Land REITs: Hedge Inflation - And Chaos

Summary

• While still outperforming the REIT Index this year, timber and farmland REITs have pulled back amid cooling inflation expectations, slumping global commodity demand, and regional weather complications.
• A hedge on chaos? Amid indications that the Russia-Ukraine conflict may drag on indefinitely, we expect continued global market share gains for North American producers of the disrupted agricultural products.
• Feast or famine? Despite severe drought conditions in the West, a strong growth season in the Midwest and South has raised aggregating farm incomes to near-record highs this year.
• For timber REITs, slumping home construction demand resulting from rising rates follows a record year of profits - but the slowdown doesn't alter the longer-term need for increased single-family home production.
• The recently-passed “Inflation Reduction Act” included provisions that enhance REITs’ ability to benefit economically from owning solar and wind facilities through expanded investment tax credits - a potential new ancillary revenue stream.
• This idea was discussed in more depth with members of my private investing community, Hoya Capital Income Builder. Learn More »

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REIT Rankings: Timber And Farmland REITs

This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on September 6th.

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Publicly-traded landowners - specifically timber and farmland REITs - have been among the better-performing real estate sectors this year, but have pulled back in recent months amid cooling inflation expectations, slumping global commodity demand, and regional weather complications. In the Hoya Capital Timber REIT Index, we track the four timber REITs which account for roughly $35 billion in market value and collectively own 16 million acres: Weyerhaeuser (WY), Rayonier (RYN), PotlatchDeltic (PCH), and CatchMark Timber (CTT). We also track the two farmland REITs in the Hoya Capital Farmland REIT Index, which account for roughly $1.5 billion in market value: Gladstone Land (LAND) and Farmland Partners (FPI).

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Amid the ongoing Russia/Ukraine conflict - which together are among the world's largest exporters of agriculture, gasoline, and timber products - the importance and value of North American production in these key commodities has become especially evident. While the significance of Russian oil and natural gas production has been the key focus of politicians and consumers alike as gasoline prices soared to record-highs, Russia is also the world’s largest exporter of lumber - primarily softwoods - and the seventh-largest exporter of forestry products. Ukraine, meanwhile, is responsible for more than a quarter of the world’s wheat exports, a fifth of corn exports, and nearly 30% of barley exports. With indications that the conflict may drag on indefinitely, we expect continued global market share gains for North American producers of the disrupted agricultural products.

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Timber REITs own and/or manage over 30 million acres of North American timberlands - more land than the smallest five states in the US combined. Notably, Weyerhaeuser and PotlatchDeltic are considered to be more "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.

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U.S. Farmland, meanwhile, is one of the largest commercial real estate sectors valued at roughly $2.5 trillion, comprised of roughly two million farms - 90% of which are considered small family-operated farms. Farmland consists of row crops (e.g., corn, wheat, soybeans) - which is the focus of Farmland Partners - and permanent crops (e.g., fruits, nuts, berries) - which is the primary focus of Gladstone Land. Increased demand for food globally has been met with a shrinking supply of available agricultural land, but the productivity of this land has increased substantially in recent decades, roughly doubling in output every 20 years. Farmland leases generally have a 1-3 year term for row crops and a 5-10 year term for permanent crops, and leases are primarily fixed-rate, but some have a revenue-share component.

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Land REITs' inflation-hedging attributes and portfolio diversification characteristics are among the most appealing investment characteristics. Consistent with its historical inflation-hedging attributes, timberland values averaged roughly $1,900 per acre in 2021, an increase of 7% from 2020. The Western U.S. - home to higher-valued timber species such as Douglas Fir - has the highest value-per acre at $3,300/acre followed by the U.S. South - home to the relatively cheaper Southern Pine species - at $1,800/acre while the Northern US timberlands are valued at $800/acre. Per the US Dept. of Agriculture, farmland values averaged $3,380/acre for 2021, up $220/acre (7.0%) from 2020. On a per-acre basis, crop and farmland in California is the most valuable at over $10k/acre, followed by the Midwest at $6-8k per acre and the Southeast at $4-5k/acre.

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Historically, timberland and farmland have exhibited low correlations to other asset classes and both timber and farmland REITs exhibit some of the lowest levels of interest rate sensitivity within the real estate sector. Investors should note that while timber REITs are quite economically-sensitive due to their high correlation with wood products demand and lumber prices, farmland REITs exhibit limited sensitivity to economic growth expectations, as food demand tends to be far less cyclical. As it relates to inflation-hedging, however, timber REITs reign supreme in the REIT sector, exhibiting one of the strongest upside correlations to inflation expectations, but farmland REITs are close behind.

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Timber Industry Overview And Update

Lumber prices have been on a wild ride since the start of the pandemic with prices peaking at record-highs above $1,600 per thousand board due to soaring demand for homebuilders, robust DIY home renovation activity, and supply chain issues stemming from the pandemic - but have since dipped back down below $500 amid a rate-driven cooldown in new home construction activity and the easing of supply chain bottlenecks. Single-family housing starts were lower by nearly 20% year-over-year in the latest monthly report surging mortgage rates have poured cold water over the previously red-hot single-family housing market. As noted in our recent Homebuilder report, the near-term outlook for home construction activity remains very-much rate-dependant, but the longer-term demand outlook remains quite favorable following a decade of historic underbuilding of single-family homes.

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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 month showed that wood product manufacturing levels are now about 5% above pre-pandemic levels after operating well below pre-pandemic capacity for much of 2020.

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Farmland Industry Update

Grains prices have been on a similar trajectory, and the Russia/Ukraine conflict came as global wheat and corn stockpiles were already shrinking after a below-average growing season in 2021 and lingering supply chain issues, resulting in significant food price inflation over the prior six months. The Russia conflict has sent prices of corn, wheat, and soybeans higher by 10-20% this year in the U.S. - and at a far faster pace in Europe. Even before the full effects of the Russia conflict were felt, global food prices climbed to an all-time high in 2020, according to the United Nations’ Food and Agriculture Organization, while U.S. food prices in February were up 7.9% from last year.

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Farm incomes have recovered to near-record-highs as severe droughts in the West have been offset by a solid growth season in the Midwest. The USDA’s Economic Research Service reported last week that net farm cash income, a broad measure of profits, is now forecast to increase by 15.1% this year from 2021 despite a 50% decline in direct government farm payments. Driven by "higher expected prices and quantities," soybean receipts in 2022 are expected to increase by 30.6% while corn receipts are forecast to increase by 16.7%. Conditions in the Western United States, however, are quite a bit bleaker amid the second year of severe drought conditions. Per a recent AFBF survey, 74% percent of respondents rated a reduction in harvest yields due to drought as prevalent or higher in their area which has "negatively impacted business income, putting the solvency of many farms and ranches at risk."

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Farmland And Timber REIT Performance

Among the better-performing real estate property sectors this year, Timber and Farmland REITs have posted more-muted declines than the broader REIT Averages with farmland REITs lower by just 6.5% this year and timber REITs off by 15% this year - each outperforming the -20.8% decline on the Vanguard Real Estate ETF (VNQ) and the -17.4% decline on the S&P 500 ETF (SPY). Cooling inflation expectations, slumping global commodity demand, and regional weather complications have dragged on these land-based property sectors over the past quarter, however, pulling valuations of several of these REITs back towards more compelling levels.

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CatchMark Timber has led the gains this year after agreeing to be acquired by PotlatchDeltic in a roughly $600 million all-stock deal. The combined company will own 2.2 million acres of timberlands, including 626,000 acres in Idaho and over 1.5 million acres in the U.S. South and have a market valuation of roughly $4 billion. PCH paid a 55% premium to its most recent close - which is roughly at the levels that CTT traded in late 2021 before running into a myriad of issues with its now-exited Triple T joint venture. PotlatchDeltic shareholders will own 86% of the combined company. In its press release, PCH also highlighted the potential "Highest and Best Use" ("HBU") real estate opportunities from CTT's portfolio which is closer to large population centers compared to PCH's existing Idaho-heavy portfolio, which may be more fruitful following the passage of the “Inflation Reduction Act” which includes provisions that enhance REITs’ ability to benefit economically from owning solar and wind facilities through expanded investment tax credits.

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Deeper Dive Into The Timber Industry

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.

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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.

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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.

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Takeaways: Buying Land At A Discount?

While still outperforming the REIT Index this year, timber and farmland REITs have pulled back amid cooling inflation expectations, slumping global commodity demand, and regional weather complications. With indications that the Russia-Ukraine conflict may drag on indefinitely, we expect continued global market share gains for North American producers of the disrupted agricultural products – notably grains and lumber. For farmland REITs, despite severe drought conditions in the West, a strong growth season in the Midwest and South has raised aggregating farm incomes to near-record highs this year. For timber REITs, slumping home construction demand resulting from rising rates follows a record year of profits - but the slowdown doesn't alter the longer-term need for increased single-family home production. Meanwhile, the recently-passed “Inflation Reduction Act” included under-reported provisions that enhance REITs’ ability to benefit economically from owning solar and wind facilities, providing a potential new ancillary revenue stream for land REITs.

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For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Farmland, Storage, Timber, Mortgage, and Cannabis.

Disclosure: Hoya Capital Real Estate advises two Exchange-Traded Funds listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index and in the Hoya Capital High Dividend Yield Index. Index definitions and a complete list of holdings are available on our website.

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Disclosure: I/we have a beneficial long position in the shares of RIET, HOMZ, PCH, WY either through stock ownership, options, or other derivatives. 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.