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1
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.
2
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
4
Introduction Most portfolio investments are financial
assets, such as:• Common stock
• Corporate bonds
• Bank certificates of deposit
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– 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
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)
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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.
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
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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
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
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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
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
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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.
36
Future Prospects Introduction Index Problems Social Risk
37
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
38
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
39
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
40
Real Estate Investment Trusts Introduction Types of REITs
41
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
42
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
43
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
44
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)
45
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”
46
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
47
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
50
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
51
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
52
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.
53
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
54
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
58
Bullion (cont’d) Shortcomings of bullion:
• Subject to theft
• No income productivity
• Lack marketability
59
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
62
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
63
Popular Coins for Investment
American Eagles
Australian Nugget
Austrian Philharmonic
Canadian Maple Leaf
Mexican Peso
South African Krugerrand