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Chapter 12

The Role of Real Assets

Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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Gold still represents the ultimate form of payment in the world.

Alan Greenspan

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Outline Introduction Real Estate in General Timberland in Particular Real Estate Investment Trusts Types of Real Estate Value Gold

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Introduction Most portfolio investments are financial

assets, such as:• Common stock

• Corporate bonds

• Bank certificates of deposit

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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

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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– Every plot of land is unique

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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

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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

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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 (cont’d) Undeveloped (raw) property has no

improvements• e.g., undeveloped lots

• Investors purchase undeveloped property:– To speculate– For timber, crop, or livestock production– 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 2.27 billion acres, of which about 20.9 percent are 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 or forest product companies

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Institutional Interest in Timberland (cont’d)

Examples of institutional interest:• Timberland investment management

organizations (TIMOs) managed about $14.4 billion in timberland near the end of 2004

• 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 company’s 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:• California Public Employees Retirement

System

• John Hancock Financial Services

• New Hampshire State Employees Retirement System

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Timberland Ownership in the United States (thousand of acres)

Owner Class 1952 1970 2002

Federal 103,124 107,108 147,278

State, County, and Municipal

27,216 29,010 37,559

Forest Industry, Farmer Owned, and Other Private

358,269 363,576 356,261

Total Timberland 488,609 499,697 541,098

Total Forestland 664,194 753,549 748,923

Source: Agricultural Statistics” 1956, 1976, 2004, United States Department of Agriculture, U.S. Government Printing Office.

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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 (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

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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

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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 (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

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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 (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

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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 (cont’d)

Examples of timber indexes:• Wachovia’s Timberland Performance Index

(TPI)• The Warnell School’s Timber Mart South• 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

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Timberland Correlation

Coefficients (1960–2002)

0.39Inflation

–0.32Long-term corporate bonds

0.04Treasury bills

–0.14International equities

–0.10Small cap equities

–0.17S&P 500 index

–0.08Commercial real estate

1.00Timberland

Correlation CoefficientInvestment

Source: Data from Hancock Timber Resource Group. “Timberland as a Portfolio Diversifier,” Research Notes, 2003.

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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

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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Real Estate Investment Trusts Introduction Types of REITs

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Introduction A real estate investment trust is a

convenient means of investing in a portfolio of real estate properties• It is essentially a closed-end investment

company including real estate• It usually owns and operates a variety of forms

of income-producing real estate

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Introduction (cont’d) As long as a REIT distributes at least 90

percent of its taxable income to its shareholders, the firm is able to deduct the dividends from its corporate taxable income• Most REITs distribute all their income and pay

no federal taxes

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Types of REITs Equity REITs own and operate income-

producing real estate• Probably the most popular and common type

Mortgage REITs buy mortgages or lend money directly to property purchasers

Hybrid REITs own and operate properties as well as engage in the financing of property

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Types of Real Estate Value Investment real estate is sometimes

described as a bond with inflation-protected principal and a coupon that:• Might be zero (zero coupon)• May be a constant monthly rent (fixed coupon)• May be adjusted periodically according to the

prevailing prime interest rate (variable coupon)

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Types of Real Estate Value (cont’d)

Market value is “the most probable price which a property would bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller acting prudently, knowledgeably and assuming the price is not affected by undue stimulus”

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Types of Real Estate Value (cont’d)

Fee simple value is a measure of what a property would be worth if there were no leases encumbering it

Leased fee value is the value of the property given its existing leases

Leasehold value is basically the value of the lease

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Types of Real Estate Value (cont’d)

Investment value is the value of a property to a particular investor and may be more or less than market value

Assessed value is the basis on which the city levies property taxes

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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 (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 –0.04

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Determinants of the Price of Gold

The 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 (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.

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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 10:30

a.m. and 3:00 p.m. London time

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The London Fix (cont’d) 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 (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

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Bullion (cont’d) 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 (cont’d)

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

gold speculators

A coin’s 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

American Eagles

Australian Nugget

Austrian Philharmonic

Canadian Maple Leaf

Mexican Peso

South African Krugerrand