The current economic climate, defined by low interest rates, volatile equity markets and poor short-term visibility, is leading Investors of all shapes and sizes to investigate alternative investment assets in an effort to boost portfolio performance whilst also reducing exposure to traditional assets like equities.
Forestry is one sector where investment returns are driven more by the biological growth of trees into valuable timber than traditional growth fundamentals. Forestry also provides a shelter for capital, and superior compound growth, even during falling markets.
Institutional Investors have led the charge into forestry investments with Pension Funds and Hedge Funds acquiring timberland properties as part of their diversification strategy. This has led to the emergence of a plethora of forestry investment products aimed at the retail Investor.
With options to acquire small forestry plots within large, managed plantations in Brazil, Costa Rica, Panama, Sri Lanka, Fiji, Thailand, Nicaragua, Australia and New Zealand, potential Investors could be forgiven for feeling confused, and the lack of quality information about the sector for Financial Advisors leads many to divert their Clients attention to other, more traditional investment assets like residential or commercial property, or even equities.
In this article we look into the main concerns regarding these retail forestry investments, and look to how risk can be properly assessed and mitigated.
The main issue regarding the vast majority of direct forestry investment products on the market is the basic structuring of the product. To avoid being classified as a collective investment scheme, many of the projects mean individual Investors purchase or lease a defined individual plot within a larger plantation, and having a notional choice of Forest Manager to look after the property and harvest / sell timber at the relevant point in the life cycle of the Forest.
Avoiding collective investment regulations means that Promoters can market and sell to any Investors freely, without the restrictions associated with collective investments which allow only certified sophisticated or high net worth individuals participate.
In reality, only two such schemes have been found to be operated in the way laid out in the marketing material, whereas the majority, it seems, do in fact manage the entire plantation as a whole, pool all plantation income and distribute to individual Investors based on their proportional ownership. Investors do not in fact receive income from their own, individual plot.
Whilst actually more secure (no physical risk to your individual plot), this structure managed in this way is quite simply a collective investment scheme. No commercial forest can be operated in any other way, fact. Most forestry investments therefore, should be collectives.
It is this collective management, combined with the fact that most of these investment opportunities are heavily front-loaded with profit for the Promoter and Project Developer that make for a huge counterparty risk. One such scheme in Brazil is selling a hectare of young teak trees (worth no more than $5,000 in the real estate market) to Investors for £100,000 on the basis that the timber sold will generate a profit.
Of course, investing in forestry is not a one-off capital investment; trees must be expertly managed over long periods of time and this requires capital. So the bulk of the invested capital is likely to be required to fund the on-going management of the trees and infrastructure. However only one company out of 9 assessed has been able to show that the majority of invested capital is ring-fenced for property management, in fact much of the revenue from Investors ends up in the salesmen’s pocket, earning up to 20 per cent of invested capital commissions. A different project identified in Brazil offered a 40% commission to interested Brokers!
Let’s look at the numbers and run a very basic feasibility study. One hectare of established teak will encompass circa 1,250 trees, with around 400 trees making it to year 25, at which point they will yield something like 1 cubic metre of commercially viable timber per tree. Teak timber trades at about $400 per cubic metre for processed wood and about $250 for logs, so one hectare will produce about $100,000 worth of logs to be sold at the farm gate, minus the cost of harvesting.
How then is an Investor paying the equivalent $155,000 for this hectare today supposed to make a profit if total revenue (excluding any residual revenue from intermittent thinning) is less than $100,000? Are investors reliant on timber prices increasing?
Well, if timber price were to increase at a rate of 6% per annum, then plantation income would jump up to $300,000 at harvest ($756 per log) in 25 years’ time, but factor in inflation at then current rate of 5% per annum and the income in real terms (inflation adjusted), falls back to $120,000. A 20 per cent return over 25 years equates to a simple annualised rate of less than 1%.
It is extremely likely that, once Investment eventually dries up as Investor appetite is satiated (as in the case of many similar failed Managed Investment Schemes in Australia), then the Project Developer has no economic incentive to continue, and there is no capital left to fund the continual management of the property.
At this point the Project Developer disappears and Investor are left with a few trees worth much less than they paid for them, with no way of accessing them or managing them, or even disposing of them. It is in fact most likely that the assets would be sold by receivers to recoup some capital and in that instance, Investors would get back only the real estate value of the property (remember the $5,000 per hectare).
In short, there is a huge economic incentive for Promoters to establish and sell such schemes as they make huge profits up front, but very little incentive to continue to operate them after the lion’s share of capital is invested (and syphoned off).
There is a huge risk that Investors could be left high and dry with notional ownership of assets worth nothing and no way to access them.
Although one or two good schemes do exist, the majority we have assessed have demonstrated nothing but the willingness of some ‘entrepreneurs’ to jump on the bandwagon and cash in on unsuspecting Investors.
For further information about direct forestry investments involving the acquisition of timber properties, including direct investments in UK forestry properties, please contact DGC Asset Management.
DGC Asset Management offer research, due diligence and opportunities to invest in real-assets in the agriculture, forestry and renewable energy sectors.
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