Chapter 13 The Role of Real Assets Portfolio Construction, Management, & Protection, 5e, Robert A. Strong Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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

Introduction 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 Most portfolio investments are real assets Stocks Bonds Bank certificates of deposit

Real Estate Investment Characteristics Immobile Land cannot be moved Indestructible Land cannot be destroyed Nonfungible Every plot of land is unique

Real Estate 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

Real Estate Categories Residential 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

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

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

Pension Fund Investment in Real Estate U.S. pension funds have over $170 billion invested in real estate Office buildings (33%) and malls (30%) account for most of pension funds’ allocation to real estate Real estate investment trusts (REITs) are popular and convenient to purchase real estate Ownership, and cost, is divided into many shares

Timberland 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

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

Institutional Interest in Timberland (cont’d) Examples of institutional interest: In 2001, Harvard Management put 6 percent of its portfolio into timberland In 2008, California Teachers’ Retirement System increased its real estate percentage to 10 percent, or $17.4 billion Timberland investment management organizations (TIMOs) managed about $16 billion in timberland near the end of 2006

Portfolio Aspects of Timberland Loans are routinely secured with timberland by life insurance companies 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

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

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

Timberland Ownership in the United States (thousands 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.

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

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

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

Biological & Productivity Risks Biological risk is the risk of loss due to natural events: Fire Insects Disease Wind Productivity risk refers to the possibility that a stand of timber will not produce the anticipated volume of wood due to: Species competition Drought

Economic Risks Price Demand Liquidity Management risk means that poor management practices can erode the value of timberland Liquidity risk relatively limited market for timber and timberland Regulatory risk statutes and ordinances limit forest management and land use options

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

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

Timberland as A Portfolio Component Virtually all studies of timberland find very low or negative correlation between timberland and other investment alternatives

Timberland Correlation Coefficients (1960–2002) 0.39 Inflation –0.32 Long-term corporate bonds 0.04 Treasury bills –0.14 International equities –0.10 Small cap equities –0.17 S&P 500 index –0.08 Commercial real estate 1.00 Timberland Correlation Coefficient Investment Source: Data from Hancock Timber Resource Group. “Timberland as a Portfolio Diversifier,” Research Notes, 2003.

Future Timberland Prospects 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

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

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

Real Estate Investment Trusts 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

REIT Distribution Rules 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

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

Types of Real Estate Value 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”

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

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

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

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

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

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.

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

Gold 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

Equivalent Troy Ounces Gold 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

Gold Bullion (cont’d) Shortcomings of bullion: Subject to theft No income productivity Lack marketability

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

Shares in Mining Companies Purchasing shares in mining companies is the most popular form of gold ownership in the U.S. South African mining companies Some mutual funds specialize in gold or other precious metals

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

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

Popular Coins for Investment American Eagles Australian Nugget Austrian Philharmonic Canadian Maple Leaf Mexican Peso South African Krugerrand