How 'Timber-Like' Are Timber REITs?

As I noted in a previous article, timber has outperformed stocks, bonds, and commodities over the past several decades. But in practice, no suitable pure-play timber vehicle exists for retail investors. Timber real estate investment trusts (REITs) are the most commonly used substitute, but how timber-like are they?

Unfortunately, none of the three timber REITs -- Plum Creek Timber (PCL), Rayonier (RYN), and Potlatch (PCH)  -- are pure plays. Rather than divest their manufacturing operations, the REITs have merely moved them into taxable subsidiaries. Thus, REIT shareholders are stuck with significant exposure to sawmills, pulp mills, and paper mills.

For instance, timberland-related revenue (which I define as timber harvesting plus real estate gains from forestland sales) constituted merely 17% of total sales for Potlatch in 2007, while the other 83% came from manufacturing. Timber constituted a slightly greater proportion (28%) of revenue for Rayonier. Plum Creek had, by far, the highest timberland exposure (71%) and is the only REIT that I'd have no reservations calling a timber company.  

The REITs' exposure to manufacturing negates many of the benefits conferred by timber. Manufacturers exhibit highly cyclical results and are subject to high tax rates compared to what REITs pay for their timber harvests. Mills also spend heavily on labor, energy, equipment, and facilities. As such, they are characterized by low operating margins, depreciating assets, and substantial debt.

By contrast, trees are relatively low-maintenance assets. After all, trees have grown successfully for nearly 400 million years without human assistance. The key ingredients for tree growth -- soil, sunlight, air, and water -- are readily provided by Mother Nature at no cost. Timber may be the only asset in existence that reliably exhibits physical growth for decades with no involvement from the owner.

Timber REITs have historically generated solid returns, but are they a good proxy for timber? If so, their returns should strongly correlate with the returns of the NCREIF Timberland Index. Ideally, a proxy would score between 0.80 and 1.00. Unfortunately, my analysis of annual returns since 1997 showed only a mildly positive correlation for the three REITs (ranging from .06 to .33).

While this indicates returns haven't been very timber-like in the past decade, I suspect correlations will increase significantly in the future as these firms continue divesting manufacturing assets and increase their focus on timber. For instance, Potlatch recently announced a proposal to spin-off its pulp-based businesses, which I will discuss in a forthcoming article.

However, investors need to be aware that even if these REITs eventually become timber pure-plays, they are unlikely to show a very high correlation to timber due to the various economic factors that specifically affect stocks and REITs, but not timber. (Such factors explain why the stocks of commodity producers capture only some of the diversification benefits provided by commodity futures contracts.)

So, what are the implications for investors? Among all timber vehicles available to retail investors, I believe Plum Creek is the most attractive option. Other vehicles suffer from high manufacturing exposure, illiquidity, tax issues, or other drawbacks.

Plum Creek, the largest non-government owner of timberlands in America, will reap the benefits of this asset class by virtue of its 8 million acres of forests. Shareholders just need to realize that Plum Creek isn't a proxy for direct timber ownership and its performance will not closely track the NCREIF Timberland Index.

Disclosure: none

Comments

[John Shade:]

Interesting piece, but just how reliable is date on timber sales for one year? Timber sales can vary widely from year to year. I would like to see an average over several years, or an economic cycle if such exists for the timber industry.

2008 Jul 09 10:21 AM

[John Shade:]

Interesting piece, but just how reliable is date on timber sales for one year? Timber sales can vary widely from year to year and cycle to cycle. I would like to see an average.

2008 Jul 09 10:29 AM

[cheapstockh...:]

I respectfully disagree with your analysis. In 2007 intersegment sales of timber were lower because of weakness in housing and the related weakness in their wood products division (lumber). Because pricing was much stronger in pulp (driven by China demand) the company, in the best interest of creating shareholder value, delayed harvesting some timber, and more aggressively harvested softwoods to take advantage of pulp pricing. This I am sure generated a higher ROIC than would be the case if they cut more hardwood. Also, while resource sales were about 20% of total, I believe the more relevant metric the market values these assets is the EBITDA they generate. In 2007 PCH generated about 60% of its EBITDA in its resources & real estate segments. that is all.

2008 Jul 09 12:05 PM

[George Nichols:]

Thanks for your feedback on my article! I agree that there is no single metric that definitively quantifies the "purity" of a timber REIT. Investors should consider many data points (income, revenue, etc) over various time periods (latest quarter, year, and several years). In the space of my article, I just focused on a couple of metrics I considered most relevant.

Naturally, annual revenue % data varies from year to year, but the swings generally aren't dramatic. As someone noted, 2007 was marked by a poor housing market; but as I note below, sales % didn't vary dramatically during the strong housing market of 2005:

'% timberland-related revenue, 2007 -> 2005 : PCH = 17% -> 18%; RYN = 28% -> 25%; PCL = 71% -> 68%.

2008 Jul 09 01:48 PM

[FTREITguy:]

This is an interesting article, but I have a couple of questions for you about your methodology. Why use each company's return from timber-based operations to determine if investing a timber REIT is a proxy for direct timberland investment? Why not look at the return of the individual stock prices instead? After all, that is what investors can invest in and reap the benefits of. I realize that dividends may be driven from returns on timber-based activities for these companies, but an investor cannot invest solely in the timberland portion of these REITs' stocks. Also, why would you start your comparison in 1997, when Plum Creek did not become a timber REIT until 1999? Not to mention Rayonier and Potlatch, which converted in 2004 and 2006, respectively.

Jun 09 10:16 AM