How to Invest in Timber REITs

When most investors think of real estate investment trusts, or REITs, they think of companies that own buildings. For example, the best-known REITs own malls, hotels, offices, hospitals, apartments, and self-storage buildings, among other property types.

However, there are some REITs that own land, not buildings. Timber REITs are in this category. They own land and make their money primarily from harvesting the trees that grow on their land and selling wood and related products.

Timber REITs can make excellent long-term investments. However, since they make their money in a somewhat different way than most other REITs, it's a good idea to learn exactly what you're getting into before considering an investment. With that in mind, here's a rundown of what you should know before buying a timber, or timberland REIT, as well as an overview of the publicly traded timberland REITs you could invest in.

Note: The terms "timber REIT" and "timberland REIT" are interchangeable, so just be aware that when you see either of these terms, they refer to the same type of company.

Image source: Getty Images.

What is a real estate investment trust (REIT)?

A real estate investment trust, or REIT, is a specialized type of company that invests in real estate or related assets as its primary business. For example, a REIT may invest in apartment buildings with the goal of profiting from the rental income. Or, a REIT may invest in mortgages and aim to make a profit from the interest collected.

However, it's not enough for a company to simply make real estate its primary business. There are several companies that own real estate assets that aren't classified as REITs. In order to qualify as a REIT, a company must meet the following three criteria:

1. REITs must invest a minimum of 75% of their assets in real estate or related assets and must derive at least 75% of their income from these assets. In other words, a retailer who happens to own its buildings cannot qualify as a REIT, as its income is derived from its retail sales.
2. REITs must distribute a minimum of 90% of their taxable income to shareholders, and most choose to distribute all of their taxable income. This is why REITs tend to have above-average dividend yields and is the best-known attribute of REITs.
3. REITs must be classified as corporations, must have at least 100 shareholders, and no five shareholders can control more than 50% of a REIT's shares.

So, why would a company want to go through the trouble of getting classified as a REIT? Simply put, if a company meets all of these requirements, it gets a big tax advantage. REITs pay no corporate tax whatsoever on their profits -- instead, the only tax imposed on REIT profits happens on the individual level when paid out as dividends.

This is a huge advantage over how most stocks work. If a non-REIT dividend stock, say AT&T, earns a profit, that profit is effectively taxed twice -- once on the corporate level and then again on the individual level when a dividend is paid.

The majority of REITs specialize in a certain type of real estate asset. For example, you'll find REITs that own large portfolios of hotels or those own shopping malls. REITs that own physical real estate are known as equity REITs, while REITs that own mortgages and other financial assets are known as mortgage REITs.

What is a timber REIT?

Timber REITs own and operate land that is used for the production and harvesting of timber. They make most of their money by selling raw timber, refined wood, or wood-based products. In addition, some timber REITs also make money in other ways, such as by exploring and capitalizing on minerals, oil, gas, and other natural resources on their land, as well as by leasing some of their lands to other businesses.

Timber REITs make a lot of sense as long-term investments. Wood prices tend to keep up with inflation over time, and demand for wood products naturally increases over time as the population grows and the need for housing gets larger.

Image source: Getty Images.

Risks you need to know

Because they don't own buildings (at least not as a primary business function), timber REITs avoid some of the risks of other REITs. For example, timber REITs don't have to worry about vacancy risk, as they don't have tenants that can move out.

However, there are still some big risk factors timber REIT investors should be aware of:

Interest rate risk: All income-based investments that are designed to be held for the long term are vulnerable to fluctuations in interest rates. In a nutshell, rising risk-free interest rates tend to be a negative catalyst for REITs, while falling risk-free rates tend to be a positive catalyst. There's no official benchmark rate to watch, but the 10-year Treasury yield tends to be a good indicator for REITs.

The reason behind this is twofold. For one thing, most REITs need to borrow money in order to grow, and rising rates make borrowing more expensive. Furthermore, investors generally expect to receive a certain risk premium for investing in riskier assets like stocks versus what they could expect to get from risk-free investments. So, as the rates paid by risk-free investments increase, so do the yields paid by REITs. Stock prices and dividend yields have an inverse relationship, so rising yields mean lower stock prices while falling yields mean higher stock prices.

Cyclicality risk: It may come as a bit of a surprise, but timber is a highly cyclical industry. In terms of economic sensitivity, timber REITs are among the most sensitive -- ranked right up there with hotels.

For starters, there's little guaranteed income relative to other REITs. In an office building, for example, tenants generally sign multiyear leases, so if the economy takes a downturn, the building owner still gets paid. Timber REITs have no tenants, so their income depends purely on market prices and industry demand.

Speaking of demand, remember that the product that timber REITs produce (wood) is a commodity, just like oil, natural gas, or steel. Therefore, its price is only as high as market demand at any given point. Roughly 50% of U.S. softwood lumber consumption is from homebuilders, so wood demand is highly correlated with the strength of the housing market. In a recession, don't be surprised if timber REITs underperform the rest of the real estate sector.

Regulatory risk: Natural resource harvesting is a regulated industry, so it's always a possibility that government regulations can change over time. This isn't exactly a predictable risk, but it's certainly something investors should be aware of.

The four major timber REITs

As of July 2019, there are four publicly traded REITs that specialize in timberlands. Here's a list of them, ranked in descending order of market capitalization, or the total number of a company's shares outstanding multiplied by the stock's market price. That's followed by a brief description of each company and its general business strategy.

Data source: CNBC and company financials. Acreage as of Q1 2019.

Now, you may be thinking that all of these timber REITs are essentially the same. After all, don't they grow trees, cut them down, and sell them? How different can they be? You might be surprised...

1. Weyerhaeuser: The industry leader

When it comes to timber REITs, Weyerhaeuser is in a league of its own. The company is roughly three times the size of all the other timber REITs combined in terms of market capitalization.

Weyerhaeuser's strategy is: to acquire high-quality timberlands; to run the most efficient operation possible (its size gives it a huge advantage in this category); and to reinvest in the business as needed to maintain or grow its market share.

Weyerhaeuser operates in three business segments.

The timberlands segment is the largest private owner of timberlands in the U.S. and is sustainability certified. The company's land is geographically diverse, with millions of acres in the Southern, Western, and Northern parts of the country, which gives it access to a wide variety of timber types as well as easy access to markets all over the United States.

The wood products segment is a leading manufacturer of lumber, engineered wood, and other products. The company has the No. 3 market share in lumber production and the top share in engineered wood.

Finally, the real estate, energy, and natural resources segment is there to maximize the value of the company's land by exploring other money-making uses. The company has identified 1.6 million acres (about 13% of the total) of its land for various "asset value optimization" uses. This can mean mineral extraction, oil and gas production (or more specifically, leasing the land for that purpose), and using the company's land for wind or solar power generation.

Weyerhaeuser is committed to a sustainable and growing dividend and has increased its payout by a total of 127% since 2011, with raises every year from that year until the present. On top of that, Weyerhaeuser has returned an additional $3.2 billion to shareholders in the form of share repurchases.

Finally, Weyerhaeuser has a very strong balance sheet, with debt making up less than 25% of its total capitalization, a rather low leverage for a REIT. The company has investment-grade (Baa2/BBB) credit ratings and has the financial flexibility to pursue any attractive opportunities that arise.

2. Rayonier

Rayonier is the second-largest timber REIT, but it's a distant second. By land size, Rayonier is less than one-fourth the size of Weyerhaeuser.

However, there's a lot to like about Rayonier's business, which has been around since 1926. Like Weyerhaeuser, Rayonier is sustainability certified. It also has some international exposure -- in addition to large acreage in the Southern and Northwestern United States, 16% of Rayonier's timberlands are in New Zealand. This gives it a big edge, especially when selling into Asian markets (particularly China).

The biggest difference between Rayonier and Weyerhaeuser is manufacturing. Rayonier is a pure-play timber REIT. In other words, it harvests timber from its land and tries to extract maximum value in other ways, but it doesn't have a manufacturing operation. To put this into perspective, Rayonier earned 66% of its EBITDA from 2016 through 2018 from its timber operation, with virtually all of the rest coming from its real estate segment. Weyerhaeuser generated just 56% of its EBITDA for that time period from its timber and real estate operations combined, with the other 44% coming from manufacturing.

To be clear, I'm not necessarily saying one is better than another. Manufacturing certainly adds diversification to the earnings of the timber REITs who have such a business. I'm simply saying that if you want to invest in timber production and not worry about the manufacturing side of the business, Rayonier could be worth a look.

Rayonier also has a strong balance sheet, with debt making up just 17% of its total capitalization. However, it doesn't have quite as strong of a dividend track record as its larger counterpart.

RYN Dividend data by YCharts.

3. PotlatchDeltic

The third-largest timber REIT, PotlatchDeltic is about two-thirds the size of Rayonier in terms of both market capitalization and volume of land it owns. Like the previous two companies, the largest concentration of timberlands in PotlatchDeltic's portfolio is in the Southern United States (mostly in Arkansas), with the rest in Idaho and Minnesota.

In addition to its timber operation, PotlatchDeltic has a large manufacturing business. Through its seven large manufacturing facilities that produce lumber and plywood, PotlatchDeltic is one of the Top 10 lumber producers in the U.S. What's more, the company's manufacturing business has been growing rapidly. Thanks to major capital investments, the company's lumber shipments grew by 70% from 2013 to 2019.

PotlatchDeltic's real estate segment is somewhat different from Weyerhaeuser's. The company has identified about 230,000 acres of land in rural areas that it plans to sell over time. They aren't just for minerals and oil/gas subleases. PotlatchDeltic plans to sell lands primarily for recreational and residential purposes. In fact, the company even has a 4,800-acre master planned community in Little Rock, Arkansas, that has been successful at generating strong returns.

PotlatchDeltic has a strong dividend track record, with a 29% increase in its dividend per share from 2012 through 2018. And while the company doesn't buy back shares at a massive rate, it does so strategically when it makes sense. For example, in the first quarter of 2019, PotlatchDeltic bought back $10 million of its stock for 30% less than the original issue price of those shares.

4. CatchMark Timber Trust

The smallest timber REIT, CatchMark owns about 1.6 million acres, although as noted in the table above, the majority of those acres are owned in joint ventures, hence the relatively small market capitalization. Virtually all of the company's timberlands are located in the Southern United States, with a particularly large presence (over 1 million acres) in Texas. The company recently started to diversify into the Pacific Northwest, but this is (for now) a small piece of the pie.

CatchMark has a somewhat unique mix of earnings. About half of its EBITDA comes from its timber business, while the rest is roughly split between its real estate operations (27% in 2018) and its investment management segment (21%). Like Rayonier, CatchMark has no manufacturing business.

The company's real estate segment sells non-core land from the company's portfolio, and also leases land for hunting and other recreational purposes. And the investment management segment is a unique aspect of CatchMark, as the company gets significant management fee income from its joint ventures.

CatchMark is a relatively young company, having completed its IPO in 2013. It's important to realize that in the process of ramping up its operations, the company took on quite a bit of debt. In fact, the company's debt makes up about 50% of its total capitalization as of March 2019 (recall that Weyerhaeuser and Rayonier had debt to capitalizations of 20% and 17%, respectively, at the same point in time). CatchMark's net debt to EBITDA (2019 expected) ratio of 8.6-to-1 is certainly on the very high end for REITs. The company plans to reduce its leverage going forward, but for now, it is certainly something investors should be aware of.

The bottom line on timber REITs

Timber REITs can be a great way to capitalize as the U.S. housing market strengthens. While housing starts have steadily risen since the end of the Great Recession, they are still quite low on a historical basis. Since 1970, housing starts have averaged 1.5 million per year, and the latest data shows an annualized rate of 1.25 million as of July 2019.

In addition, because housing starts are at a historically low level, the average age of the existing housing supply is increasing. From 2005 through 2017, the average age of a house in the U.S. has increased from about 31 years to more than 38 years, which has created a strengthening remodeling market. Both of these factors point to a rising need for lumber.

The bottom line is that if you have a positive outlook on the U.S. housing market, one of these four timber REITs could be a good addition to your portfolio.