Features and Investment Characteristics of Raw Land, Timberland, and Farmland

Natural resources are essential production inputs that play a crucial role in the economy and daily life. These resources can be categorized into three main types:

• Plants and animals are also known as soft commodities (grown over a period of time). For instance, cotton is a soft commodity that is used in the textile industry to produce clothing and other fabric-based goods.
• Energy and minerals are also referred to as hard commodities (those mined). An example of this would be crude oil, which is a vital resource in the energy sector and is used for heating, transportation, and the production of various goods.
• Metals and industrial goods are used in the manufacturing of goods and provision of services. For example, steel is an industrial good used in construction, automotive, and many other industries.

A significant portion of investments in natural resources are made directly in farmland, raw land with exploration and mining rights, and timberland.

Defining Land Investments

• Farmland: Comprises row crops (e.g., corn, wheat) and permanent crops (e.g., apples, grapes). It can also be used as pastureland for livestock.
• Timberland: Functions as both a factory and warehouse, allowing flexibility in harvesting based on market conditions.
• Raw land: Refers to undeveloped land that has not been improved. It is land that remains in its natural state and hasn’t been developed for any specific purpose.

Summary of Features and Investment Characteristics of Farmland, Timberland, and Raw Land

$$\begin{array}{c|c|c|c}
& \textbf{Raw land} & \textbf{Farmland} & \textbf{Timberland} \\
\hline \text{Return drivers} & \text{Price of land} & \begin{array}{l}
\text{Harvest quantities} \\
\text{Commodity prices} \\
\text{Price of land}
\end{array} & \begin{array}{l}
\text{Biological growth} \\
\text{Harvest quantities} \\
\text{Lumber prices} \\
\text{Land Price}
\end{array} \\
\hline \begin{array}{l}
\text{Source of direct} \\
\text{revenue}
\end{array} & \begin{array}{l}
\text{Price appreciation} \\
\text{Lease revenue}
\end{array} & \begin{array}{l}
\text{Sale of crops and} \\
\text{other agricultural} \\
\text{products} \\
\text{Price appreciation} \\
\text{Lease revenue}
\end{array} & \begin{array}{l}
\text{Sale of trees, wood,} \\
\text{and other timber} \\
\text{products} \\
\text{Price appreciation} \\
\text{Lease revenue}
\end{array} \\
\hline \text{Value} & \text{Physical location} & \begin{array}{l}
\text{Physical location} \\
\text{Growth cycle} \\
\text{Soil quality}
\end{array} & \begin{array}{l}
\text{Physical location} \\
\text{Quality of timber} \\
\text{Phase in timber} \\
\text{production}
\end{array} \\
\hline \text{Major risks} & \text{Best alternative use} & {\begin{array}{l}
\text{Weather factors and climate change} \\
\text{Biological factors, diseases}
\end{array}} &{\begin{array}{l}
\text{Weather factors and climate change} \\
\text{Biological factors, diseases}
\end{array}} \\
\hline \text{Type of Owners} & \begin{array}{l}
\text{Primarily institutional,} \\
\text{some individual}
\end{array} & \begin{array}{l}
\text{Mostly individuals,} \\
\text{some institutional}
\end{array} & \begin{array}{l}
\text{Mostly institutional,} \\
\text{some individual}
\end{array} \\
\hline \text{Ownership structure} & \begin{array}{l}
\text{Direct ownership,} \\
\text{partnership}
\end{array} & \begin{array}{l}
\text{Direct ownership,} \\
\text{partnership, REIT}
\end{array} & \begin{array}{l}
\text{Direct ownership,} \\
\text{partnership, REIT,} \\
\text{TIMO}
\end{array} \\
\end{array}
$$

Comparing Land Investments and Real Estate

Similarities

Investments in farmland, timberland, and raw land share common features with real estate. Both of them are unique, illiquid assets that are characterized by their distinct geographic location and features. Moreover, these assets involve forms of ownership capital, which are claims to residual cash flows. In some cases, such as developed real estate and farmland, there may also be steady cash flow streams from leases.

The sources of return from less developed land (farmland, timberland, and raw land) and associated mineral or drilling rights include expected price appreciation over time and cash flows. These cash flows can come from farm lease payments for owners, farm operating income for owner-operators, farm timberland income, and mineral and drilling royalties.

Differences

Compared to real estate, in raw land, farmland, and timberland investments, there is minimal emphasis on the physical improvements to the land. The value of these investments is determined by the quality of the soil, climate features, or geology, not the value of buildings, construction, and development.

The location of the land is also important, with land closer to transportation and markets commanding higher prices. While proximity to transportation is also crucial for real estate, transportation expenses can significantly affect the price of products from timberland and farmland.

Investing in raw land, timberland, or farmland requires specialized knowledge and understanding of the natural resource. For example, investors investing directly in timberland need forest investment expertise to manage a forest over its life cycle. Many major institutional investors lacking this specialized knowledge often turn to timberland investment management organizations (TIMOs). These entities aid institutional investors by overseeing their timberland investments and securing appropriate land holdings.

Commercial and residential real estate presents numerous financing options, whereas farmland, timberland, and raw land have fewer alternatives. Typically, these investments rely on bank loans or direct, private debt investment for financing.

Farmland, timberland, and raw land are assets that lack liquidity, having a restricted pool of potential buyers and sellers. This limitation is a result of the specialized knowledge and significant capital needed for engaging in these transactions.

Features of Farmland and Timberland Investment

• Resilience: These investments provide a cushion against financial market fluctuations, as evidenced by the positive returns of US farmland during the 2008 financial crisis.
• Recurring Income: Farmland and timberland produce regular income from crops and timber sales.
• Inflation Protection: Owning land offers protection against inflation.
• Market Cycle: These investments have long market cycles, particularly in new-growth forests and certain crops.
• Revenue Determinants: The prices of agricultural products and timber, combined with harvest quantities, influence the revenue from these investments. Moreover, the value of the land may fluctuate over time for both farmland and timberland, which impacts investment returns.

Forms of Farmland and Timberland Investment

Direct Investment

The primary form of natural resource investment has been direct ownership of farmland and timberland. This approach has traditionally been favored by long-term, tax-exempt investors, including pension funds, foundations, and endowments.

Direct timberland investors often engage Timberland Investment Management Organizations (TIMOs) to select, manage, and dispose of assets in alignment with their investment goals. TIMOs frequently collaborate with indirect investment vehicles like limited partnerships, limited liability corporations (LLCs), and private Real Estate Investment Trusts (REITs) to optimize investment strategies.

Indirect Investment

Indirect investment in farmland and timberland is usually preferred by smaller investors interested in timber and farmland. Indirect investment occurs through investment vehicles such as investment funds which are either offered on public markets, such as Real Estate Investment Trusts (REITs) in the United States, or managed privately through limited partnerships.

Indirect investment vehicles in agriculture often use separately managed accounts that differentiate between owner and owner-operator models. In the owner model, investors rent out land used for row crops like grains, receiving fixed cash flows. In the owner-operator model, applicable to permanent crop properties like orchards and vineyards, investors retain some level of operating control. Here, cash flows tend to be variable, with investors assuming a portion of the operating risk.

Challenges in Farmland and Timberland Investments

• Illiquidity: Direct investments in farmland and timberland are not easily liquidated.
• Price Transparency: Limited information is available for investment decisions without sector specialists.
• Risks: Farmland investments are vulnerable to unpredictable weather patterns, which can adversely affect crops and revenue. Hedging strategies, such as agricultural commodity futures contracts, can mitigate some of these risks.

Environmental and Social Benefits of Farmland and Timberland Investments

• Carbon Sequestration: This is the process of storing carbon in a carbon pool. Farmland and timberland act as carbon sinks, offsetting human carbon emissions.
• Conservation: Conservation easements may enhance value by promoting traditional and natural conservation.
• ESG Considerations: Investments in sustainable farming and timberland practices align with Environmental, Social, and Governance values, attracting specific investor groups.

Question

In the context of farmland and timberland investments which of the following statements is most likely true?

1. The market prices for agricultural products and timber do not fluctuate considerably over time.
2. Timberland serves as both a factory and a warehouse, offering the flexibility of harvesting when timber prices are up and delaying harvests when prices are down.
3. Farmland mainly consists of row crops like corn and wheat that are planted and harvested, and it does not include permanent crops like apples or grapes that grow on trees or vines.

The correct answer is B.

Timberland indeed serves as both a factory and a warehouse, offering the flexibility of harvesting when timber prices are up and delaying harvests when prices are down. This is one of the unique characteristics of timberland investments. The growth of timber is a biological process that continues regardless of market conditions. Therefore, the owner of a timberland investment has the option to harvest the timber when prices are favorable and delay the harvest when prices are low.

This flexibility can help to smooth out the returns from timberland investments over time and reduce the impact of short-term price fluctuations. This characteristic, combined with the long market cycle of timberland investments, can make them an attractive option for investors looking for long-term, stable returns.

A is incorrect. The market prices for agricultural products and timber do fluctuate considerably over time. These fluctuations can be due to a variety of factors, including changes in supply and demand, weather conditions, and economic conditions. Therefore, the statement that the market prices for agricultural products and timber do not fluctuate considerably over time is not accurate.

C is incorrect. Farmland does not only consist of row crops like corn and wheat that are planted and harvested. It also includes permanent crops like apples or grapes that grow on trees or vines. Therefore, the statement that farmland does not include permanent crops is not accurate. The type of crops grown on a piece of farmland can have a significant impact on its value and the returns that it can generate for investors.