Ever consider buying trees to enhance your investment portfolio? Over the years, timber investments are gaining interest from both institutional and retail investors for their diversification and inflation hedging characteristics, and as a sound alternative to stocks and bonds. The relatively inefficient timber market is continually evolving, creating new opportunities for investors to allocate capital for both income and appreciation.

In addition, in 2008, the management of timberland is steadily moving from manufacturers of timber-related products to timber management organizations that have the technical and market knowledge to maximize yield, increase transparency and enhance investor return. If you haven't considered timber as an investment, this article will give you some reasons why you should, as well as a few simple ways to add this asset class to your portfolio. (Alternative Assets For Average Investors explains how investments in non-financial assets can help diversify your portfolio.)

Fundamental Market Change
Since the early 1990s, a fundamental change in the ownership of commercial timberlands has occurred. Major manufacturers of timber-related products have historically owned timberlands to ensure access to the supply of trees. Increasingly, these companies are divesting their tree stock, and the associated management and farming issues, by selling it to investors and management companies with the financial and forest management knowledge to maximize production. Manufacturers can ensure access to supply by entering into supply contracts with owners. These supply contracts are usually made at pre-negotiated prices, allowing manufacturers to hedge movements and volatility in timber prices.

Public and private pension funds funds, private equity investments in limited partnerships (LP), commingled funds and insurance company separate accounts have all invested in timberland. This trend is expected to accelerate as more of the available timberland transfers from forest products companies, increasing the number of investment products and making the market more liquid and efficient. These fundamental market changes are creating a more robust futures and derivatives market in timber and in ancillary investments, including those based on supply contracts. (For related reading, see Becoming Fluent In Options On Futures.)

The cash flow characteristics of timber are very similar to those of zero-coupon bonds in that investors must wait a number of years for the investment to "mature". The tree is planted and depending on the type - soft woods, such as pine, or hard wood, such as cherry oak or maple - it is harvested within 15 to 30 years, providing income and appreciation when it is sold. Portfolio managers provide diversification, manageable cash flows and dividends by buying tracts of land with differing harvest maturities. Because the trees are all planted at the same time in "stands", maturity diversification can be accomplished within a single investment. Due to the various uses of wood, investment managers can also choose to cut early if doing so provides financial opportunity. Unlike lumber products, products such as pulp wood for paper do not require mature trees. In periods where pulp prices are more favorable than lumber prices, lumber managers can take advantage by harvesting early and replanting. The differing uses of wood also allow investment managers to insulate investments from downturns in adversely affected markets. When housing starts are low due to problems in the real estate markets, for example, managers can sell more timber to paper companies or other forest product companies. The use of supply contracts helps investment managers hedge price movements when they predict future price volatility. These differing uses of timber at different points and prices on the maturity scale create a yield curve for the timber stock. Investors can follow strategies along the yield curve for lumber products to maximize return.

The continual transfer of timberlands into the hands of investors managed by Timber Investment Management Organizations (TIMOs) is providing increased opportunity for investors. These TIMOs employ experts in forestry management as well as research analysts and market experts who can design and execute the appropriate investment strategy.

Why Timber?
In addition to wealth-building opportunities created by market changes, there are a number of other reasons to consider adding timber to a portfolio. (For more, read Three Simple Steps To Building Wealth.)

  1. The demand for timber  is increasing.
    As of 2008, the demand for timber has been increasing as forest-related product development grows. Even paper recycling efforts have had little effect on demand, and according to the Society Of American Foresters, every American consumes a 100 ft. tree each year.
  2. Timber is an inflation hedge.
    Timber increases in value "on the stump" at a greater rate than inflation. According to legendary investor Jeremy Grantham, timber prices in the last century (~1905-2005) have also grown at a rate that is approximately 3% greater than inflation.
  3. Timber returns beat stocks.
    Measuring returns using the National Council of Real Estate Investment Fiduciaries (NCREIF) Timberland Index, timber investment returns exceeded those of the S&P 500 from 1990 through 2007. In that period of time, the NCREIF Timberland Index annual compounded return was 12.88% versus 10.54% for the S&P 500 index. This excess in return was also provided with less volatility as shown by the Sharpe ratios for the same period (1.06  for timber, versus .45 for the S&P 500), underscoring the risk/return benefits of timber over the overall stock market. (To learn more about this ratio, see Understanding The Sharpe Ratio.)
  4. Timber has low correlation to other asset classes.
    Commercial timberland prices are impacted by a different set of market and economic factors than other asset classes. Because prices are not affected by the same factors, timber returns are not correlated to returns of other asset classes, such as stocks, bonds and real estate. The addition of a low correlation timberland asset will increase the diversification of an investment portfolio. The NCREIF Timberland Index returns from 1990 through 2007 showed moderate to weak correlation against equity and fixed-income indexes and a negative correlation to real estate. (For more insight on asset class, read Diversification: It's All About (Asset) Class.)
  5. Investment in land as an appreciating asset. 
    Although the land necessary to grow timber stock can be leased, the majority of timber investors purchase the land. The land supply is limited and demand continues to grow as the population and commercial development expands. Depending on location, some property can be targeted as "higher and better use" land that can be sold to developers at a premium, providing additional appreciation benefits for timber owners.

    The collapse of markets that require timber as inputs looms as a potential risk. However, timberland is a natural warehouse where stock can be stored on the stump until markets and demand rebound. While natural disasters, such as unfavorable weather and fire can also reduce stock, even events such as the Mount St. Helens eruption in 1980 did not wipe out investors. Damaged stock was still valuable and was sold to lumber and paper companies, then replanted for future profit.
Investment Options
Retail investors have several ways to invest in timber. There is direct investment, LPs, exchange-traded funds (ETF) and equity in public timber companies.

Direct investment is probably too expensive for the average investor. Other alternatives are LPs and TIMOs, and these typically require a minimum investment of at least $1 million.

Timber ETFs are a relatively new, less expensive investment option. In November 2007, Claymore Securities announced the launch of the first U.S.-listed global timber ETF, the Claymore/Clear Global Timber Index ETF (PSE:CUT). CUT tracks the Clear Global Timber Index, which includes companies that own or manage forested land and harvest the timber for use and sale of wood-based products, such as lumber, pulp and paper products. Components must have at least a $300 million market capitalization and the index excludes any companies that do not own or manage forested land. Any component in the index cannot exceed 4.5% of the total index.

You can also investigate several timber stocks, including Deltic Timber Corp. (NYSE:DEL), Plum Creek Timber REIT (NYSE:PCL), Rayonier (NYSE:RYN) and a Canadian company, TimberWest Forest Corp. (TOR:TWF.UN).

Conclusion
One of the most compelling reasons for including timberland investment in any investment portfolio is the ability to enhance risk/return characteristics. In addition to being an excellent portfolio diversifier and inflation hedge, timberland makes a good investment because its returns are equal to or better than other asset classes.