land are responsive to inflation and are credible hedges against unanticipated inflation. Both farmland and timberland have historically generated sufficient returns regardless of the intensity of the inflationary environment. Therefore, both timberland and farmland investments should be particularly appealing to institutional investors concerned with preservation of longer-term wealth.
Low correlation
Real asset returns typically do not move in lockstep with returns of traditional asset classes such as equities and fixed income (see chart, page 40). Using the long history of performance available in the U.S. as an example, farmland returns exhibit a negative correlation with returns from the S&P 500 Index, the U.S. 30-day T-bill and the U.S. 10-year T-bond. Farmland has shown to have low to negative correlation with the GS Commodity Index. U.S. timberland returns exhibit a negative correlation with returns from the U.S. 30-day T-bill and the U.S. 10-year T-bond, and no correlation with the S&P 500 Index.
As farmland and timberland show low correlation with financial assets, adding timberland and farmland to a well-diversified portfolio can help enhance returns and reduce risk by mitigating the impact of financial market volatility.
Desirable investment length
A key goal for plan sponsors is to align the duration of a portfolio with its liabilities—in general, strive to mitigate the risk of pension plan assets being insufficient to meet the plan’s obligations. For many plans, this means gradually increasing allocations to long-duration fixed income securities. If bond yields should decrease, for example, resulting in increased liability values, a plan needs to offset the imbalance by having corresponding increases in asset values. With assets typical of long lives and predictable long-term income flows, timberland and farmland have duration characteristics that can be a good match for long-dated liabilities.
Timberland is a long-term investment vehicle with long-tailed cash flows from timber harvesting. Farmland, with proper management, has an infinite productive life. Both assets can provide institutional investors with steady income returns. In fact, the income landowners receive from leasing farmland to tenant operators, for example, is similar to the interest payment investors receive from a fixed income product. Instead of clipping a coupon, however, farmland investors receive rental income from row crop assets such as corn, soybeans, cotton, rice, vegetables and wheat. For this reason, some institutional investors view farmland as a replacement for fixed income and manage their farmland allocation within their fixed income portfolio. Farmland and timberland investments have a growing history of being valued by institutional investors for appropriate long-term liability-matching needs.
Growing investor demand
Direct investing in timberland and farmland is not new; both are fast-growing institutional asset classes. In the 16 years through 2011, portfolio investment in U.S. timberland grew at an annualized rate of 15% to US$35 billion. Farmland portfolio investment has also grown—21% a year in the five years through March 2012 to US$3.2 billion, according to growth in the NCREIF Farmland Index total market value.
Direct investment should not be confused with indirect investment. Indirect investment in farmland or timberland through a publicly listed company or one of the newer public funds has shown a weak link to private timberland or farmland and the benefits these direct investments offer. A direct investment in timberland or farmland is one that is held in private ownership in either a separate or commingled fund and typically requires substantial upfront costs and committed capital for the long time horizon. These barriers to entry are generally only accessible to institutional investors such as pension plans with the necessary large pools of available capital.
Investors are increasingly shifting their attention to real assets because of the uncertain outlook of traditional equity and fixed income investments. Timberland and farmland investments are particularly appealing because they provide exposure to rising economic growth in emerging market economies. They can also offer strong, risk-adjusted returns, including a regular income stream, while offering low correlation with financial assets to provide an attractive alternative investment option.
Mary Ellen Aronow is senior forest economist with Hancock Timber Resource Group, and Cody Dahl is senior agricultural economist with Hancock Agricultural Investment Group. Both are units of Hancock Natural Resource Group, a Manulife Asset Management company.