Farmland and Timberland – Comparison of these two Asset Classes

 Timberland and Farmland possess certain similarities as an asset class, but that there are many differences.  jw

Asset Class Battle: Timberland Vs. Farmland

Source: Seeking Alpha

by Jussi Askola

Jul. 19, 2016 3:03 PM ET

Summary

Timberland and farmland have both achieved historically very attractive risk adjusted returns and in many time periods even outperformed the broad equity markets.

Both asset classes provide great portfolio diversification and share many similar characteristics.

Farmland wins the contest according to my analysis.

You can easily gain exposure to the farmland and timberland asset classes by buying shares of REITs.

With interest rates at ridiculously low levels, the stock market trading at above average P/E multiples, I have recently been looking more and more for opportunities in the alternative investment market which seems to have assets trading at more reasonable valuations in many instances. Timberland and Farmland are both distinct asset classes sharing certain similarities but that also have many differences. During my research, I was looking for a comparison of both asset classes with the ambition of identifying the superior investment opportunity, but was not able to find a comparison online and hence decided to create one for my Seeking Alpha readers.

I will first note the similarities between both asset classes and their general investment characteristics which make them attractive assets as part of a diversified portfolio. Then I will compare both Timberland and Farmland and seek to identify the superior investment opportunity. Finally, I will present my conclusions and recommend an approach for investing in both asset classes.

Why you should add Farmland and/or Timberland to your portfolio:

High returns: Historically farmland and timberland have both achieved returns often surpassing the broad equity markets. According to the National Council of Real Estate Investment Fiduciaries (NCREIF) direct investing in US farmland has averaged annual returns of 16.92% during the time period between 2005 and 2014. Over longer time periods, the average annual returns of farmland were not that high but still often achieved double digit returns and over many time periods outperformed the S&P500. Timberland also performed particularly well with returns in excess of 10% between 1990 and 2011 according to the NCREIF.

Low risk: The interesting part is that the higher returns were achieved with relatively low volatility. After all, the supply of land is limited, the demand is growing and the product derived from farmland and timberland are necessities.

Low/negative correlation: Farmland and Timberland values do not fluctuate with the stock market, the bond market or even the real estate market. The diversification benefits are stronger than average and very appreciated during the occasional bear market.

Inflation protection: For the last 20 years, the NCREIF annual farmland and timberland indexes have had positive correlations with inflation. During inflationary periods, commodity prices tend to increase and so do the farmland and timberland values.

So both asset classes seem very attractive, but which is one is the best and why?

This is why I believe farmland is a better asset class than timberland for addition to a portfolio of traditional assets:

The long term fundamentals of farmland for future land value appreciation are stronger than timberland. The value of timberland is highly correlated with the housing industry, and building materials can be replaced with substitutes in case of high increases in wood prices. However, corn, soybeans or wheat can hardly be replaced and are indispensable. Simply put, farmland produce more of a vital necessity than timberland.

Farmland owners enjoy more stable cash flow than timberland owners. Farmland owners rent the land to a farmer (tenant) that often pays a consistent rent and accept the commodity price volatility risk. With timberland investment, there is no tenant and the owner has to wait for the right time to sell the commodity in case of large price fluctuations.

Expected demand growth for primary crops is stronger than for wood due to the rising incomes in the emerging economies that causes a change in people’s diet. As income increases, people’s diet tend to change as they increase their consumption of protein including beef, poultry, pork, dairy… As more livestock is needed to satisfy the increasing demand for protein, more feed grain especially corn and soybeans are required. The direct beneficiary of this change in diets are the US farmland owners who are able export their produce to the emerging countries including China.

The farmland universe is much larger than the timberland universe. It is an untapped market by institutional investors compared to timberland which is already a well represent asset class in institutions’ portfolios. Example: only a couple nano-cap REITs specialize in acquiring farmland, but multi billion dollar REITs exist in the timberland industry. Since institutional investors are less active in the farmland market, there are likely to be more opportunities to purchase farmland from unsophisticated farmers at discount prices to market value. The reason why institutional investors haven’t historically invested much in farmland is because it is difficult to find large parcels owned by one farmer to allocate their large amount of capital. The timberland industry is better suited for their scale.

Farmland is less exposed to the risk of fire than timberland. If one year’s farmland crop is bad because of weather or a natural disaster, next year’s crop is likely to be unaffected. However, if the trees of timberland go to waste, it will take many years to grow them back.

Farmland is less sensitive to the general economy than timberland. Eating habits will not drastically change in a recession, however construction activity can completely stop. In a recession the demand for wood might decline substantially and result in a severe drop in wood prices. The real correlation between timberland and the stock market would hence be positive as timberland rely on the strength of the economy. The diversification benefits of farmland would then be stronger than timberland.Conclusions and recommendationIn my last article: The Bull Thesis for Farmland, I explained that in my opinion the best approach to gain exposure to the farmland asset class is through the purchase of REITs. This also applies for Timberland for the same following reasons:

Whether you decide to invest in farmland or timberland, you are likely to achieve very attractive risk adjusted returns over the long run. Additionally, you will reduce the volatility of your portfolio thanks to the low/negative correlations and feel more comfortable during the occasional bear market. If I had to invest in only one, I would pick farmland, but nothing forbids you from investing in both. Also, keep in mind that there are certainly good counter arguments in favor of timberland. This comparison reflects only my personal view which might be subjective or incomplete.

REITs are able to mitigate the investment risk by being widely diversified.

An internally managed REIT possesses all the advantages of private partnership including professional management, but with less conflicts of interest and no management or incentive fee structure.

It is a liquid and cost efficient way of participating in the returns of a diversified portfolio of farmland or timberland assets with yearly dividend distributions and good long term capital appreciation potential. Shares can be sold anytime, in one click of mouth, and with only minimal transaction cost.

From a return performance perspective, it could also be argued that REITs have the capacity to achieve higher returns thanks to their access to a wider range of potential deals and a broader access to capital at a lower cost than most individual investor. The historical performance proves this statement as on average REITs have returned 14% yearly from 1975 to 2010.REITs clearly have an important edge over direct property investing and private partnerships. The underlying asset is identical, but REITs have the capacity to achieve potentially higher total net returns while reducing significantly the risk of the investors.     With mainstream asset classes trading at very high valuations, and the risk of a new recession, I believe that investors should seriously consider allocating a portion of their portfolio to real assets and especially farmland and/or timberland which will not only provide good long term returns but also great diversification benefits.