1

Chapter 14

The 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 CategoriesResidential Commercial Industrial Farm Special

Purpose

Owner occupied

Office buildings

Light manufacturing

Timberland Cemeteries

Rental Store properties

Heavy manufacturing

Pastureland Churches

Lofts Mining Ranches Government properties

Theaters Orchards Golf courses

Garages Farmland Parks

Hotels and motels

Public bldgs. and streets

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)Owner Class 1952 1970 1996

Federal 103,124 107,108 124,008

State, county, and municipal

27,216 29,010 36,177

Forest industry, farmer owned, and other private

358,269 363,576 357,840

Total timberland 488,609 499,697 518,025

Total forestland 664,194 753,549 746,798

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)Investment Correlation Coefficient

Timberland 1.00

Commercial real estate -0.11

S&P 500 index -0.29

Small cap equities -0.12

International equities -0.22

Treasury bills -0.02

Long-term corporate bonds -0.30

Inflation 0.37

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)Unit of Weight Region Where Used Equivalent Troy Ounces

One Troy Ounce

USA, UK, Australia --

100 Grams Globally 3.2151

10 Tola India, Pakistan, Middle East, Singapore

3.75

5 Tael Hong Kong, Taiwan, China 6.017

10 Baht Thailand 4.901

5 Chi Vietnam 0.603

10 Dons Korea 1.206

51

Bullion (cont’d) Shortcomings of bullion:

• Subject to theft

• No income productivity

• Lack marketability

52

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

53

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

54

Shares in Mining Companies (cont’d)

Owning shares in mining companies or mutual funds has advantages:• Shares are instantly marketable

• Shares can generate some income through dividends

55

Coins Gold coins are popular with investors and

speculators

A coin’s intrinsic value is the higher of:• Its bullion value• Its fiat value

– The value assigned by the issuing government

56

Popular Coins for Investment

American Eagles

Australian Nugget

Austrian Philharmonic

Canadian Maple Leaf

Mexican Peso

South African Krugerrand