Timber: A Renewable Resource

Since 1987, the timber industry has outperformed the S&P, according to the National Council of Real Estate Investment Fiduciaries (NCREIF). The timber index produced average annual returns of …

Since 1987, the timber industry has outperformed the S&P, according to the National Council of Real Estate Investment Fiduciaries (NCREIF). The timber index produced average annual returns of more than 15 percent during the past 20 years, compared with less than 12 percent for the S&P.

Timber’s increasing popularity means that these impressive returns may not last forever. As more investors move into timber, many experts predict that the industry returns will settle in the 7 to 9 percent range. Many of timber’s new enthusiasts view it as a low-risk, high-return investment. They believe it will produce capital growth comparable to equities while only requiring bond-level risk.

That may be slightly ambitious, but timber does have significant advantages that lower its risk. Timber is both a hard asset and a renewable resource. Its value increases over time “on the stump,” even if investors wait around and do nothing.

In fact, the longer investors wait to cut down and sell the trees, the more valuable their investments grow. This enables many timber organizations to wait out downturns and sell their timber later when prices are more favorable.

The world has a limited supply of both land and timber, and global demand for timber is increasing as the global population increases. The long-term global market is solid; the U.S. may encounter short-term housing market downturns, but China, India and other booming populations show no sign of slowing in demand.

Timber prices are not correlated with stock market trends, even though some timber companies are publicly traded on the market. Timber tends to do well during stock downturn periods when investors shift from riskier stocks to safer investments.

Publicly-traded timber companies can provide strong and reliable dividends, particularly those in the form of Real Estate Investment Trusts (REITs). REITs are not considered corporations and do not pay corporate income tax. REITs are required to pay out 90 percent of their profits as dividends, so timberland REIT investors have the confidence of knowing that even if their REIT’s stocks drop, dividends should remain steady.

Private timber companies and those which are publicly traded in non-REIT form aren’t required to offer dividends, although they can do so at their discretion. This gives non-REIT public corporations and private institutional timber investment management organizations (TIMOs) the advantage of being able to wait out downturns. REITs, on the other hand, may feel pressured to sell their timber even during low market conditions to produce dividends.

Timber trends

Ownership of timberland has shifted dramatically in recent decades as industrial, publicly-owned forest product companies sell to institutional investors. In 1981, forest product companies owned approximately 58 million acres of U.S. commercial timberland, but that number dropped to less than 21 million acres by 2005, according to a study produced by Seneca Creek Associates for the American Forest and Paper Association.

The American Forest and Paper Association also reports that of the 504 million acres of U.S. timberland, private investors hold 356 million acres, more than 70 percent of that total. These private investors consist of individuals, trusts and corporations. In contrast, just 146 million acres, or 29 percent, are owned by federal, state and local governments.

Institutional investors now own approximately $22 billion in timberland, according to The National Real Estate Investor. Most of that money—$15 to $17 billion—is managed by private institutional investors in the form of TIMOs, while REITs hold the rest. This shift toward institutional investors owes much to the tax advantages they have over publicly-traded companies. Institutional investors are motivated to achieve the highest possible returns with the least amount of risk.

Environmental impact

Although the timber industry may have some lingering stigma for cutting down forests, many of today’s timber organizations see the importance of preserving timber as a sustainable and renewable resource into the future. Government policies reward timber organizations in the U.S. for sustainable practices.

Timber companies also have their own financial sustainability at stake; if the forests were destroyed, the timber companies would go down along with them. This provides a strong incentive to practice renewable and sustainable timber growth and harvesting. Many investors seeking “green” investments are turning to timber because of its renewable quality.

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Timber companies in the U.S. today have little motivation to cut down old growth forests. The approval process is complex and does not inspire public approval. In addition, once old growth has been cut down, timber companies would have to plant new growth anyway.

Today’s timber organizations find it more practical to buy land and turn it into timber plantations rather than cut down old growth forests.

To maintain a steady stream of profits, some timber holders harvest a different timber plantation or section of a plantation each year. This way, there is always new timber ready for harvesting each year. If the year is not a favorable one for prices, the organization can cut and sell less timber (or none at all) and wait for prices to improve.

Most growth cycles are approximately 10 to 40 years. In areas with favorable climates, the growth timetable may happen slightly faster; in less favorable conditions, it may take a few more years.

Timber companies have historically encountered cases where their land would have greater value if used for suburban development, and that phenomenon has increased significantly in recent years with the global population boom.

Some timber organizations allocate a certain amount of land to sell each year. They select the most valuable land that could have a more profitable use in suburban development and sell that land to developers. The timber companies can then reinvest that money into cheaper land in other locations for growing timber.

Ways to invest

There are currently three main ways for investors to gain exposure to timber:

1. Publicly-traded companies, including Real Estate Investment Trusts (REITs)

Publicly-traded companies are the most affordable and accessible timber investments, since shares are traded on the stock exchange. They currently take the form of either traditionally-structured companies or REITs.

Traditionally structured companies pay out dividends at their discretion; these dividends are typically substantially higher than dividends from standard stock investments. These companies have the flexibility to decide when to sell and when to hold their timber; they have more freedom to wait out low markets and sell later when prices are higher.

A new trend in publicly-traded timberland companies is conversion to REIT status. This provides huge tax advantages by exempting the REIT from corporate income tax on earnings from land holdings, but it requires they pay out 90 percent of their profits in dividends to shareholders. This is a big attraction for investors seeking regular, reliable dividends.

Most timberland REITs are currently paying out around 4 percent in annual dividends, compared with around 3 percent for regular REITs and 1.8 percent for the S&P 500 overall.

Timberland REIT investments also provide tax advantages for investors; dividends are considered capital gains, so they are taxed at the 15 percent maximum capital gains rate. This is an advantage compared with regular REIT dividends, which are taxed at a higher rate based on income tax minimums.

Some REITs diversify into commodities other than timber, such as mining, depending on the most profitable use for the land owned by the REIT.

The most notable downside to REITs is that pressure to provide dividends to shareholders can force them to sell even during low markets.

Although the results of timberland REITs and traditional publicly-traded companies are not entirely correlated to the general stock market trends, their inclusion in the stock market makes them somewhat volatile and subject to fast changes.

2. Timber Investment Management Organizations (TIMOs)

Higher net worth individuals and institutional investors have the option of investing in TIMOs rather than REITs. TIMOs are privately-held organizations that manage timberland with the intention of producing the greatest long-term returns possible with minimal risk.

TIMOs are not traded on the stock exchange, and they can generally afford to wait out market downturns. TIMOs are strictly timberland; they don’t own manufacturing operations.

After the Employee Retirement Income Security Act (ERISA) in 1974, TIMOs became popular with institutional investors. Pension funds in particular began investing in TIMOs in their move toward diversification.

TIMO investments usually require a large minimum investment. According to The National Real Estate Investor, a separate account usually runs an investor $20 to $100 million. Commingled funds are usually around $2 to $5 million; a few require as little as $250,000. Many require 10-year commitments with options to extend.

TIMOs require management fees of approximately 1 percent of assets, and managers sometimes also receive a percentage of profits.

Like REITs, investments in TIMOs are not hands-on investments. The organization makes the official business decisions and handles the practical management of timber growth and maintenance.

 

3. Purchasing land directly

Investors can also buy raw land directly and develop it for timber. Investors buying land that they anticipate will be in the path of progress can add value by planting trees on the land and then holding it for 20 years or more. The land can then be sold to a TIMO, REIT or lumber investor along with the timber, or the investor can harvest the trees and sell the land to a land developer.

Land investors interested in growing timber should research areas likely to produce well and provide easy transport, since timber transport can be costly. The investor must then decide what sort of trees to grow and determine how to plant and cultivate them.

Unless the investor already has expertise in this field, a manager may be needed to plant, maintain, oversee and harvest the timber growth. Some areas will require more maintenance than others, depending on climate and environmental factors.

This approach tends to appeal more to hands-on investors who like direct control over their investments. Many investors interested in timber will prefer to have a large institution manage the practical aspects of timber production, but for those who are not afraid of getting their hands dirty, this can be a great way to add value to land purchases.

Raw land investors already interested in areas favorable to timber growth may want to consider planting timber while waiting for the underlying land value to increase.

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