Multi asset investment has grown in popularity over the past decade. Pension funds, endowments and private clients are reducing their asset allocation to more conventional equities and bonds in favour of alternative investments such as property, private equity, hedge funds and infrastructure. Even excluding property, UK pension funds’ exposure to alternative assets now averages more than 9 per cent and this figure is rising. Historically the focus in the UK has been on private equity, hedge funds and infrastructure, but commercial forestry is slowly becoming more mainstream. It is a trend that is following the US where commercial forestry, or timber as it is more commonly known, is a significantly larger and more mature market.
Commercial forestry’s unique return characteristics have caught the attention of fund managers attempting to generate superior risk-adjusted performance. Over the 10 years to 31 December 2014, UK commercial forestry, as measured by the IPD Forestry index, has generated annualised returns of 18.8 per cent, with no years of negative returns. It has outperformed all other traditional and alternative asset classes. Furthermore, these returns have been achieved with an annual standard deviation of less than 10 per cent. Unsurprisingly, this kind of performance has piqued the interest of both institutional and private investors.
Performance has been driven by a combination of factors, including: the biological growth of the trees, the rising timber price, the increase in land values and the higher and better usage of land as an alternative energy source. Above all, forestry has certain unique return drivers: trees grow! Regardless of what GDP or the stock or bond markets are doing, trees will grow and the volume of the timber that is standing in the forest available for sale will increase every year. On a UK commercial softwood 35-40-year-cycle this equates to a 4 to 5 per cent annual volume growth rate. Not only is that more volume but the percentage of the tree in the more valuable large diameter cuts increases too as the tree expands.
While returns achieved from UK commercial forestry over the past decade are unlikely to be repeated over the next 10 years, we expect long-term annual nominal returns of circa 10 per cent based on predictable volume and value growth of the trees and anticipated modest appreciation in timber prices and land values. This positive outlook is shared by global investment management firm GMO Woolley, which forecasts that timber will outperform international large-cap equities by 3.2 per cent per annum in real terms over the next seven years.
Looking beyond the next decade, the supply demand dynamic for UK timber is also strong. The UK still imports more than 60 per cent of the timber that the country uses, fluctuating with FX rates. A shortfall in tree planting in the UK during the early 1990’s will create a shortage of timber supply from 2030 onwards. This coincides with the growing timber component within housing, the need for carbon neutral building materials and demand for biomass.
UK forestry returns are further enhanced by the compelling tax benefits. Income derived from selling timber is tax free and the increase in the value of the trees is exempt from capital gains tax. Furthermore, the whole investment is exempt from inheritance tax after two years of ownership. By way of example, the income tax relief means that a return of £5m from a forestry investment is equivalent to a return of £8.3m from an asset class where returns are subject to 40 per cent tax.
These returns and benefits have not gone unnoticed from some significant institutional investors but thus far, in the UK at least, the asset class hasn’t been accessible to all investors. This will change. With the attractive anticipated returns and accessibility it is an asset class that is becoming increasingly difficult to ignore.
Rupert Robinson is managing director at Gresham House Asset Management