REIT Rankings: Timber REITs
(Hoya Capital Real Estate, Co-Produced with Colorado WMF)
How Hot is Too Hot? For Timber REITs, scorching-hot lumber demand from the resurgent housing industry, combined with sawmill production bottlenecks, sent lumber prices soaring to extreme levels in late 2020 and into early 2021. However, these REITs have been the victim of their own success of late, as logjams begin to ease and as lumber prices pull back sharply from record highs. In the Hoya Capital Timber REIT Index, we track the four timber REITs which account for roughly $35 billion in market value: Weyerhaeuser (WY), Rayonier (RYN), PotlatchDeltic (PCH), and CatchMark Timber (CTT).
Despite reporting the strongest two quarters of profitability on record, timber REITs have been among the weakest-performing property sectors this year amid a recent slump in lumber prices as inflating construction materials prices - and the outright inability to source necessary goods in some cases - forced some home builders to delay projects and put many smaller-scale renovation projects on hold. Combined with the effects of recovering sawmill production capacity levels, lumber prices have dipped nearly 70% from their early-summer peak at nearly $1,700 which - whether fundamentally warranted or not - have pulled down timber REIT valuations along with it.
Timber REITs own nearly 30 million acres of US timberlands, more land than the smallest five states in the US combined. Notably, Weyerhaeuser and PotlatchDeltic are considered "vertically integrated" timber REITs as they each have significant business operations along the lumber supply chain - not only timberland ownership but also in lumber production and manufacturing - transforming the raw timber into usable construction materials. As a result, these REITs tend to be more sensitive to changes in lumber prices and short-term fluctuations in demand. Rayonier and CatchMark, on the other hand, are more "pure-play" timberland owners and as a result, have seen more muted effects - both on the upside and downside - from volatility in lumber prices.
Lumber sawmills - the source of much of the supply chain bottlenecks and the resulting surge in lumber prices - are finally beginning to catch up and address the supply/demand imbalance as producers have invested heavily into building immediate and long-term capacity over the past several quarters including WY's $157M investment in its Louisiana sawmill, West Fraser Timber's (WFG) $150M investment into five of its U.S. South lumber mills, and Interfor's (OTCPK:IFSPF) $30M investment to expand production at its South Carolina sawmill. Industrial Production data last week showed that wood product manufacturing levels are now 5% above pre-pandemic levels after operating well below pre-pandemic capacity for much of 2020.
Victims of their own success? As discussed in our REIT Earnings Recap, the normalization in lumber prices is due in no small part to the record production levels reported by the two vertically-oriented REITs over the past several quarters. Boosted by surging lumber prices, WY reported a 300% surge in adjusted EBITDA - the most closely watched earnings metric while PCH reported a jump of more than 600% compared to last year. The pure-play timberland owners, on the other hand, reported more modest - but nevertheless impressive - earnings growth in the second quarter with CTT seeing an 87% jump in EBITDA. RYN reported a 21% gain and also boosted its full-year outlook - the lone timber REIT that provides earnings guidance.
While these REITs expect a moderation in EBITDA due to the pullback in lumber prices in Q3, WY was particularly bullish on the long-term outlook for the U.S. housing industry, citing the substantial underinvestment in new home construction over the last decade and backlog of delayed projects. Second-quarter earnings results confirmed that because homebuilders were already operating at or above maximum build capacity, the modest cooldown in activity during the Spring and early Summer had a limited impact on earnings results. Despite a cooldown in new orders, homebuilders still have 160,000 units in their backlog - 63% higher from the prior year - which implies some hefty demand for lumber in the quarters ahead.
WY also noted that after a slowdown in activity through the home improvement and repair and renovation channels, that activity began to pick up late in the second quarter, consistent with commentary and earnings results from home improvement retailer Lowe's (LOW), which reported better-than-expected Q2 earnings results last week, noting that it saw total U.S. sales increase 21% against the 2019 level. Lowe's commented that its outlook for home improvement spending remains "very positive" citing higher household formation trends a "longer-term spending share shift towards the home." These strong results followed mixed results from competitor Home Depot (HD) which missed consensus estimates on same-store sales but provided a similarly upbeat outlook for longer-term home improvement trends.
Despite reporting the fastest revenue growth of any REIT sector through the first half of 2021 - nearly doubling cash flows and revenues - and despite the expectation of significant dividend increases later this year - timber REITs have been the weakest-performing property sector this year, significantly underperforming the Vanguard Real Estate ETF (VNQ) and the S&P 500 ETF (SPY). We believe that for investors that can tolerate volatility and value inflation-hedging attributes, valuations have become considerably more attractive this year as long-term fundamentals remain compelling amid historic levels of housing demand and record-low housing supply.
Valuations appear particularly compelling for the two vertically integrated REITs - WY and PCH - which have significantly underperformed their two pure-play peers - RYN and CTT - over the last several months, which we view as an over-reaction to the slump in lumber prices. Ultimately, we view an investment in the Timber REIT sector - especially these vertically integrated REITs - as a play on the continued recovery in the single-family homebuilding sector following a decade of underbuilding in the post-GFC period.
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.
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.
Riding robust earnings growth, we expect to see several of these timber REITs eventually added to the list of nearly 100 REITs that have raised their dividends this year. WY - which reduced its dividend last year - commented that it plans to "return significant cash to shareholders through the variable supplemental component of our new dividend framework." This follows similar commentary from PCH which commented that it expects to pay a "meaningful special dividend in the fourth quarter." PCH was among the relatively small number of REITs - and the only timber REIT - that raised its dividend in 2020.
Timber REITs have historically been one of the lowest dividend-paying REIT sectors, but have seen their dividend yields swell back towards the REIT sector average over the past year. Timber REITs pay a dividend yield of 2.3%, on average, compared to the roughly 2.7% market-cap-weighted REIT average. Timber REITs pay out just 39% of their available free cash flow, however, which is towards the bottom of the REIT sector, leaving ample capital available for future dividend growth.
Within the sector, we note the varying dividend strategies of these four REITs. CatchMark Timber is the highest-yielding timber REIT with a 4.66% dividend yield, by employing a more "REIT-like" strategy of paying out the majority of its cash flow. PotlatchDeltic is next with a dividend yield of 3.26% followed by Rayonier at 2.95% while Weyerhaeuser pays a dividend yield of 1.97%.
Timber REITs - particularly the vertically-oriented REITs - have been victims of their own success of late as the surge and subsequent correction in lumber prices comes after a historic quarter of lumber production and profitability. The earnings power of these REITs is far less impacted by changes in lumber prices than recent market pricing would seem to suggest, and we believe that for investors that can tolerate the volatility, valuations and long-term fundamentals appear compelling amid historic levels of demographic-driven housing demand, record-low housing supply, and a substantial backlog of new home orders and deferred repair and renovation projects, implying significant embedded upside for lumber demand in the quarters and decade ahead.
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