Chapter 14 The Role of Real Assets

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Chapter 14The Role of Real Assets
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• Though wisdom cannot be gotten for gold, still
  les can it be gotten without it.
• - Samuel Butler

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Outline

• Introduction
• Real estate in general
• Timberland in particular
• Gold

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Introduction

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

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Introduction (contd)

• Real assets
• Are assuming an increased role in some of the
  countrys 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

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Real Estate in General

• Investment characteristics
• Developed and undeveloped property
• Pension fund investment in real estate

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Investment Characteristics

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

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Investment Characteristics (contd)

• Characteristics of land (contd)
• 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

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Real Estate Categories
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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

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Developed and Undeveloped Property (contd)

• 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

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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)

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Timberland in Particular

• Introduction
• Institutional interest in timberland
• A timberland investment primer

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Introduction

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

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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

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Institutional Interest in Timberland (contd)

• 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

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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

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Timberland as An Asset

• Timberland as collateral
• Timberland as a strategic investment
• Timberland as a pure investment

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Timberland as Collateral

• Loans are routinely secured with timberland by
• Life insurance companies
• The Federal Land Bank

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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 companys cash flows

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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

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Timberland Investors

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

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Timberland Investors (contd)
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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

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Timberland Returns (contd)

• A timberland investors 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

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Timberland Returns (contd)

• A timberland investors return is a function of
  (contd)
• Market price
• Investors have substantial discretion in regard
  to time of harvest
• Price is influenced by the relative size of trees
  on the land

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Timberland Risks

• Biological risks
• Economic risks

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Biological Risks

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

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Biological Risks (contd)

• 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

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Economic Risks

• Economic risks include
• Quality
• Liquidity
• Demand
• Price
• Management practices
• Changes in the regulatory environment

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Economic Risks (contd)

• 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

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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

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Problem of Lack of Information (contd)

• Examples of timber indexes
• Wachovias Timberland Performance Index (TPI)
• The Warnell Schools Timber Mart South and Timber
  Mart North
• Log Lines
• National Council of Real Estate Investment
  Fiduciaries

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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

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Timberland Correlation
Coefficients (1960-2000)
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Risk and Return (1981-2000)
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Future Prospects

• Introduction
• Index problems
• Social risk

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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

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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

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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

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Gold

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

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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

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Motivation for Gold Investment (contd)

• 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
  Exchanges gold and silver index and the SP 500
  index since 1986 has been 0.14
• The relationship is tenuous

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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

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Determinants of the Price of Gold (contd)

• 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.

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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 1030
  a.m. and 300 p.m. London time

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The London Fix (contd)

• Gold prices also change in response to
• Continuous exchange trading
• Economic news
• Political news

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Investing in Gold

• Bullion
• Gold certificates
• Shares in mining companies
• Coins

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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

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Bullion (contd)
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Bullion (contd)

• Shortcomings of bullion
• Subject to theft
• No income productivity
• Lack marketability

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Gold Certificates

• Gold certificates are
• Obligations of the issuer to deliver gold upon
  demand
• Issued by banks
• Registered in your name
• Readily sold back to the dealer
• Gold certificates have the risk that there is no
  gold backing them

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Shares in Mining Companies

• Purchasing shares in mining companies is the most
  popular form of gold ownership in the U.S.
• E.g., Homestake Mining is the largest U.S.
  gold-mining company
• Some mutual funds specialize in gold or other
  precious metals

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Shares in Mining Companies (contd)

• Owning shares in mining companies or mutual funds
  has advantages
• Shares are instantly marketable
• Shares can generate some income through dividends

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Coins

• Gold coins are popular with investors and
  speculators
• A coins intrinsic value is the higher of
• Its bullion value
• Its fiat value
• The value assigned by the issuing government

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Popular Coins for Investment