By Klaus Biskup
Specialist knowledge is essential to maximizing timberland investment opportunities, and in particular, assessing the risks involved…
Over recent years timberland investments have gained interest across the financial markets from private investors to sovereign wealth funds, based on their reputation for possessing inflation hedging characteristics, their use in portfolio diversification, and for having outperformed almost every other asset class for decades.
But returns are just one side of the performance coin, on the other side is negative volatility, or risks. What should an investor know about specific risks involved when considering investing in timberland? Klaus Biskup, of forestry investment and asset management specialists EccoWood offers his thoughts on risk assessment and strategy planning.
The expert’s view: Klaus Biskup
Certain risks may already be inherent by comparison, as often the performance of timberland is compared to other asset classes through the NCREIF timberland index. But if you are, for example, considering investing in teak plantations, the performance of the NCREIF index doesn’t mean anything since it is not exposed to teak. Because trees need years to mature, some like to compare them to 15 – 30 year Zero Coupon Bonds, but this may not be very useful if you have the opportunity to buy a mature or semi-mature plantation, or to invest in a three year rotation biomass project, or into a timberland with many different ages of trees. Also the Sharpe Ratio of 1.06 to 0.45 compared to the S&P 500 may not indicate the whole truth since not all asset returns from your timberland may be normally distributed.
These general indicators describing the average project may attract the attention of the investor, but they can’t of course replace the obligation to assess any particular given investment opportunity. To do so a proper understanding of the general risks in timberland investments is crucial.
To begin with there should be an agreement about the definition of risk, or more specifically, what is at risk. Is it the risk of losing the invested amount? The risk of not reaching predetermined objectives? Or the risk of not realising the full potential of the investment opportunities?
For instance, a frequent temptation in timberland investments is to include land appreciation beyond general inflation due to a possible occurrence of rezoning and Higher & Better Use (HBU) in the calculation of returns. But risks you can’t mitigate, at least to a certain degree, should not exist within your strategy!
In general, risks can be avoided as in any other asset class by diversification. In timberland we can diversify by geography, currency, species and market segment. However, when investing in five or more very different subprojects, you should be careful about the costs of increasing complexity. The additional cost and risk of complexities of running five or more sub-projects tends to detract from the synergies achieved when just running three sub-projects simultaneously.
Inflation and exchange rates may create global windfall opportunities rather than risks in timberland investments: U.S.$ and Euro dominated revenues and the existence of floating or semi-floating exchange rates may curb in many cases the effect of inflation. In countries where in the long-run rising inflation could go along with currency appreciation such as China, India, or Brazil, restrictions of exportation and local market opportunities make you produce for the local market anyway.
Political risks, however, deserve special attention. Besides the general geopolitical risks when investing in any country such as war, expropriation, law enforcement issues, or corruption, there are particular political timberland risks – on both sides – in the country where the plantations are as well as in the countries where the sales markets are based. General semi-official country rankings tend to over-stress given risks for timberland investments. Timberland investments are often long-term projects offering opportunities in emerging markets, which are often volatile in political structure, but also subject – mostly by law – to stability guaranteeing customary and tribal boards. And most emerging markets do eventually emerge. In many cases political risk insurance through the MI GAS procedure of the World Bank is also available. Some countries are offering up to 30 years legal stability warranty agreements for your particular project – such as Colombia.
Sometimes local communities have neither statutory, through the government, nor customary rights, but are nevertheless used to exploiting forests or land in some way. The involvement of local communities and stakeholders should be checked before entering into any venture to avoid social risks. Participatory decision making and partnerships may however turn social risks into mutual benefits and opportunities. Apart from land rights issues, forestry licenses and forestry certifications are indispensable parts of any due diligence – without a certificate for sustainable wood production you might not be able to sell any of the timber you produce.
It is important to monitor the timber and forestry related legislative initiatives in the countries of production as well as in the sales markets. China for instance is the biggest pulp wood and timber importer in the world. But log and lumber imports depend on the political decision to create a lumber export industry. Simultaneously China has by far the largest wood plantation activities in the world and could become completely self sufficient by 2040 covering domestic as well as export demand. Some countries are seriously discussing export restrictions. Several countries – like Gabon and Indonesia – have introduced measures such as log export bans to promote their local lumber industry, while others have different rules according to the species. India has a wood export ban; Russia has announced it will raise export duties from 25 per cent up to 80 per cent – yet discussions to join the World Trade Organisation could require a reduction down to 5 per cent. This makes advice impossible when deciding whether to invest in export-oriented Russian timberland.
Various teak wood projects around the world rely on today’s biggest teak wood buyer in the world, India. But over the next 15 years the Indian government is encouraging huge teak reforestation projects that will – in the long run – reduce the Indian appetite for imports.
Brazil has recently introduced restrictions on foreign ownership of timberlands, other countries like Argentina are considering going in the same direction.
Politics has created a whole new segment of the forestry market – related to greenhouse gas reduction, and future political decisions may have greater influence still. What happens to forestry based carbon credits in 15 months time when the Kyoto protocol period ends, is still unknown. The woody biomass market is today mostly an EU driven market (reduction of GHG by 20 per cent by 20 per cent renewable energy in 2020). What happens in future U.S. legislative initiatives or in Japan after Fukushima might strongly influence the future chips and pellets price. The extension of FLEGT treaties and REDD + initiatives to protect natural forests will enhance the demand for plantation timber. But almost any political restriction in forestry also creates new opportunities. Natural or semi-natural forests are generally more risk prone than timber plantations. They often become subject to political debate about infrastructure and land use, rezoning may not only lead to HBU, but may eventually work in the opposite direction and lead to protected areas losing real estate value. Any scientific discoveries of synergy between flora and fauna can impede a planned forestry venture at any given time.
The selection of the sites and of the apt species requires not only edafo-climatic analysis and detailed knowledge of forestry geographics, but also operational knowledge to avoid for instance landslide and erosion prone areas. Insufficient infrastructure, expensive access and long distances may also determine the feasibility of a timber venture not just in areas like Siberia, central Congo or Bolivia but in other locations as well, so always investigate this. Also the questions of where to get huge quantities of seedlings have to be addressed, e.g. for a particular bamboo variety for a biomass project or improved cacao seedlings for a large agro-forestry project.
Any risk appraisal requires an understanding of market trends by species. In all but one market – the U.S. – the performance of timberland investments is not correlated to the general macro-economic picture. In the U.S. however – the biggest timber market in the world – the timber market is closely linked to the housing market. World demographics, emerging economies and the orientation towards renewables will guarantee high demand and rising prices for wood for decades to come.
It is already known that the world won’t have enough tropical wood, that cheap pulp wood will be in high demand by emerging economies, and cheap biomass wood will be in demand by developed countries. The evolution of expensive, precious hardwood, however, may not be predictable in the same way. Already the potential sustainable harvest volume is 35 to 40 per cent above the actual harvests and the stock keeps on growing. Additionally the market for these timbers are not used for long-term agreements with buyers, which is increasingly the case with the pulp and pellet market, which is even seen working with futures and options.
The calculations of revenues from timber projects based on very expensive species and very small niche markets – like Agar or Sandal wood – should mitigate the risk that you might not be the only one who picked that species and that a run into these niches or even the volume of your own project may dilute today’s price levels by over-supply. Some species may even be subject to the volatility of fashion.
Forecasts and projection
Timberland as an investment class is relatively new: to run timber plantations rather than natural or semi-natural forests means the outcome of a timber venture may sometimes not be known for decades. This can cause overestimations of the projections of tree growth, wood quality and price, and underestimations of the costs for lengthy operations and maintenance – creating the risk of regarding a project as too promising during the project development phase. General return expectations in timberland ventures started in 2010/11 are in IRR ´s 8 per cent in western Europe, 9 per cent in New Zealand, 10 per cent in the US, 11 per cent in eastern Europe, 12 per cent in Latin America, 17 per cent in Asia and 20 per cent in Africa. These figures are averages – and there are accurately calculated opportunities well above these averages – but these figures may serve as an indicator of when a certain proposal deserves closer assessment. These figures show also that “high” returns are relative, and indicate a certain correlation between high return and high continent – but not country – risk. Countries like Costa Rica, Uruguay, Togo, Ghana, Cameroon or Malaysia are not currently considered risky by timberland investors.
Poor project management
Without proper pruning and thinning you might harvest fire wood instead of expected veneer logs. Problems often begin with poor soil preparation and a poor quality of seedlings. Incorrect irrigation, insufficient fertilisation, overcrowding and disease monitoring and mitigation are equally important.
Sometimes the wrong harvest technology destroys what has been well maintained for years. A careful selection of the operating management should reduce risks. Because timber projects require less labour than agricultural projects, project managers tend to assign maintenance to fluctuating local staff underestimating the significance of focused and well-considered maintenance on the investment. To ensure that the motivation required to maintain a 20 year project doesn’t fade away the operating team should work on a success fee basis – perhaps with milestone incentives along the way.
Last and least, the risk of natural disasters has to be taken into consideration. When discussing wood, everybody thinks immediately of the threat of fire. But the risk of fire in the managed timber plantations globally is 0.02 per cent. There are countries, such as Australia, where the likelihood is higher, and there are areas in the world where nobody invests in timberland for this very reason. The risk of fire can even be reduced through prevention measures by the maintenance team; satellite based hot-spot detection, for example, can identify fires in early stages. Storms are actually a bigger threat to timberlands than fire, although very rare in plantations too. Even the eruption of the Mount St. Helens in 1980 damaged the stock, but still left valuable timber. The risk of natural catastrophes in an area is assessed by empirical data and bush fire or hurricane prone areas have to be excluded when developing a project. But sometimes it may not be very helpful to know that statistically every 400 years a disaster might occur. In some areas there aren’t records going far enough back to deliver statistically sufficient data, so all risk appraisal is based on observation and knowledge of past events alone. But climate change has already increased the frequency of fires, pests and thunderstorms, and may create risky areas that have historically never experienced such risks. Hence forecasts based on trends from the last 20 years may differ heavily from forecasts based on the last 200 years. Natural disasters are very rare but might also be extremely severe when they do occur. Risk mitigation means to eradicate gambling. But it may be that in the field of natural disaster there remains a slight element of gambling. For those who want to get rid or to reduce even this risk there is special timberland disaster insurance available.
For further information please visit: www.eccowood.com