Chapter 14 The Role of Real Assets

1. Chapter 14The Role of Real Assets

2. Though wisdom cannot be gotten for gold, still les can it be gotten without it. - Samuel Butler

3. Outline • Introduction • Real estate in general • Timberland in particular • Gold

4. Introduction • Most portfolio investments are financial assets, such as: • Common stock • Corporate bonds • Bank CDs

5. Introduction (cont’d) • Real assets: • Are assuming an increased role in some of the country’s largest pension funds and in private investor portfolios • Include timberland and gold • Do not have a corresponding liability unless one is created to finance the purchase of the real asset

6. Real Estate in General • Investment characteristics • Developed and undeveloped property • Pension fund investment in real estate

7. Investment Characteristics • Characteristics of land: • Immobile • Land cannot be moved • Indestructible • Land cannot be destroyed • Nonfungible • Ever plot of land is unique

8. Investment Characteristics (cont’d) • Characteristics of land (cont’d): • Land is typically a long-term investment • Especially for institutional timberland owners • Land can be a short-term investment • E.g., timberland may be used for development or the extraction of minerals

9. Real Estate Categories

10. Developed and Undeveloped Property • Developed property is land with improvements on it • E.g., shopping malls and apartment complexes • Purchased by investors for: • Income-producing characteristics • The tax advantage from depreciation of buildings

11. Developed and Undeveloped Property (cont’d) • Undeveloped (raw) property has no improvements • E.g., undeveloped lots • Investors purchase undeveloped property: • To speculate • For the production of subdivided lots for resale or development

12. Pension Fund Investment in Real Estate • U.S. pension funds have nearly $100 billion invested in real estate • In 2000, the average pension fund had about 20 percent of assets invested in real estate • Real estate investment can be convenient through a real estate investment trust (REIT)

13. Timberland in Particular • Introduction • Institutional interest in timberland • A timberland investment primer

14. Introduction • Timberland is a very viable investment form of real estate for large portfolios • The U.S. encompasses about 468 million acres of timberland

15. Institutional Interest in Timberland • Innovative forms of ownership in timberland have been developed: • Public limited partnerships • Closed-end investment companies in timberland • Securitized units of timberlands of forest product companies

16. Institutional Interest in Timberland (cont’d) • Examples of institutional interest: • Timberland investment management organizations (TIMOs) managed about $9 billion in timberland near the end of 2001 • In 2001, Harvard Management put 6 percent of its $18.3 billion portfolio into timberland

17. A Timberland Investment Primer • Timberland as an asset • Timberland investors • Timberland returns • Timberland risks • Problem of lack of information • Timberland as a portfolio component • Future prospects

18. Timberland as An Asset • Timberland as collateral • Timberland as a strategic investment • Timberland as a pure investment

19. Timberland as Collateral • Loans are routinely secured with timberland by: • Life insurance companies • The Federal Land Bank

20. Timberland as A Strategic Investment • Timberland serves as a strategic investment when owning it: • Helps ensure the long-term viability of a company or • Reduces the volatility of a company’s cash flows

21. Timberland as A Pure Investment • Portfolio managers hold timberland as a pure investment: • The property is held for its own investment merits • The property is not held as part of a strategic plan or to assist in project financing

22. Timberland Investors • The largest current owners of timberland for pure investment purposes are: • CALPERS • John Hancock Financial Services • New Hampshire State Employees Retirement System

23. Timberland Investors (cont’d)

24. Timberland Returns • Timber grows on the land and is sold and renewed • Growing timber is stumpage • The value of a stand of timber depends on: • The volume of wood on the acreage • The size and quality of the trees • The market price of the species of forest products

25. Timberland Returns (cont’d) • A timberland investor’s return is a function of: • The acquisition cost and selling price • Site productivity • The ability of a site to grow timber, depends on weather, soil conditions, etc. • Management competence • Silvicultural practices and management strategies can affect return

26. Timberland Returns (cont’d) • A timberland investor’s return is a function of (cont’d): • Market price • Investors have substantial discretion in regard to time of harvest • Price is influenced by the relative size of trees on the land

27. Timberland Risks • Biological risks • Economic risks

28. Biological Risks • Biological risk is the risk of loss due to natural events: • Fire • Insects • Disease • Productivity • Wind

29. Biological Risks (cont’d) • Productivity risk refers to the possibility that a stand of timber will not produce the anticipated volume of wood due to: • Species competition • Drought • Disease

30. Economic Risks • Economic risks include: • Quality • Liquidity • Demand • Price • Management practices • Changes in the regulatory environment

31. Economic Risks (cont’d) • Management risk means that poor management practices can erode the value of timberland • Liquidity risk exists because there is a relatively limited market for timber and timberland • Regulatory risk stems from statutes and ordinances that limit forest management and land use options

32. Problem of Lack of Information • Problems with constructing a standard timber index: • Must consider the growth in timber volume • Must consider the low volatility associated with land • Focusing on timber prices alone biases the return downward and biases volatility upward • Timberland is nonfungible

33. Problem of Lack of Information (cont’d) • Examples of timber indexes: • Wachovia’s Timberland Performance Index (TPI) • The Warnell School’s Timber Mart South and Timber Mart North • Log Lines • National Council of Real Estate Investment Fiduciaries

34. Timberland as A Portfolio Component • Virtually all studies of timberland find very low or negative correlation between timberland and other investment alternatives • Allows for substantial diversification benefits

35. Timberland Correlation Coefficients (1960-2000)

36. Risk and Return (1981-2000)

37. Future Prospects • Introduction • Index problems • Social risk

38. Introduction • An increasing number of portfolio managers may discover timberland as an investment: • Asset allocation strategies are in vogue • Timberland allows for substantial portfolio diversification • Pension funds will probably continue to be the principal private investors

39. Index Problems • The lack of a consistent timberland index is the single biggest barrier to increased investment by pension funds: • Continuous pricing by the market is difficult due to: • Lack of liquidity • Timberland is not an exchange-traded product • Regional variations • The appraisal-based nature of timberland

40. Social Risk • The timber industry considers forestland to be a renewable resource • Many environmentalists do not consider forestland to be a renewable resource • The length of reforestation depends on the species

41. Gold • Motivation for gold investment • Determinants of the price of gold • The London fix • Investing in gold

42. Motivation for Gold Investment • People often buy gold because of the security it is expected to provide during times of trouble • An insurance policy against inflation • Particularly pronounced in Europe • A currency without a country

43. Motivation for Gold Investment (cont’d) • Gold can be an attractive investment because: • Gold has demonstrated returns that are unrelated or even opposite to those of the stock market • The correlation between the Philadelphia Stock Exchange’s gold and silver index and the S&P 500 index since 1986 has been 0.14 • The relationship is tenuous

44. Determinants of the Price of Gold • Strength of the U.S. dollar • Influenced by trade balances and protectionism concerns • The strength of foreign currencies • Stronger foreign currencies decrease the value of gold measured in the home currency for foreign investors

45. Determinants of the Price of Gold (cont’d) • Inflation and rising oil prices • An increase in the price of oil raises fears of inflation and an increased price for gold • International finance uncertainty • Investors turn to gold as a result of mounting debt, third-world loans, etc.

46. The London Fix • The London fix is the price of gold that reflects the relative buy and sell orders that have been placed with member firms of the London Gold Market • The fix is determined twice each day at 10:30 a.m. and 3:00 p.m. London time

47. The London Fix (cont’d) • Gold prices also change in response to: • Continuous exchange trading • Economic news • Political news

48. Investing in Gold • Bullion • Gold certificates • Shares in mining companies • Coins

49. Bullion • Gold bars are bullion • There are different sizes of gold bars (see next slide) • Investors can acquire smaller quantities of gold: • 1-ounce bars • Nuggets • Gold dust

50. Bullion (cont’d)