Alternative Asset Investing: Real Estate, Farmland, and Timber

I have been the capital deployments among America’s wealth, and according to a recent U.S. Trust white paper, affluent Americans are looking towards more esoteric alternative asset investments in real estate, farmland, and timber:

Although 89% of respondents say their biggest investment gains have come from traditional stocks and bonds, more sophisticated strategies are present in the portfolios of the wealthy. Use of tangible assets — such as investment in real estate, farmland and timber properties — is substantial and increasing. Nearly half of the wealthy (48%) currently [editor’s note: this is 2016] own tangible assets, up from 41 percent in 2014.

U.S. Trust Insights on Wealth and Worth

That is quite the striking passage. In other words, this quote is wealthy, presumably very smart, somewhat older, Americans saying: “I made almost all of my money from x. I know x works. But I want to do y because it is cooler.” If people with over $3 million can think like this, your starting assumption should be that you can as well.

Heck, I’ve done it. I remember finding a very small, Midwestern bank trading at $8 per share when its book value was $23 per share. It didn’t pay out a dividend, had only 340,000 shares outstanding, and was being valued at around $2.7 million when it was probably worth around $8 million. Owners of the stock, in aggregate, only sold about 20,000 shares over the course of the year. The year prior to my examination of the investment had a lull from February through May when no shares at all were bought and sold. It was the illiquid side of the publicly traded markets.

The cool part was that it only took something like an investment of $8,000 to get your hands on 1,000 shares and own 0.3% of the bank. If you wanted to own 1% of the bank, you’d need to get your hands on 3,400 shares, which at the time, cost $27,200. Instantly owning 1% of a bank might feel a lot more interesting than owning a 1 out of 5 billionth interest in Apple.

It just so happened that, at the time that I made this bank investment, I also purchased shares of Berkshire Hathaway at the then-existing price of $83 per share (now it’s up to $198, and a few years from now, we’ll be looking back at the $198 price the same way we look back at the $83 price now). Guess what? The shares of Berkshire Hathaway have slightly outperformed the shares of this micro-cap Midwestern bank over the past 6-7 years. Both investments have done fine and well, but at this juncture, a higher net worth would have resulted from ordering a double shot of Berkshire.

At the 1997 Berkshire Hathaway annual meeting, Warren Buffett spoke about these small Midwestern insurers that he had suggested to Benjamin Graham as a potential investment for his clients at the Graham-Newman hedge fund well over over half-a-century ago. Graham would respond, “That looks promising, but is it better than buying more GEICO? Remember, you don’t get extra points for making your money more off the beaten path. A dollar is a dollar.”

Put in a more accessible way, if the American wealthy are part of the 89% that state their greatest gains have come from plain vanilla stock and bond investments, the general rule should be: I’m going to stick with this unless I am certain that I can find something clearly better.

If you think Berkshire Hathaway is going to compound at 12%, that off-beaten investment should probably offer the realistic possibility of 15% returns or better. If you are going to make oddball investments, you better be well compensated for the illiquid nature, perhaps lack of pre-existing expertise or at least impending departure from the status quo, and lack of deep institutional vastness that is characteristic of the more familiar S&P 500 terrain.

The move towards real estate, farmland, and timber should also be approached with a certain amount of caution. In addition to the liquidity concerns associated with these investments, there are often frictional expenses that can accumulate–property taxes, appraisals, insurance, property management fees that are often much higher than expected, and a generally low, fixed ceiling for investment returns. If someone is going to undertake that work, cost, and risks, it should come with a better payoff than you’d get from passively acquiring stakes in ExxonMobil and Royal Dutch Shell and collecting the dividends.

I understand the appeal of something like timber land. If someone owns 50 acres populated with 2,500 fully grown white oak trees, they could seemingly sell it for a gross price of $600,000. You could seemingly pay for the college tuition of all your kids, get them a car, and a starter home while starting their career. All from 50 acres! The catch is that you have to pay thirty or more years of property taxes for that land, which could be $25,000, insure the trees against risk like forest fires which could cost $50,000 over the time frame, and then you’d have to pay the forest manager their literal cut which could eat up $200,000 of the sale. If you perform any maintenance over the years, there’s another $25,000. Boom, your $600,000 just became $300,000.

Foresting white oak trees, which results in nice one-time capital infusions, is offset by the decades of paying annual property taxes, insurance, and maintenance expenses prior to that point. Plus, there is a significant forestry management fee for harvesting the timber land.

The economics are generally terrible when you have to wait half a lifetime in order to generate a sale/profit from your ownership of an asset. Although there is not a timber stock index fund, it could be worthwhile to look at a stock like Weyerhauser, which trades at $26 per share, and traded at $14 per share in 1987. Although there have been some dividends along the way, the stock has not yet doubled in thirty-two years. The compound average annual returns are 5.5% over thirty-years. If that is what the largest industrial processor generates over a multi-decade period, I would not expect to do any better unless you did something like buy a vast timber folding in 2009 at auction. I would not want to own timberland unless I was getting something like a 70% discount, which occurred in 1973-74, 1986, 1991, and 2008-2009, moments when other investments were cheaper anyway.

Owning real estate outright shares many of the same concerns. Real estate investors typically underestimate the cost of property management, which can be 10% of the rent, plus lease renewal fees, and often a month’s rent for placing a tenant. Even if you do this yourself, there is still legal costs (which can equal half-a-year’s rent) in eviction from the time you file the action for rent and possession until the time the writ is issued to remove the non-paying tenant from the premises. All the while, you are assuming the risk that the former tenant will destroy or impair the property and expenses such as property taxes, insurance, and mortgages continue to accrue while you have no money coming in.

And this does not even get into the cost of maintenance and repairs. Charge $1,000 per month in rent and have to replace the roof? There goes eight months of rent towards the roof. Need a new furnace or air conditioning in the same year? You just made no profit that year. It is not uncommon for landlords of residential units in areas that experience no capital appreciation to only have $100-$250 per month to show for all of their work, as something like an extended vacancy, eviction, or high repair cost such as a roof can wipe away the potential profit before you know it.

The old country song proverb that you should “dance with the one who brung ya” has a point. If all your goals in life are being accomplished because you owned giant stakes in ExxonMobil, Coca-Cola, Johnson & Johnson, Colgate-Palmolive, Nestle, Berkshire Hathaway, and Microsoft, you don’t have to search for the esoteric as your next move. Buying another 100 shares of Berkshire Hathaway might be the wisest course of action.

If you are considering an alternative investment, the question should be: Are you only intrigued because it is different? If wealth-building is the goal, that answer is not enough. In fact, illiquid investments should be disfavored and pursued reluctantly only when they offer superior returns to the obvious investment candidates. For me, that would mean that you find a real estate, farmland, or timberland opportunity with a high likelihood of 15% annual returns, net of fees, expenses, and taxes, for the costs and active time investments to be worth it.

Originally posted 2019-03-10 14:39:10.

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