1. 1 Chapter 12 The Role of Real Assets Portfolio Construction, Management, & Protection, 4e, Robert A. Strong Copyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

2. 2 Gold still represents the ultimate form of payment in the world. Alan Greenspan

3. 3 Outline u Introduction u Real Estate in General u Timberland in Particular u Real Estate Investment Trusts u Types of Real Estate Value u Gold

4. 4 Introduction u Most portfolio investments are financial assets, such as: Common stock Corporate bonds Bank certificates of deposit

5. 5 Introduction (cont’d) u 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. 6 Real Estate in General u Investment Characteristics u Developed and Undeveloped Property u Pension Fund Investment in Real Estate

7. 7 Investment Characteristics u Characteristics of land: Immobile –Land cannot be moved Indestructible –Land cannot be destroyed Nonfungible –Every plot of land is unique

8. 8 Investment Characteristics (cont’d) u 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. 9 Real Estate Categories ResidentialCommercialIndustrialFarmSpecial Purpose Owner occupied Office buildings Light manufacturing TimberlandCemeteries RentalStore properties Heavy manufacturing PasturelandChurches LoftsMiningRanchesGovernment properties TheatersOrchardsGolf courses GaragesFarmlandParks Hotels and motels Public bldgs. and streets

10. 10 Developed and Undeveloped Property u 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. 11 Developed and Undeveloped Property (cont’d) u 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

12. 12 Pension Fund Investment in Real Estate u U.S. pension funds have nearly $100 billion invested in real estate u 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. 13 Timberland in Particular u Introduction u Institutional Interest in Timberland u A Timberland Investment Primer

14. 14 Introduction u Timberland is a very viable investment form of real estate for large portfolios u The U.S. encompasses about 2.27 billion acres, of which about 20.9 percent are timberland

15. 15 Institutional Interest in Timberland u 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

16. 16 Institutional Interest in Timberland (cont’d) u 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

17. 17 A Timberland Investment Primer u Timberland as an Asset u Timberland Investors u Timberland Returns u Timberland Risks u Problem of Lack of Information u Timberland as a Portfolio Component u Future Prospects

18. 18 Timberland as an Asset u Timberland as Collateral u Timberland as a Strategic Investment u Timberland as a Pure Investment

19. 19 Timberland as Collateral u Loans are routinely secured with timberland by: Life insurance companies The Federal Land Bank

20. 20 Timberland as a Strategic Investment u 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. 21 Timberland as a Pure Investment u 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. 22 Timberland Investors u 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

23. 23 Timberland Ownership in the United States (thousand of acres) Owner Class195219702002 Federal103,124107,108147,278 State, County, and Municipal 27,21629,01037,559 Forest Industry, Farmer Owned, and Other Private 358,269363,576356,261 Total Timberland488,609499,697541,098 Total Forestland664,194753,549748,923 Source: Agricultural Statistics” 1956, 1976, 2004, United States Department of Agriculture, U.S. Government Printing Office.

24. 24 Timberland Returns u Timber grows on the land and is sold and renewed Growing timber is stumpage u 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. 25 Timberland Returns (cont’d) u 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. 26 Timberland Returns (cont’d) u 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. 27 Timberland Risks u Biological Risks u Economic Risks

28. 28 Biological Risks u Biological risk is the risk of loss due to natural events: Fire Insects Disease Productivity Wind

29. 29 Biological Risks (cont’d) u 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. 30 Economic Risks u Economic risks include: Quality Liquidity Demand Price Management practices Changes in the regulatory environment

31. 31 Economic Risks (cont’d) u Management risk means that poor management practices can erode the value of timberland u Liquidity risk exists because there is a relatively limited market for timber and timberland u Regulatory risk stems from statutes and ordinances that limit forest management and land use options

32. 32 Problem of Lack of Information u 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. 33 Problem of Lack of Information (cont’d) u 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

34. 34 Timberland as A Portfolio Component u Virtually all studies of timberland find very low or negative correlation between timberland and other investment alternatives

35. 35 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.

36. 36 Future Prospects u Introduction u Index Problems u Social Risk

37. 37 Introduction u An increasing number of portfolio managers may discover timberland as an investment: Asset allocation strategies are in vogue u Pension funds will probably continue to be the principal private investors

38. 38 Index Problems u 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

39. 39 Social Risk u The timber industry considers forestland to be a renewable resource u Many environmentalists do not consider forestland to be a renewable resource u The length of reforestation depends on the species

40. 40 Real Estate Investment Trusts u Introduction u Types of REITs

41. 41 Introduction u 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

42. 42 Introduction (cont’d) u 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

43. 43 Types of REITs u Equity REITs own and operate income- producing real estate Probably the most popular and common type u Mortgage REITs buy mortgages or lend money directly to property purchasers u Hybrid REITs own and operate properties as well as engage in the financing of property

44. 44 Types of Real Estate Value u 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)

45. 45 Types of Real Estate Value (cont’d) u 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”

46. 46 Types of Real Estate Value (cont’d) u Fee simple value is a measure of what a property would be worth if there were no leases encumbering it u Leased fee value is the value of the property given its existing leases u Leasehold value is basically the value of the lease

47. 47 Types of Real Estate Value (cont’d) u Investment value is the value of a property to a particular investor and may be more or less than market value u Assessed value is the basis on which the city levies property taxes

48. 48 Gold u Motivation for Gold Investment u Determinants of the Price of Gold u The London Fix u Investing in Gold

49. 49 Motivation for Gold Investment u 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

50. 50 Motivation for Gold Investment (cont’d) u 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

51. 51 Determinants of the Price of Gold u The strength of the U.S. dollar Influenced by trade balances and protectionism concerns u The strength of foreign currencies Stronger foreign currencies decrease the value of gold measured in the home currency for foreign investors

52. 52 Determinants of the Price of Gold (cont’d) u Inflation and rising oil prices An increase in the price of oil raises fears of inflation and an increased price for gold u International finance uncertainty Investors turn to gold as a result of mounting debt, third-world loans, etc.

53. 53 The London Fix u 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

54. 54 The London Fix (cont’d) u Gold prices also change in response to: Continuous exchange trading Economic news Political news

55. 55 Investing in Gold u Bullion u Gold Certificates u Shares in Mining Companies u Coins

56. 56 Bullion u Gold bars are bullion There are different sizes of gold bars (see next slide) u Investors can acquire smaller quantities of gold: 1-ounce bars Nuggets Gold dust

57. 57 Bullion (cont’d) Unit of WeightRegion Where UsedEquivalent Troy Ounces One Troy Ounce USA, UK, Australia— 100 GramsGlobally3.2151 10 TolaIndia, Pakistan, Middle East, Singapore 3.75 5 TaelHong Kong, Taiwan, China6.017 10 BahtThailand4.901 5 ChiVietnam0.603 10 DonsKorea1.206

58. 58 Bullion (cont’d) u Shortcomings of bullion: Subject to theft No income productivity Lack marketability

59. 59 Gold Certificates u 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 u Gold certificates have the risk that there is no gold backing them

60. 60 Shares in Mining Companies u 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 u Some mutual funds specialize in gold or other precious metals

61. 61 Shares in Mining Companies (cont’d) u Owning shares in mining companies or mutual funds has advantages: Shares are instantly marketable Shares can generate some income through dividends

62. 62 Coins u Gold coins are popular with investors and gold speculators u A coin’s intrinsic value is the higher of: Its bullion value Its fiat value –The value assigned by the issuing government

63. 63 Popular Coins for Investment American Eagles Australian Nugget Austrian Philharmonic Canadian Maple Leaf Mexican Peso South African Krugerrand