(Hoya Capital Real Estate, Co-Produced with Colorado Wealth Management)
Reignited by the red-hot U.S. housing market, timber REITs and lumber producers have "caught fire" since mid-2020 as lumber prices have soared to record highs amid a historic supply shortage. In the Hoya Capital Timber REIT Index, we track the four timber REITs which account for roughly $40 billion in market value: Weyerhaeuser (WY), Rayonier (RYN), PotlatchDeltic (PCH), and CatchMark Timber (CTT). Timber REITs own nearly 30 million acres of US timberlands, more land than the smallest five states in the US combined.
Throughout the pandemic, housing has proven to be the "ultimate essential service" as households have prioritized housing-related investments in home improvement and living situation upgrades. The pandemic-fueled surge in lumber demand for home construction has clashed with bottlenecks at sawmills as lumber producers were caught flat-footed by the velocity of the rebound in lumber demand. Lumber prices - which averaged $300 from 2000-2019 and on rare occasions eclipsed $400 - soared to record-highs at more than $1,600 earlier this month before moderating a bit in recent days.
Lumber sawmills - the source of the supply chain bottlenecks due in part to a lack of investment in capacity in the post-GFC period - are scrambling to catch up as producers invest in building immediate and long-term capacity. Weyerhaeuser announced last week that it will invest $157 million in its sawmill in Louisiana. Canadian firm West Fraser Timber (WFG) announced it will invest $150 million at five of its U.S. South lumber mills while also increasing the number of working shifts to where possible while Interfor (OTCPK:IFSPF) plans the completion of a new Georgia sawmill by the second half of 2022.
Timber REITs and lumber producers still expect supplies to remain limited and for prices to remain elevated into 2022, but some industry commentary suggests that the worst of the shortage may be easing, which is good news for these REITs and the broader housing industry. Importantly, Weyerhaeuser and PotlatchDeltic are "vertically integrated" with significant business operations in lumber production - transforming the raw timber into usable construction materials. Rayonier and CatchMark, however, are more "pure-play" timberland owners and have seen more muted benefits from soaring lumber prices.
First-quarter earnings results underscored emerging bifurcation between these two "sub-sectors" within the timber REIT sector and the importance of understanding the opportunities and exposures inherent with these REITs. The vertically-integrated timber REITs (WY, PCH) each reported their strongest quarter on record with WY seeing a 166% surge in adjusted EBITDA - the most closely watched earnings metric while PCH reported a jump of more than 300% compared to last year. The pure-play timberland owners (RYN, CTT), on the other hand, reported results that were less than impressive, but all four REITs should see accelerating growth into 2022 as sawmill bottlenecks ease.
Primarily concentrated in the Pacific Northwest and the Southern US, there are roughly 200 million acres of commercially forested timberlands in the United States. Timberland ownership, while still a highly fragmented industry comprised of thousands of individual landowners, has undergone a continued wave of consolidation and institutionalization over the past four decades. The first Timber REIT was established in 1999 with the conversion of Plum Creek from an MLP into a REIT. Rayonier and Potlatch followed in the early 2000s. Weyerhaeuser converted to a REIT in 2010 and 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.
Wood is arguably the most important natural and renewable resource on Earth. A highly versatile and cost-effective material with applications across all industries from paper to fuel, residential construction accounts for the majority - roughly two-thirds - of wood demand. The vast majority of single-family homes in the US are built primarily with wood products, and wood has been increasingly used as a primary structural material in larger multi-family or commercial structures. Wood products account for more than a third of total construction materials cost inputs in the typical single-family home, and the average-sized home requires between 150 and 300 trees to construct.
For investors that can tolerate volatility and value inflation-hedging attributes, long-term fundamentals look compelling amid historic levels of demographic-driven housing demand and record-low housing supply. Grouped in the Home Building Products and Materials sector, Timber REITs comprise roughly 3% of the Hoya Capital Housing Index, the benchmark that tracks the performance of the US housing industry. Ultimately, we view an investment in the Timber REIT sector - especially the vertically integrated REITs (WY and PCH) - as a play on the compelling long-term trends in the US housing sector over the next decade, more specifically, a view in favor of the continued recovery in the single-family homebuilding sector following a decade of underbuilding.
Timber REITs were initially slammed during the early stages of the pandemic, but powered by the confluence of near-term and longer-term tailwinds that have led to a rejuvenation across the U.S. housing industry, Timber REITs more-than-doubled from their lows during the worst of the pandemic last March and ended 2020 with total returns of over 10%, significantly outperforming the Equity REIT Index for the second consecutive year.
While the sharp rebound caught many investors by surprise, we've emphasized since the dark days of late March that several substantial tailwinds should help to counteract the pandemic-related headwinds on the housing market including favorable millennial-led demographics, historically low housing supply, record-low mortgage rates, and the post-pandemic suburban revival. Housing demand is showing few signs of cooling, either, as Redfin (RDFN) reported last week that the typical home is selling after just 18 days on the market, the lowest on record while the NAHB Buyer Traffic Index remains near the highest level on record according to data this week.
Meanwhile, as discussed in our Real Estate Earnings Recap, recent earnings reports from homebuilders indicated that homes are still being sold as fast as they can be built as builders battle with these lumber bottlenecks and struggle to keep up with record-levels of demand. The fifteen builders in our coverage have an aggregate backlog totaling 125,000 units, the highest on record, after reporting order growth of nearly 50% in Q1. Despite the supply chain bottlenecks, six of the eight builders that provide full-year guidance for deliveries in Q1 boosted their outlook, an impressive quarter across the sector.
Meanwhile, Zillow (Z) reported earlier this month that it's seeing record-levels of traffic on its website and expects "an even stronger housing market this year" as homes are "flying off the shelves." Specific to the critically important repair and remodeling segment which is the primary source of lumber demand, recent earnings results from Home Depot (HD) and Lowe's (LOW) have underscored the dramatic rebound in home improvement spending with comparable same-store sales surging to record-highs in the back-half of 2020.
Riding this housing market momentum, Timber REITs are higher by another 16.5% so far in 2021. By comparison, the Vanguard Real Estate ETF (VNQ) is higher by roughly 14% while the S&P 500 ETF (SPY) has gained 11%. The gains on the sector index do hide the bifurcation within the sector as the vertically integrated REITs (WY, PCH) that are benefiting from surging prices for lumber have delivered far superior earnings performance compared with the pure-play timberland owners (RYN, CTT) throughout the pandemic.
The two pure-play REITs (RYN, CTT) declined by 6% and 14%, respectively last year, but have bounced back since the start of the year buoyed by signs that the sawmill glut may be starting to ease. Since the start of 2020, however, PCH has gained more than 45% on a total return basis followed by WY with gains of 30%. RYN has gained 22% while CTT has returned 14%. Since the start of 2015, Timber REITs have outperformed the REIT Index, delivering average annual total returns of roughly 10%.
While they've been around for two decades, Timber REITs are still considered a "specialty" REIT sector that straddles the line between the REIT and building materials industries. 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. Usage of timber products for biomass-fueled energy production falls into this category as well.|
|2) Real Estate - These companies lease land to third-parties for various uses, including energy production, mining, or recreation, and also market land for sale to homebuilders or other developers. This business line 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. Production facilities are generally located in close proximity to timberlands.|
An old forestry maxim is "the forest that pays, stays." 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 of privately-owned land and growing demand for wood products (including lumber, paper, and biomass) and despite several years of above-average incidences of wildfires, primarily on federally-owned land on the West Coast, there are actually more trees now than there were 100 years ago, according to the Food and Agriculture Organization.
Timberland itself is generally viewed as an uncorrelated asset class, but Timber REITs tend to be quite correlated with the economic cycle and with the broader U.S. equity market. 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 single-family home construction ETFs, the SPDR Homebuilders ETF (XHB) and iShares U.S. Home Construction ETF (ITB) than to Equity REIT ETFs. Importantly, Timber REITs also are among the most "immune" from the effects of rising interest rates and have historically exhibited inflation-hedging properties.
Two ETFs track the broader Timber and Foresting sector: the iShares S&P Global Timber & Forestry Index ETF (WOOD) and the Invesco MSCI Global Timber ETF (CUT). Other major publicly traded companies in the lumber production industry besides these REITs include Canadian firms West Fraser Timber, Interfor, and Canfor (OTCPK:CFPZF) as well as Georgia-based Louisiana-Pacific (LPX). Private players include Georgia Pacific Company, Sierra Pacific, and Hampton Affiliates.
As a whole, timber REITs command some of the strongest balance sheets across the REIT sector, an important attribute considering the high degree of economic sensitivity. Weyerhaeuser, the largest Timber REIT, trades on the S&P 500 (SPY), while Rayonier and PotlatchDeltic are included in the S&P 400 (MDY) mid-cap index. Three of the four Timber REITs hold investment-grade long-term bond ratings from S&P. CatchMark Timber, the smallest REIT of the group, takes on a higher degree of leverage.
Timber REITs are one of the most "growth-oriented" REIT sectors, paying a relatively modest dividend yield of 2.1%, on average, compared to the roughly 3.1% market-cap-weighted REIT average. However, PotlatchDeltic was one of 52 equity REITs to raise its dividends last year. WY announced a new dividend framework - "Base Plus Variable Supplemental" - during its recent earnings report that aims to achieve a total return of 75-80% of its annual Adjusted FFO. WY expects the variable portion of these dividends to be paid annually based on prior-year cash flow and expects the first payment in Q1 2022.
Within the sector, we note the varying dividend strategies of these four REITs. CatchMark Timber is the highest-yielding timber REIT with a 4.47% dividend yield by employing a more "REIT-like" strategy of paying out the majority of its cash flow. Rayonier is next with a dividend yield of 2.85% followed by PotlatchDeltic at 2.75% while Weyerhaeuser pays a dividend yield of 1.79%. Timber REITs pay out just 38% of their available free cash flow, however, which is towards the bottom of the REIT sector, leaving ample capital available for future dividend growth.
Below, we outline the five reasons that investors are bullish on Timber REITs.
Below, we outline the five reasons why investors are bearish on Timber REITs.
Reignited by the red-hot U.S. housing market, timber REITs and lumber producers have "caught fire" since mid-2020 as lumber prices have soared to record highs amid a historic supply shortage. For investors that can tolerate volatility and value inflation-hedging attributes, long-term fundamentals look compelling amid historic levels of demographic-driven housing demand and record-low housing supply. Freddie Mac estimates that the U.S. housing market is 3.8 million single-family homes short of what's needed to meet the country's demand, representing a 52% rise in the nation's housing shortage compared with 2018, a shortage that's likely to intensify throughout 2021.
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