REIT Rankings: Timber REITs
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Timber REIT Sector Overview
The newest addition to our coverage universe, Timber REITs are typically considered a “specialty” real estate sector and comprise roughly 2-3% of the broad REIT ETFs (VNQ and IYR). We view Timber REITs as the link connecting the commercial REIT sector with the residential construction sector. Residential construction is responsible for roughly half of wood product consumption in the US. In the Hoya Capital Timber REIT Index, we track the four timber REITs, which account for roughly $30 billion in market value: Weyerhaeuser (WY), Rayonier (RYN), PotlatchDeltic (PCH), and CatchMark Timber (NYSE:CTT). Two ETFs track the broader Timber sector: the iShares S&P Global Timber & Forestry Index ETF (WOOD) and the Invesco MSCI Global Timber ETF (CUT).
Timber REITs own nearly 20 millions acres of US timberlands, more land than the smallest five states in the US combined. Primarily concentrated in the Pacific Northwest and the Southern US, there are roughly 200 million acres of commercially-forested timberlands. While timberland foresting companies often get a "bad rap" from environmental groups, Timber REITs are among the leaders in sustainable foresting, with all four timberland REITs having 100% of their land third-party certified as sustainable either by the Sustainable Forestry Initiative (SFI) or the Forest Stewardship Council (FSC). Due to responsible foresting and growing demand for wood products (including lumber and paper), there are actually more trees now than there were 100 years ago according to the Food and Agriculture Organization. Again, due to demand for wood products, Timber REITs generally plant significantly more trees in a given year than they harvest. So perhaps printing out those emails and online articles onto paper may actually be good for the environment after all!
Timberland ownership, while still a highly fragmented industry comprised of thousands of individual landowners, has undergone a continued path towards consolidation and institutionalization over the past four decades. The wave of institutionalization began during the 1980s, but the first Timber REIT was not established until 1999 with the conversion of Plum Creek from an MLP into a REIT. Rayonier and Potlach followed in the early 2000s with Weyerhaeuser finally joining the party in 2010 and eventually merged with Plum Creek in 2016 to form the largest Timber REIT. CatchMark Timber went public in 2013 and most recently, Potlatch and Deltic Timber merged in 2018.
Real estate ownership is only part of the business for Timber REITs, which take on quite a bit more operational responsibilities than other REIT sectors. There are three primary business lines for timber REITs:
1) Timberland: The “core” business line, these companies sell timber that is cut and delivered to a production facility by the company itself or through “stumpage” whereby a third-party is responsible for the cutting and transportation. A true commodity, prices of timber are determined by prevailing supply and demand conditions.
2) Real Estate: These companies lease land to third-parties for various uses including energy production, mining, or recreation. Interestingly, this business line only encompasses about 20% of total EBITDA and Timber REITs have special exemptions under the tax code to qualify as REITs despite operating outside of the traditional definitions of “real estate.”
3) Wood Production: To varying degrees, these companies are involved down the supply chain in the production and manufacturing of wood products. Mills transform the raw timber into various wood products, including lumber, OBS, engineered wood, or wood pulp-based products such as paper.
Comparing these four Timber REITs, it's important to note that Rayonier and CatchMark are more "pure-play" timberland owners while Weyerhaeuser and PotlatchDeltic are more vertically-integrated down the supply chain with significant business operations in the wood products segment. In general, pure-play timberland REITs are more commodity-like and have higher correlations with lumber prices while the vertically-integrated REITs are less correlated with lumber prices. Vertically-integrated REITs tend to be more correlated with the US economic business cycle, particularly the performance of the residential housing sector.
Ultimately, we view an investment in the Timber REIT sector as a play on the US housing sector, and more specifically, a view in favor of the continued recovery in the single-family homebuilding sector following years of historically low home construction in the post-recession period. Part of the Homebuilding Products & Materials sector, Timber REITs are included in the Hoya Capital Housing Index, which tracks the performance of the US housing industry. We estimate that annual spending on home building and construction accounts for around 30% of total spending on housing and housing-related services at roughly $1.1 trillion in 2018. Wood products account for more than a third of total construction materials cost inputs in the typical single family home and the average-size home requires more than 300 trees to construct.
Highlighting the importance of the performance of the US housing market to Timber REITs, it's interesting to note that Timber REITs actually have a higher correlation with the homebuilding ETFs (XHB and ITB) than to the real estate ETFs (VNQ). As expected, the more vertically-integrated REITs - WY and PCH - have the highest correlations with the homebuilding sector. Timberland is generally viewed as an uncorrelated asset class, but Timber REITs tend to be quite correlated with the economic cycle. As we'll discuss in more detail later in this report, Timber REITs exhibit very little sensitivity to interest rates which makes them rather unique within the REIT sector.
Timber REIT Fundamentals & Performance
Speaking of lumber prices and the performance of the US housing market, it's been quite the roller-coaster ride for the Timber REIT sector over the past two years as lumber prices hit all-time highs around this time last year before plummeting over the past year. Last Spring, the combination of a strong demand outlook and supply concerns sent lumber prices surging to all-time record highs. On the demand side, the single-family housing markets were still in high-gear and demand from fast-growing Asia was growing rapidly. On the supply side, the combination of Pacific Northwest forest fires, beetle infestations in Canadian timberland, and the intensification of the US/Canada softwood lumber trade dispute had many market participants expecting significant supply shortages. Last year’s slowdown in the single-family housing market took its toll on lumber prices, which reversed those gains are now lower by more than 40% year over year.
Lumber prices, however, have begun to stabilize and reaccelerate over the past three months. As we've been discussing for the past several months, the forward-looking metrics in the housing market suggest a solid recovery in home sales and housing starts data throughout 2019 if post-recession correlations hold. Mortgage rates are now lower by more than 70 basis points on a year-over-year basis, a sharp reversal from the 100 basis point headwind that slowed the housing market in 2018. As lumber prices and timber REIT performance are both highly-correlated with new residential construction activity, a reacceleration in housing market data should be a positive catalyst for the sector for the rest of 2019.
The sharp reversal in timber prices and softness in the single-family housing markets in late 2018 was bad news for Timber REITs, which was the worst-performing REIT sector in 2018. Timber REITs dipped by more than 32% compared to the NAREIT All Equity REIT total return of -4%. Since NAREIT began tracking Timber REITs as a distinct sector in 2011, the sector has produced average annual total returns of 6.6%, trailing the broader REIT average of 9.0% during that time and has lagged the average in five of those eight years.
Powered by renewed signs of life in the single-family housing market, 2019 has been much better for the Timber REIT sector, which has climbed nearly 22% so far this year. Interestingly, Timber REITs have far outpaced the timber ETFs so far this year with CUT higher by 14% and WOOD higher by just 7% YTD. The Homebuilding Products & Materials sector in the US Housing Index, meanwhile, is up more than 28% this year, the second-best performing housing sector.
Performance has been particularly strong over the past month with the sector jumping more than 15% compared to just a 3% gain in the broader REIT sector. As shown below, CatchMark Timber has been the best performer so far this year, jumping more than 50% after being the worst-performer last year.
Bull and Bear Thesis for Timber REITs
For better-or-worse, the performance of Timber REIT is highly linked to the single-family housing markets. Powered by strong demographics and ideal economic conditions for growth in single-family household formations, we believe that the 2020s will see a "revival" of the single-family housing markets and could go down as one of the best decades for the US housing industry since the end of WWII. Last week, the Joint Center for Housing Studies at Harvard University released its annual State of the Nation's Housing Report. Among other key findings in the comprehensive report, the researchers noted that "demographic trends should support a vibrant housing market over the coming decade," projecting that the number of households in their mid-30s to mid-50s will increase by a substantial 2.9 million over the next decade at a time when housing construction and existing housing inventory remains historically depressed. We believe that single-family homebuilding will provide a significant demand tailwind for timber over the next decade.
While new single-family construction accounts for the bulk of lumber demand from the housing sector, the home repair and remodeling industry is also responsible for a sizable percentage of lumber and wood products demand. Due to historically low levels of new home construction in the post-recession period, the US housing stock has been rapidly aging. Significant investment in single-family building (and relatively low-levels of multifamiy building) from the 1960s through the early 2000s brought the average age of the owner-occupied single family home into the mid-20s. The near-shutdown in single-family homebuilding after the recession and subsequent grinding recovery in new home construction has brought the average age of owner-occupied homes back near 40 years old. Aging homes require exponentially more maintenance, and as a result, we believe that the home repair and remodeling business will drive incremental growth for timber over the next decade.
Additionally, amid the continued wave of consolidation throughout the timberland industry, size and scale have proven to be competitive advantages. Because of the unmatched access to capital and tax advantages of the REIT structure, we believe that Timber REITs will be able to continue to accretively grow through external acquisitions. Finally, as discussed above, Timber REITs may also be a nice complement to a REIT portfolio due to its limited interest rate sensitivity and more growth-like features. Below, we outline the five reasons that investors are bullish on Timber REITs.
As illustrated by the steep plunge last year, Timber REITs are certainly not without their risks. While Timber REITs are poised to be among the biggest beneficiaries of a continued single-family housing construction recovery, the sector has been negatively affected by last year's housing slowdown, which was driven by higher mortgage rates and unaffordability issues. Timber REITs are also among the most exposed real estate sectors to the effects off natural disasters including wildfires, droughts, hurricanes, as well as insects and diseases. If we are indeed seeing an increased incidence of extreme weather, the value of timberland could be impaired. Additionally, despite being excellent environmental stewards, Timber REITs are exposed to environmental policy risks that may make foresting more expensive or less productive. Finally, trade policy risks remain an issue for the sector with the ongoing multi-decade-long softwood lumber dispute between the US and Canada. Below, we outline the five reasons that investors are bearish on Timber REITs.
Timber REIT Valuations
Timber REITs trade at discounted valuations relative to the broader REIT sector average across most metrics. Timber REITs are among the "cheapest" REIT sector based on free cash flow (aka AFFO, FAD, CAD) and screen as attractive based on the modified PEG ratio, FCF/G. While it is difficult to determine and consensus data is limited, we believe that Timber REITs are trading at roughly NAV parity or a mild NAV premium, trading at an implied capitalization rate of around 6.5% compared to the post-recession average of 7.5%.
Dividend Yield of Timber REITs
Based on dividend yield, Timber REITs rank towards the top, paying an average yield of 4.7%. Timber REITs pay out roughly 85% of their available free cash flow, which is towards the top of the REIT sector.
Within the sector, Weyerhaeuser and CatchMark are the highest yielders, each paying dividend yields in excess of 5%. Rayonier pays a yield of 3.5%, but distributes just 70% of their available free cash flow, leaving room for future dividend increases.
Interest Rates And Timber REITs
Timber REITs are classic "Growth REITs," exhibiting limited interest rate sensitivity, but a higher level of correlation with equity markets. Like hotels, Timber REITs exhibit essentially zero or negative "beta" with the 10-year yield but have an equity beta near or above 1.0 with the S&P 500.
Bottom Line: Can't Ignore This Growth Sector
Timber REITs are the newest addition to our coverage universe. Timber REITs own 20 million acres of timberlands, more land than the five smallest states in the US combined. Timber REITs are the link connecting the commercial real estate sector to the residential homebuilding sector. Residential construction is responsible for roughly half of wood product consumption in the US. Last year’s slowdown in the single-family housing market took its toll on lumber prices and Timber REITs, which were the worst-performing real estate sector of 2018. Lumber prices peaked in May 2018 on supply shortages in the Pacific Northwest and the ongoing softwood lumber dispute with Canada. Prices have plunged 40% since last Spring.
Long-term fundamentals look strong for the Timber REIT and broader housing sectors, powered by demographic trends that suggest a revival of the suburbs and single-family housing in the 2020s. Powered by strong demographics and ideal economic conditions for growth in single-family household formations, we believe that the 2020s will see a "revival" of the single-family housing markets and could go down as one of the best decades for the US housing industry since the end of WWII. We prefer the vertically-integrated Timber REITs, Weyerhaeuser and PotlachDeltic, which we believe are less commodity-like and are more closely linked to the performance of the US single-family housing industry.
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Disclosure: I am/we are long WY, PCH, VNQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.
Hoya Capital Real Estate advises an ETF. Real Estate and Housing Index definitions are available at HoyaCapital.com.