| comments (2) in Forest Carbon, Forest Finance & Economics, Risk Management, Timberlands

Ode to Alternative Assets: Timberland Investments, Liquidity, and Inflation

Markets for alternative, specialized assets – like vintage water pistols, 101-year-old scotch, and drivable Corvairs – must overcome high “search costs” to match suitable, qualified buyers and sellers. The abilities to evaluate, value, and manage such assets comprise a Rubik’s cube of characteristics that winnows the list of candidates able to get a deal done. Consider the case of investable timberland.

When timberland goes on the market, it is generally accepted that the seller knows more about their forest than you do, in almost every situation. Current owners know the roads and local markets and fishing holes. They know where the bodies are buried, figuratively and literally.

Buyers, on the other hand, do have their hand to play. They know their situation, skill set, and ability to pay. Any given forest may serve an investment thesis or objective unavailable to or unexecutable by the current owner. [Just because you know what a 90-mile an hour fastball looks like doesn’t mean you can throw one.] For timberlands, value-added strategies could include development projects, forest carbon, budgets for better seedlings, or conservation programs.

The opacity of trading alternative assets such as timberland is part of what makes them attractive, inflation-hedging, and diversifying. The frictions associated with buying and selling alternative assets create an illiquid space from the overall high-volume liquid markets for stocks and bonds.

In 2021, private timberlands as tracked by NCREIF returned 9.17% while inflation climbed to 4.7% (and beyond) for the year. Investors entered 2021 expecting inflation of 2-2.5% and real returns for timberlands of 4-6% (6-8% nominal). Higher inflation worries investors because it can translate into increased discount rates, which erode the present value of future cashflows in their valuation models and portfolios.

Think about inflation as the domestic exchange rate. In international markets, we trade, for example, dollars for euros. At home, the domestic inflation-affected exchange rate refers to the exchange rate between domestic currency and domestic goods and services. When inflation changes, it gets harder to “read” the market. It reduces the reliability of price signals, which complicates planning and projecting cashflows. Rising inflation masks economic relationships.

I am as guilty as the next person of applying words like liquidity and diversifying and spicy as if they communicate clean, commonly understood concepts available to all. In practice, many assets are illiquid relative to cash, bonds, or public stocks. Cars and homes take weeks and months to buy or sell. For institutional investors, buying into or selling out of private companies or private equity funds require months or years. While we can view this illiquidity as a constraint that limits short-term options, we can also see it as a protective moat that better preserves value for knowledgeable owners.

Comments (2)

  1. Sam Radcliffe / Reply

    Brooks, thanks for the Corvair reference. I drove my Dad’s ’64, just as pictured in the Wikipedia link, only lemon yellow, pun intended . We were knowledgeable owners, but skeletons still popped up on a regular basis.

    My view is that you only need to diversify that portion of your portfolio that is destined to provide cash on a regular basis. For example, in a portfolio of stocks and timberland, when you need cash but the stock market is down, the diversification provided by timberland does you no good, because it is illiquid. So prospective timberland investors need to understand very well what they are trying to achieve. Many institutional investors make a decision to get into timberland, then hire an expert to execute. Seems backward to me.

    • Brooks Mendell / Reply

      Sam: thank you for taking the time to read and comment. My Mom’s first car was a Corvair and, as she tells it, the engine fell out at some point, so the experiences seem to align… 🙂 Also, I appreciate your view on diversification. One thing to add, perhaps, is the wealth preservation aspect of the diversification. To me, liquidity is largely a function of time horizon. If you’re never in a hurry, you “always” have some measure of liquidity. On the value side, if you have time, the timberland never goes to zero, as you always have the land. I recognize and acknowledge part of this is psychological, so finding comfort (and having feelings) may be insufficient for cold-blooded financial analysis, but my mind does go there… Hope you are doing well! You are missed. – BCM

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