Forestry has the potential to become a megatrend

Every year, ca. 35 billion tonnes of carbon dioxide are emitted worldwide. Forests make a valuable contribution to neutralising these emissions. They are appreciated by investors not only because they retain their value, but also because of their ability to absorb carbon dioxide. Another characteristic that makes investing in forestry particularly interesting at the moment: its increase in value has continuously outstripped the rate of inflation for every ten-year period for the last 60 years.

Tying up capital for 10 to 15 years might seem a deterrent at first. In an environment of increased inflation, however, it pays off in the long run. However, the direct acquisition of forest land is not feasible for most investors, and an equity portfolio consisting of stocks from the wood processing or packaging industry offers too little risk dispersion for diversifying a portfolio.

For private as well as institutional investors, an investment in a globally diversified fund, which in turn acquires direct holdings, may be more feasible. Outsourcing forest management to experts reduces the risk of value losses from fire or pest damage. Where forest is managed as an investment, significantly less damage occurs than in public forests. Firebreaks and dedicated firefighting teams protect the value of the trees. Planting pest and drought-resistant species helps survival in periods of low rainfall.

"Forest as an asset class has a significantly better Sharpe ratio than the world's largest and most developed corporate market"

Financially, investors are rewarded with an attractive risk-return ratio. The American NCREIF Timberland Property Index is the benchmark for forest property performance used worldwide. Over thirty years, the index recorded an average annual increase in value of almost nine percent with an average fluctuation of also almost nine percent. In comparison, an investment in US equities yielded a return of 10.5 percent per year. The average fluctuation, however, was 17 percent annually. Forest as an asset class thus has a significantly better Sharpe ratio than the world's largest and most developed corporate market.

Comparison of Risk and Return between the NCREIF Timberland Property index and the Standard & Poor's 500 Index (30 years, 1992-2021)

Sources: Standard & Poor's NCREIF, United States Treasury
*The Sharpe ratio assumes a risk free rate of 2.29%, which is the rate of return of 3-month U.S. Treasury Bills from 1992-2021

The most important return factor of a forest portfolio is the biological growth of the trees. Growth rates in Latin America, Australasia and even the US are higher than in Europe, particularly Scandinavia. The potentially higher returns mean that to invest reasonably in forests, investors therefore need to take a global perspective.

However, a historical analysis of the returns from an investment in forestry provides the most important insight: the increase in value of American forest land has always exceeded inflation over the same period in every decade since 1960. In each case, inflation has been outpaced by 2.5 per cent or more. This effect was particularly pronounced in the 1980s, i.e. at a time when central banks were fighting high inflation rates with hefty interest rate hikes.

"The path to a net-zero economy literally leads to the forest"

Institutional investors are concerned with another issue: financial investments should be targeted towards projects that have a positive impact on the environment. There are four billion hectares of forest on earth, which significantly improves the planet's greenhouse gas balance. It is estimated that forests sequester one third of the carbon dioxide released by burning fossil fuels every year. The path to a net-zero economy therefore literally leads to the forest. Targeted reforestation and the planting of fast growing species in the warm, high-precipitation regions of New Zealand, Australia or Latin America will have a great effect. The potential risks of other jurisdictions can be mitigated by a fund structure that is compliant in the home market.

Commercially managed forests are currently worth between 300 and 400 billion dollars globally. Of this, about 100 billion is owned by institutional investors, the rest by forestry companies, private individuals as well as municipalities. This valuation does not yet take into account the new opportunities for forest owners to receive carbon certificates for the amount of carbon absorbed. The trading of such certificates adds a new component to the return opportunities of an investment in forests. The asset class could be worth up to a trillion dollars if carbon markets and prices continue to develop. The increase in current returns has a structural and a cyclical component. Global demand for wood is expected to increase by half of current consumption by 2050. Wood is a sought-after, ecological, building material. It is also used for packaging materials and in the textile industry.

In the long term, forests are of proven value that compensates for inflation. Trees grow independently of economic cycles, are resilient in recessions and their owners can delay harvesting if timber prices are unfavourable. Moreover, investing in forests actively helps to absorb carbon on a net basis. Next year, when companies have to report in more detail on their impact on the climate, this could give a dynamic boost to demand for assets that measurably reduce CO2. Even leaving this aspect aside, investors should seriously consider international investment opportunities in forests. The current market environment fulfils essential conditions for forestry investment to become a megatrend.

Sources: 

Forest Research Notes, Vol. 19, No. 2. Inflation and Timberland Returns – Update

Timberland Investment Resources Europe LLP. Investment Attributes

 

Interested to learn more? 

Evli's Roger Naylor: 4 reasons to invest in forestry

Impact forest investments: Seeing the carbon sink for the trees