Cream of the crop

Timber and farmland investments are better able to withstand downturns and are stronger performers than traditional real estate. We investigate the reasons why more investors aren’t committing capital to these asset classes.

Whether part of a real estate allocation or the larger category of real assets, timber and agriculture have caught the eye of many public institutions. However, while a number of investors are taking a closer look, few have taken the plunge thus far. Indeed, industry insiders estimate that less than 25 percent of US public pension plans currently have 5 percent or more of their assets invested in timber and agriculture.

The case for investing in both timber and agriculture has grown more compelling, given current economic conditions. “We see demand growing as it relates to the global population growing and a growing middle class,” says Jose Minaya, head of natural resources and infrastructure investments at TIAA-CREF, which manages a forestry portfolio of more than $1.3 billion and owns more than 400 farms in the US, Australia, Brazil and Eastern Europe. “Yet, on the supply side, you’ve got finite resources, whether it’s agriculture or timber.”

Meanwhile, with interest rates at historic lows, many public institutions have been restructuring portfolios that have been heavily weighted to fixed-income investments – which are more sensitive to interest rate hikes – to stable assets that could better withstand a rising interest rate environment. Such assets include timber and agriculture, which tend to produce strong income that in turn protects valuations in a downturn.

Timber and farmland also have a lack of correlation to other asset classes. “While stock and fixed-income markets may fluctuate, timberland and farmland investments perform based on the value of the land and crops, as well as the constant underlying demand for food and wood products,” wrote Heather Davis, senior managing director of global private markets and Minaya’s colleague, in a recent paper on real assets. “People have to eat and they need the products that timber creates.”

The two asset classes – sometimes classified as subcategories within an investor’s real estate allocation – are similar to core real estate in that they are hard assets and derive the majority of their investment return from income, although each has distinct drivers. While real estate tends to be driven by employment levels, timber is more influenced by global GDP growth and farmland by population growth. Indeed, according to data from the National Council of Real Estate Investment Fiduciaries (NACREIF), the correlation between the NCREIF Property Index and farmland is 0.19 percent and -0.036 percent between property and timber.

Notably, forest and farmland investments generally have outperformed real estate. The NCREIF Farmland Index has returned 12.1 percent annually over the past 20 years and 11.6 percent since inception in the fourth quarter of 1990. The NCREIF Timberland Index has returned 8.88 percent annually over the past 20 years and 12.7 percent since inception in the fourth quarter of 1986. By comparison, NCREIF Property Index returns have averaged 8.95 percent over the past two decades and 9.10 percent since inception in the fourth quarter of 1977.

Supply constraints

Despite these benefits, many investors have yet to make a move into timber and agriculture. “Most investors who are thinking about timber and agriculture are often at the stage of ‘why’,” says Howard Kaplan, president of Farmvest, a Clayton,

California-based firm that advises institutional investors on both asset classes. “There’s really a lot more people that are looking and kicking the tires than there are actual investors.”

This isn’t for lack of interest. In the case of farmland, for example, more than $2 billion in investor capital currently is on the sidelines waiting to be invested, according to a September report from San Francisco-based consulting firm Callan Associates.

The opportunities “are pretty thin,” says Vince Smith, chief investment officer at the New Mexico State Investment Council (SIC), which manages the state’s $16.5 billion oil and gas endowment. “There’s so many of us with so much money seemingly chasing just a few assets.”

For starters, access to opportunities in both timber and agriculture is limited. The universe of investment managers in these two asset classes is small – Kaplan estimates about 25 managers in timber and roughly 40 in agriculture. Compounding that is the fact that even fewer firms have long track records.

Timber and farmland also are less mature asset classes than property. According to Minaya, agriculture as an institutional asset class is at the stage of development where real estate was 40 to 50 years ago, while timber is about 15 to 20 years ahead of farmland.

Other obstacles

The general lack of familiarity among pension plan boards and committees with timber and agriculture as asset classes has been another impediment. “Whenever you want to do something new, you need to educate your board on the subject before you ask them to take action,” observes Mark Canavan, senior portfolio manager of real assets at the New Mexico Educational Retirement Board (ERB).

Canavan recalls how his first recommendation for an agriculture investment in 2009 was shot down during an investment committee meeting. “I fault myself for not holding educational sessions providing a foundation in the asset classes,” he says. “We have a bright board, but that doesn’t absolve investment staff from the responsibility to make sure their boards and committees are properly informed.”

ERB’s investment staff later worked to get the committee up-to-speed on farmland, the risks involved with investing and ways to mitigate risks, and the pension plan’s first farmland investment finally was approved in 2010. To date, ERB has committed $100 million to agriculture in the US and potentially may invest an additional $25 million to $50 million this year. It also has allocated $125 million to timber investments in the US and Brazil, including a $45 million commitment to Timber Investment Resources in April.

Another obstacle to making more investments in timber and agriculture has been the difficulty of finding investment professionals to focus on the asset classes. Shortly after establishing its new asset allocation policy, New Mexico SIC began an unsuccessful search for a real assets investment officer. While a lack of funds for adequate compensation was an issue, so too was the dearth of people with the desired experience and background. The endowment instead hired a less experienced professional for an analyst position and, having resolved the compensation issue, now plans to resume its search for a more senior investment officer.

New Mexico SIC has targeted timberland to comprise 30 percent of its real assets portfolio, with the remainder divided roughly equally between energy and infrastructure. The endowment made its first investment in timber last October, committing $100 million to Brookfield Asset Management’s $750 million Brookfield Timberland Fund V and plans to make a new timber commitment with the Hancock Timber Resource Group this year.

New Mexico SIC also is considering opportunities in agriculture, although prices for farmland in the US have appreciated considerably in tandem with commodity prices. “We’re just not seeing the opportunities here in the US to get us very excited, but we do see things overseas that could,” says Smith. The endowment does not have a specific allocation for farmland, but it likely would use an equal portion of capital from its timber and infrastructure allocations to fund any potential investments.

Not for every investor

Partly because of the challenges in sourcing opportunities, timber and agriculture aren’t appropriate for the short-term investor. “It’s very difficult to buy high-quality assets because people who have them don’t want to sell,” says Kaplan. “It takes patience to assemble a quality portfolio.” Indeed, most funds in the two asset classes typically have three- to five-year investment periods and seven- to 13-year holds, if not longer.

“Farmland is a long-term, illiquid asset class,” wrote Jamie Shen, practice leader of alternative investments consulting at Callan, in a September report. “It probably is not the right asset class for investors who are looking to judge returns over the next one to three years; it will take that long just to build a portfolio.”

The Second Swedish National Pension Fund, known simply as AP2, began considering timber and agriculture investments as part of a diversification drive that was initiated in 2008. Part of the appeal of those asset classes, as the pension plan highlighted at the time, was the long-term holds of such investments.

“We are looking for investments that are much more long-term and cash-flow oriented than other investment vehicles out there that are a bit more private equity-like,” says Tomas Franzén, chief investment strategist at AP2, which began investing in timber and agriculture two-and-a-half years ago and today has amassed a portfolio of approximately $400 million.

Last year, for example, the Swedish pension – along with British Columbia Investment Management and the Caisse de dépôt et placement du Québec – were among the institutions that invested with TIAA-CREF in TIAA-CREF Global Agriculture, an entity that raised $2 billion in capital commitments to invest in farmland in the US, Australia and Brazil. That entity has a 20- to 30-year investment horizon.

Timber and farmland are included within AP2’s 10 percent real estate allocation, a limit that Franzén says the pension plan is rapidly approaching. As a result, the pension may consider increasing its overall real estate allocation in the fall, potentially by an additional five percent.

Franzén anticipates that AP2’s current 1.5 percent allocation to forest and agriculture will grow in the future and be funded partly through the sale of public equities. That said, he expects “there will be scarcer opportunities overall in alternative real estate markets like timber and agriculture than traditional real estate.” One critical issue with putting capital to the former asset classes is the social, environmental and governance impacts of such investments. “That hasn’t necessarily restricted opportunities greatly, but I would assume that it will reduce opportunities somewhat,” he says.

Risks and mitigation

Private market investments in timber and agriculture are subject to a multitude of risks, such as property value fluctuations and volatility in commodity prices. Additionally, the markets lack transparency, particularly with farmland, where the vast majority of properties still are held by private owners rather than institutional investors.

Timber and agriculture investments also can involve putting capital into emerging markets such as Brazil, which has a climate that is conducive to both forests and farmland. The downside of emerging markets, however, is the lack of adequate infrastructure to support the transport of goods to market, as well as the higher political and financial risks.

Kaplan points out that, while more developed markets like the US have a more established infrastructure to support timber and agriculture, that too comes at a cost. “You pay up for it because it’s mature,” he says. “If you invest in Brazil, where the infrastructure still is being developed, you’re in much more of a growth situation than a mature situation.”

Investors, however, have ways of mitigating the risks relating to both timber and agriculture. The advantage to timber is that the owner can simply choose not to harvest, which makes the trees become more valuable every year. “You can store value in timberland, even though the price is subject to cyclicality,” says Smith. And while farmland prices rise and fall with commodity prices, underlying agriculture demand continues to grow.

Moreover, in the case of farmland, investment managers typically buy the land and then lease the properties out to farmers. Investors therefore earn stable income from the farmers’ rent payments and also are protected from the risks of operating the farms, including external factors such as weather and drought.

Diversification also is critical, both by geography and strategy. Canavan plans to consider more investments outside of the US, such as Australia and New Zealand. “With regards to the theme of global population growth, you want to be able to have your product closer to that population,” he says. He also plans to pursue more opportunities where New Mexico ERB will own and operate its own agriculture properties.

“I want to be involved in not just commodities, but have exposure to more of the value chain,” Canavan says.  While he acknowledges that such a strategy would likely require a “boatload of money” and may be viewed by some as taking on a greater amount of operational risk, he considers a more extensive involvement in the agriculture process as having a lower-risk profile because of the ability to exercise greater pricing power by bypassing large commodity buyers and selling directly to end users.

Growing opportunities

While the finite nature of natural resources like timber and agriculture remains a major challenge, it creates an opportunity for investors with long-term, sustainable objectives. “The supply curve is inelastic,” says Minaya. “As you try to respond to demand, it will take a considerable amount of time to shift the supply curve.” While improvements from an infrastructure and productivity standpoint will help to increase future supply, it won’t happen overnight, he adds.

Rising investor interest also is expected to help expand available investment opportunities. “As demand for investments picks up, the supply available to investors also picks up,” says Smith. “As more managers come into the space and act as a conduit, investors like us will be able to own more land.”

Smith notes that railroad companies and other large landowners historically held much of the timberland in the US on their balance sheets, but more properties became available for sale as institutional interest in these assets grew. “I think that same process will take place in the farmland space,” he says.

Smith is glad to see more of his peers moving into timber and farmland for the first time. “Public institutions really are doing themselves a favor by diversifying their portfolios in these areas,” he says. “Over and over again, I’ve seen people moving too slowly and moving too late into things that seem pretty clear we should be doing.”