Diversification Benefits of Timber and Farmland in an Investment Portfolio

Timberland and farmland have garnered significant attention in the investment arena as weary investors look for uncorrelated returns in a volatile market environment. Much of the focus on these investments has been due to their historical ability to generate stable yields and hedging benefits during inflationary periods.

In examining historical return profiles for both timber and farmland, we see that they have, on average, outperformed traditional equity, fixed income, and other alternative investments over multiple market cycles. Through their natural biological growth features, they have provided downside protection while retaining upside participation.

If an investor has the opportunity to invest in these asset classes, coordinated investments in these two natural resources have the potential of generating portfolio efficiencies and enhancing the risk-reducing diversification of the investor’s broader portfolio.

A simple comparison of performance reveals near zero correlation between farmland/timberland and traditional investments. How do they potentially fit into a long term investment strategy?

This article starts with an examination of the historical return distribution of both farmland and timberland to help us understand their underlying performance drivers. We use index-level data, somewhat generalizing these heterogeneous asset classes, but it nonetheless serves as a suitable proxy for analysis purposes as it replicates a diversified portfolio of timberland and/or farmland holdings.

Contents

• Timberland and Farmland Investment Basics
• Historical Performance of Timberland and Farmland Investments
• Are Timberland and Farmland Investments Correlated to Other Assets?
• Uncorrelated Risks of Timberland and Farmland Investments
• How Farmland and Timberland Work Together in a Real Assets Portfolio
• Final Thoughts

Timberland and Farmland Investment Basics

Timber and farmland fall under the umbrella of real assets, as opposed to straight financial investments. They comprise individual agricultural properties acquired in the private market for investment purposes.

The differentiating factors between the two are dependent on numerous factors, including the fertility of the land. For instance, some areas of the country are most suitable for seasonal crops and are therefore dedicated to farmland activities, whereas other locations offer a climate more suitable for tree growth and are thus classified as timberland. Clearly, the most direct means to invest in these specialty assets is through outright ownership of a timber or farm property.

It is common for a third party without an ownership stake to handle forest management on a timber property, which can entail such activities as sourcing potential properties, conducting due diligence, and managing both the timing and volume of harvests giving due regard to tax implications.

Implementation in farmland can become more complex, structured in terms of cash leases or crop share agreements between owners and farmers. For this piece, we focus on cash leases, which can offer relatively stable income to property owners.

Historical Performance of Timberland and Farmland Investments

The historical record of timber and farmland has been positive in our view. Analysis points to a stronger cyclicality in timber returns than farmland, as evidenced by the last 10 years of performance. Nevertheless, we find support for the oft-not potential inflation hedging benefit of both asset classes in their historical return streams (notably in timber returns). We expect this trend to continue, as any unexpected inflation should naturally also find its way into the returns of timber and farmland via the price appreciation of the underlying property.

When compared to the S&P 500 Total Return Index and the Bloomberg U.S. Aggregate Index, we find that, on average, returns for timber and farmland have historically fallen between those of stocks and bonds—but have been positive through all recent market cycles.

Past performance does not guarantee future results and there is no guarantee this trend will continue. Note: AcreTrader internal analysis covers periods 12/31/1990 - 12/31/2021. All returns are estimates and assume reinvestment of dividends. Index information is provided for illustrative purposes only and is not meant to represent the results of an actual investment. Returns do not include any management fees, transaction costs or expenses. Volatility is measured as the standard deviation using the monthly total returns of each index or asset class. The historical performance of each index cited is provided to illustrate historical market trends. Risk/reward profile for each asset class varies significantly. This should not be construed as a recommendation of any specific security. You cannot invest directly in an index. Calculated by AcreTrader using information from Bloomberg, Federal Reserve Bank of St. Louis, NCREIF and NYU Stern School of Business. "Farmland" = NCREIF Farmland Index. "Timberland" = NCREIF Timber Index. "S&P" = Standard & Poor 500 Index. Bloomberg US Aggregate is a broad-based fixed-income index. “Small Cap” = Ibbotson® SBBI® US Small-Cap Stocks. “US Corp Bonds” = Ibbotson® SBBI® US Long-term (20-Year) Corporate Bonds (Total Return).

We believe the performance profiles of farmland and timberland to be attributable in large part to the non-financial nature of these investments. The sources of return for timber and farmland are much different than the sources of return for stocks or bonds.

From the chart below, we can see the return distributions for farmland and timberland are unlike those of other assets. Timber and farmland returns are peaked and positively skewed, whereas other asset classes tend to have wider ranges of returns.

When we examine the profile, we see the bulk of the returns in timber and farmland have fallen between 2% and 4% per quarter, with occasional returns above and few below. We find more dispersion among private equity, real estate, and tangible assets, implying a higher likelihood of experiencing large swings in performance than in timber or farmland.

Are Timberland and Farmland Investments Correlated to Other Assets?

We find historically that timber and farmland have shown little correlation to traditional investments. Being non-financial in nature, the assets have a differentiated return profile than most common asset classes. In the case of timber, biological growth acts as the primary driver of return and takes shape in two ways: first, through the natural growth in volume (i.e., trees grow tall and wide over time) and second, through an increase in per-unit value as the tree matures (i.e., larger trees command higher market prices).

Cash leases, frequently 3 years in duration, are common on farmland investments and can offer a consistent income stream that is not subject to commodity prices or broader economic activity.

Being predominantly non-financial in nature, both timber and farmland returns are independent of some economic factors, and thus, have the potential to provide a diversification benefit when added to an investment portfolio through low correlations to traditional assets

Uncorrelated Risks of Timberland and Farmland Investments

It is crucial to note that these uncorrelated returns carry with them uncorrelated risk. Fire, drought, infestation, and other natural disasters all heighten tail risk in farm and timberland.

However, risks of this nature may be relevant to different properties at different times. For example, a hurricane may cause damage to an East Coast timber holding at the same time that a Midwestern farmland holding has a strong year due to heightened commodity prices as a result of geopolitical events. At the same time, timberland and farmland investments are not immune to more broad based risks like spikes in fuel prices, supply chain disruption, price volatility of fertilizer, and labor disruption.

This regional view of farm and timberland investments highlights the importance of diversification across crop type, region, and climate, among other factors.

In all cases, allocations to these asset classes should be made with prudence and sound judgment. Investors looking at timber and farmland should also be comfortable with the illiquid nature of these asset classes in return for an opportunity for potential stable, long term capital appreciation.

How Farmland and Timberland Work Together in a Real Assets Portfolio

Because timberland and farmland have varying stress points, including allocations to both asset classes within a portfolio can help hedge against risk.

A 2019 study by Hancock Natural Resource Group of Manulife Investment Management found that coordinated investments in timberland and farmland provide a lower risk profile for investors while still achieving steady cash flows versus single asset class investments for each.

This is because while each can provide stable benefits, markets associated with farmland and timberland are cyclical and occasionally disrupted. Therefore, multiple asset classes have historically provided diversity and stability alongside steady returns.

To illustrate the potential benefits of a coordinated investment across these two asset classes, we constructed a combined timber/farm portfolio based on historical return performance for these assets in the U.S using the National Council of Real Estate Investment Fiduciaries (NCREIF) Timberland and Farmland property indexes.

For the period 1991-2021, the risk-return profile of our combined 50/50 farm/timber portfolio compared favorably to pure farmland, pure timberland, and commercial real estate. The return for our combined portfolio falls between the individual returns for farmland and timberland, yet, importantly, it has a lower volatility than either of the two separate indexes. The standard deviation, a common measure of volatility, of the combined portfolio dropped down to 6.2% versus 8.7% for timberland and 6.5% for farmland.

Past performance does not guarantee future results and there is no guarantee this trend will continue. Index information is provided for illustrative purposes only and is not meant to represent the results of an actual investment. You cannot invest directly in an index. Data source: Calculated by AcreTrader using information from NCREIF. "Farmland" = NCREIF Farmland Index.

The returns for timberland and farmland have a correlation of 0.3 but should not be considered perfect substitutes for each other.

Final Thoughts

For qualified investors, allocations to timber and farmland can play an integral role within a diversified investment portfolio. We see benefits ranging from potential risk mitigation to return enhancement in both unique asset classes.

• The biological growth associated with timberland has historically produced returns that are independent of the typical business cycle and virtually uncorrelated with traditional investments.
• Investments in farmland have historically offered a steady income stream with the potential for capital appreciation.
• Together, these two asset classes may be able to help immunize a portfolio during periods of market stress while still offering the potential for growth during normal market environments.

Create a free account today to get started building your own real assets portfolio of timberland and farmland.

Past performance does not guarantee future results and there is no guarantee this trend will continue. Note: AcreTrader internal analysis covers periods 12/31/1990 - 12/31/2021. All returns are estimates and assume reinvestment of dividends. Index information is provided for illustrative purposes only and is not meant to represent the results of an actual investment. Returns do not include any management fees, transaction costs or expenses. Volatility is measured as the standard deviation using the monthly total returns of each index or asset class. The historical performance of each index cited is provided to illustrate historical market trends. Risk/reward profile for each asset class varies significantly. This should not be construed as a recommendation of any specific security. You cannot invest directly in an index. Data source: Calculated by AcreTrader using information from Bloomberg, Federal Reserve Bank of St. Louis, NCREIF and NYU Stern School of Business. "Farmland" = NCREIF Farmland Index. "Timberland" = NCREIF Timber Index. "S&P" = Standard & Poor 500 Index. Bloomberg US Aggregate is a broad-based fixed-income index. “Small Cap” = Ibbotson® SBBI® US Small-Cap Stocks. “US Corp Bonds” = Ibbotson® SBBI® US Long-term (20-Year) Corporate Bonds (Total Return).

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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