Diversified Timber Investments as a Hedge Against Inflation

October 27, 2022
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Many investors in today's markets don’t remember the inflationary periods seen in the 1970s and the harm that inflation can do to an investment portfolio.

Portfolios of bonds lose value when inflation erodes the purchasing power of their fixed coupon payments. Stock investors can see their portfolios lose value over the short and medium term as dividend payments and capital appreciation fail to keep pace with inflation. Over the longer term, companies can pass inflationary costs on to investors.

Now, after decades of relatively low inflation, investors are beginning to wonder if the future holds higher levels of inflation. Many investors who have significant allocations to stocks and bonds may find their portfolios exposed to the impact of inflation if we are unable to reign in its current path.

In addition to their attractiveness as a low-volatility investment with consistent strong returns, historical evidence suggests that timberland investments can be a good hedge against these inflationary pressures.

Asset pricing theory suggests investors prefer a portfolio with returns that are insensitive to departures from inflation expectations. In other words, investors want equilibrium in their portfolios. And timberland is one asset that has helped investors find that equilibrium in the past.

Timber’s Historical Resiliency in Inflationary Conditions

Even if inflation protection isn’t an investor’s top priority, a dedicated allocation to “real return” assets will benefit their diversification strategy. Unlike many financial assets, timberland is often portrayed as a hedge against unanticipated inflation*, and the relationship between the two—namely, historically strong-risk adjusted returns—is used as evidence.

First, historical data shows that timber demand and pricing have tracked and benefited from inflation.

Correlation of Inflation with Common Asset Classes 1960-2021

Source: Ibbotson Associates, NCREIF. Data as of September 2022.

The chart above shows that the correlation coefficient** for inflation and timberland has been positive during the time period 1960-2021.

Since both timberland returns and inflation are generally positive, they are likely to be correlated in the same way when we calculate a correlation coefficient on two positive sets of data that would generate a positive correlation coefficient.

Beyond Correlation Coefficient as a Measure of Inflation Resistance

If we are to use the correlation coefficient as a base indicator of an asset's ability to hedge against inflation, we could conclude that timberland is a better inflation hedge than most other assets in our analysis. As demonstrated by the above chart, only treasury bills have been more strongly correlated.

Yet, if investors are looking for investments that provide protection from inflation (i.e., capital preservation), the correlation coefficient may not tell the entire story behind an asset’s ability to preserve capital or provide returns that are protected from, or are greater than, inflation.

timberland returns and inflation over 10 year investment periods

Source: Ibbotson SBBI, NCREIF. Data reflects the period 1960-2021.

Since 1960, timberland investment returns have exceeded inflation over 10-year investment periods. However, as can be seen in the chart below, U.S. T-bill returns have not. In fact, from the 1967-1975 investment period to the 1974-1983 investment period, T-bill returns were less than inflation, despite their correlation with inflation being well over 0.8.

U.S. T-Bills and Inflation: 10 Year Investment Periods

Source: Ibbotson SBBI, NCREIF

T-bill returns also fell below inflation for the 2000-2009 and 2012-2021 periods. What this demonstrates is that a strong correlation with inflation does not guarantee that an asset will maintain its value against inflation.

What Makes Timberland Inflation-Resistant?

Two primary characteristics contribute to timber’s resiliency:

  1. Continuous, positive contribution of biological growth: No matter what’s going on in the economy, trees are growing in both volume and potential uses. This growth is the source of their fundamental value.
  2. Inability to increase timber supply quickly: Most structural timber is grown in plantations over a 30-year cycle. The available timber being harvested today is driven by planting decisions made 30 years ago. By many measures, there is a fixed number of acres available for harvest at any given time.

Regional Diversification is Key

In his 2004 study, “Regional Diversification in Timberland,” Jack Lutz of Forest Research Group found that different timberland regions provided better returns over different time periods.

His conclusion was that a geographically diversified timberland portfolio was more likely to provide better returns over time than a timberland portfolio focused on a single region.

This also appears to be the case when inflation hedging is a key objective in a timberland investment strategy. The figure below shows that each investment region in the U.S. has been more strongly correlated with inflation over different time periods.

Correlation Coefficients for Timberland Returns and Inflation

Source: Ibbotson SBBI, NCREIF

Forest experts Court Washburn and Clark Binkley conducted a study similar to Lutz’s 25 years ago. Their paper “Do Forest Assets Hedge Inflation?” concluded that “forests in the West and South have been effective hedges against higher-than-anticipated inflation; northeast forests have been less effective hedges.”

Implications for the Timberland Investor

Forests in the Pacific Northwest, South, and Northeast can be combined with the investors’ financial assets that hedge lower-than-expected inflation to form a portfolio in which the portfolio value will be less sensitive to inflation surprises.

Investors with a long term investment plan may find inflation is their greatest threat. The goods and services we may wish to purchase will be priced in tomorrow’s dollars, not today’s. A rapid unanticipated inflation-reflation movement can dramatically impact bonds, and to a lesser extent, stocks.

Final Thoughts

Over the past 61 years, U.S timberland returns have historically led the U.S. Consumer Price Index by a year, and those returns were positively correlated with inflation. Returns for different regions have been correlated with inflation at different periods of time.

If individuals expect to invest in timberland as a hedge against inflation using the correlation coefficient, it is important to build a geographically diversified portfolio.

Timberland, with its market-independent characteristics, may be a potential solution for investors looking for long term stability and inflation resistance.

*Supplemental Information:

The most appropriate measure of an asset’s inflation hedging ability is the relationship between contemporaneous rates of real return for the asset and unanticipated inflation. This is because investors hedge to insure against unexpected conditions. An effective inflation hedge must therefore provide insurance against departures from an investor's inflation expectations. A measure that determines the degree to which two variables’ movements are associated. The correlation coefficient will vary from -1 to +1. A value of -1 indicates perfect negative correlation and a value of +1 indicates perfect positive correlation. Note: The information above is not intended as investment advice. Data referenced herein is through calendar year end 2021 and is sourced from Ibbotson SBBI and NCREIF, with additional calculations and analysis performed by AcreTrader.

The above content is not intended to be a comparison between products, but is intended for general, educational and informational purposes only. Any performance noted is historical and there is no guarantee any trends will continue. All investing involves risks, including the complete loss of principal. Diversification does not guarantee a profit or protect against loss in a declining market. It is important for each investor to review their investment objectives, risk tolerance, tax liability and liquidity needs before investing. Investment vehicles have differences in fee structure, risk factors and objectives. Investments are considered speculative, involve a high degree of risk and therefore are not suitable for all investors.

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