Timber is an interesting investment that has been growing in popularity but still hasn't received much mainstream attention. It benefits from a strong economy, when wood is needed for new construction projects, but it also does OK during recessions, when timber companies can simply meet lower demand by cutting fewer trees -- literally letting their inventory grow. However, it's not the easiest area to invest in, and it has certain caveats that need examining.
Let Mother Nature do the work for you
Timber companies are closely tied to the strength of the economy. The faster the economy is growing, the more houses are being built, and the more wood is needed to build them. But unlike other industries, timber inventories don't get stale or become obsolete. They just get bigger, and older, which is a good thing.
Older trees provide higher-quality wood, so while timber companies will have naturally increasing inventory in terms of volume, it will also be increasing in value at the same time. This makes timber a natural inflation hedge, as its actual utility increases at a steady rate regardless of the economy, unlike other investments like gold, which has little real utility. Indeed, according to legendary investor Jeremy Grantham, over the past century timber prices have increased at a rate of about 3% over inflation.
How to invest
There are essentially two ways to get exposure to timber. For the diversifier, there are two aptly tickered ETFs: the Guggenheim Timber ETF
There are two big downsides to these ETFs, however. The first is that they are both very new. The Guggenheim fund began Nov. 9, 2007, and the iShares fund began on June 24, 2008, so neither has much of a track record to judge it by. The other downside is that their diversification is also across the whole timber value chain. You get pure-play timber exposure, but you also get companies like International Paper
To get the purest exposure to timberland, you have to own the trees themselves. Not sure how to buy a forest? No problem. Timber real estate investment trusts have you covered. REITs have a special tax status that allows them to avoid paying income tax as long as they distribute at least 90% of their net income to shareholders. Most REIT dividends are taxed at the higher ordinary income rate for investors, but the income used to issue timber REIT dividends comes from trees, and because trees are considered capital property, timber REIT dividends are usually taxed at the much lower capital gains tax rate.
There are four main timber REITs, and each is a little different. The table below lists each company and the percent of sales it derives from timber and non-core real estate.
Sales Derived From Timber-Related Segments
Plum Creek Timber
Source: Company filings.
As you can see, even the timber REITs aren't perfectly pure plays, but they tend to offer the most exposure you're likely to find. Their special tax treatment also makes them attractive dividend payers, with each yielding more than 3%, ranging up to 6% in Potlach's case.
The Foolish bottom line
Investing in timber is not without risks. These companies are highly reliant on housing, and even the growing use of e-readers like the Kindle and iPad pose a threat, as they mean less paper used for the mass production of books. However, the nature of their product allows these companies to benefit from good times while insulating them against some ill effects of the bad times. That, coupled with their consistently strong dividends, makes them an attractive alternative to other investments like gold or even bonds.
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