Photo courtesy of AlaLandCo - AlaLandCo.com

While trees continue to grow, timberland values and a trickle of wood bioenergy projects continue to fall. In the market, timberland investors struggle with current valuations and wood bioenergy projects work to gain traction or have fallen to the sidelines as investors shake the sector like a sack of Scrabble tiles. As an analyst reviewing the data and observing events in the field, I hear Earl Weaver, the former Baltimore Orioles’ manager, screaming in my ear, “Everything changes everything!”

Wood Bioenergy Update

The New York Times, in citing Forisk’s wood bioenergy research (“Wood Makes Comeback as a Fuel”, May 2, 2012), emphasized the growth opportunities related to European pellet markets. In total, however, the wood-using energy sector has started highlighting winners and losers. Financing continues to prove a major hurdle for independent power producers.

While the number of projects that pass Forisk’s screening methodology fell from 297 to 295, the estimated volume of wood consumed by viable projects edged up 2.4%. As of April 29, 2012, Wood Bioenergy US reports that projected wood demand for all 452 announced projects in the U.S. totaled 123.7 million tons, while the 295 projects that passed Forisk’s screen could consume up to 72.1 million tons of wood annually by 2022.

Timberland Investment Purgatory

Recent returns from the NCREIF Timberland Index affirm that turmoil reigns in timber. For four consecutive quarters, NCREIF has reported negative appreciation returns for private US timberlands (Table 1). And for three consecutive years, NCREIF reported negative appreciation returns for private US timberlands (Table 2). Meanwhile, these timberlands continue to generate on the order of 1.5 – 2.5% annual cash returns.

Turmoil reflects uncertainty and confusion, and timberland returns, even in the face of positive signs from housing markets, incur disquiet. While cash returns improve with increased harvest volumes and stronger stumpage (timber) prices, timberland appreciation builds on prices paid – and received – by institutional investors.

The reality remains that investors choose timberlands for reasons in addition to returns. These include the diversification and capital preservation benefits of being in a hard asset, directly owned and managed.

So Where Are We?

In the US, forestry investment professionals understand the market, which remains undersupplied with timberland relative to demand from institutions and available capital. The purgatory – this (temporary) period of miserable waiting and scratching at Excel valuation models – resolves itself when the market decides whether or not timberland is a “6% business.” If investors expect or demand 6% real returns from new acquisitions, then math dictates additional depreciation in timberland values.

Ultimately, timber markets are uniquely local, and those trading in small parcels, outside of the institutional investment spotlight, retain niche and higher potential opportunities. The pressure on timberland markets and investors are forcing a return to forestry fundamentals that are today reshaping the timberland investment sector.

As of April 5^th, 2012, publicly-traded timberland-owning REITs posted YTD returns of nearly 10%, according to the Forisk Timber REIT (FTR) Index. This kept the sector in line with the overall lift across equity markets – the S&P is up 11% so far in 2012- and in the conversation with timberland investors who continue to test the opportunities for direct timberland investments across the United States. Looking forward, here’s our view for timberland investors interested in both future stumpage prices and the competition for timberland assets.

Timberland Ownership

Forisk’s 18-month study of timberland owners in the U.S. indicates that the top 249 owners and managers account for nearly 82 million acres of private timberlands. By acreage, these owners are concentrated, first, in the US South, and secondarily in the Pacific Northwest, Lake States and Northeast. The top 10 alone account for 32.5 million acres.  Detailed analysis of these ownership groups highlight the continued shifting of acres to institutions, and the increased activity by private individuals and “family offices” in timberland markets. Long-term owners cite a belief that resources will continue to become scarce, and that hard assets – especially land – provide protection for value and against inflation.

Stumpage Prices Moving Forward

For the second consecutive year, Forisk’s localized pine sawtimber forecast hit within 4% of actual at the state-level. South-wide, Forisk’s regional pine sawtimber average of $26.57 per ton exceeded Timber Mart-South’s actual price of $23.97 for 2011 by 4.7%. The just-published 2012 ForiskForecast for the US South and Pacific Northwest develops three economic and forest industry scenarios. The baseline and “low growth” forecasts expect relatively flat to negative pricing in 2012 for pine sawtimber, with modest strengthening in 2014 as housing returns. Higher sawtimber prices require more than simply increased housing starts; prices require a suitable balance of forest industry capacity to lumber demand and production, with sawmills exceeding 85% utilization for six to twelve months to “reset the floor.”

Meanwhile, other market activities provide opportunities to supplement needed demand, including active export markets and the expansion of the Panama Canal. Forisk developed a high growth scenario that accounts for both strong economic and housing market growth, and potential increased log export activity from the US South by state. This scenario expects strengthening in 2012-2013, with prices in 2014 $2.86 per ton higher than the baseline forecast.

Investors Remain Interested in Timber Assets

If investor phone calls and coverage by the financial press provide sufficient clues, the market remains interested in the benefits of and outlook for timberland investments. Clay Risher, in his REIT Magazine article “Planting the Seeds for Timber REIT Growth” (March 14, 2012), cited Forisk’s research in emphasizing the range of options and diversity across public timber REITs. While Rayonier (RYN) lapped the field in 2011 thanks to its specialty fibers business, other firms, such as Weyerhaeuser (WY) have led in 2012 and, along with Potlatch and Plum Creek, expect to gain more directly from improved housing markets.

Still, investing in timber REITs differs from investing in timberland. Ellie Winninghoff, in her Financial Advisor Magazine article “Balance Sheets that Always Keep Growing” (March 28, 2012), summarized Forisk’s emphasis on the local and regional nature of timber REITs and timberland investment performance. In the end, geography matters for both publicly-traded and private-placement investment vehicles.

Timberland investors and REITs rely on continued demand for wood raw materials from forest product manufacturers to justify their investments in timberland. That explains why we started fielding questions from clients late last year regarding the new Southern Yellow Pine (SYP) “design values” and the potential effects on Southern pine sawtimber markets.

“Design values” are the properties that builders expect Southern pine to deliver when used it in construction. These include, for example, lumber’s ability to resist bending, tension, and compression. In October 2011, the Southern Pine Inspection Bureau (SPIB) issued new design values, effective June 1, 2012, that reduce four of seven values by 20% to 35%.

At a high level, here’s our view on what timberland investors need to know.

Design Values: A Brief History to Today

Rigorous testing of lumber’s strength capabilities began in the 1920s. Publishing of formal design value specifications began in 1944. Since then, design values have been subject to continued review and evaluation to account for new information from laboratory tests, new developments in design, and experience with wood construction in service. Modifications to design specifications are not unusual. The 1982, 1986, and 1991 versions contain numerous revisions.

The In-Grade Testing Program, initiated in 1978, verifies existing design values. Agencies collaborate with the US Forest Products Laboratory to test thousands of pieces of lumber annually. Overall trends in annual test results suggested a potential shift in the wood mix and resource base. This prompted a directed year-long program to review and submit the revised design values.  Review of other species and product types are currently underway.

Market Implications

Changes apply to a small fraction of lumber volumes specific to visually graded SYP lumber in No. 2 and lower grades for 2×2’s through 4×4’s. This means that, at a high level, 2x2s through 4x4s produced from Southern Pine visually graded lumber are not rated as strong as they were previously. Design values for other grades will remain the same pending 2012 testing.

Amanda Lang recently presented an overview of timber markets and wood bioenergy demand at the Southeastern Society of American Foresters Meeting at Jekyll Island, Georgia. On the topic of Southern Yellow Pine “Design Values”, she said:

The overall market effect will be minimal. We do not foresee substantive changes to the overall prices or market demand for Southern pine sawtimber, although we see some changes in the types of lumber produced. Building designers/mill customers will ultimately dictate these effects. We see some shifting from visual graded lumber to machine graded lumber. Conversely, building designers may change designs to accommodate new design values while still using visual grades. Individual mills that produce majority visual grade could be affected the most by these changes, but the specific effects will be determined by mill customers.

Minimal Net Impact on Stumpage Prices

At the end of the day, changes to SYP design values represent a “second order” implication for timberland investors and managers. In other words, potential changes and strengthening of stumpage prices in the US South have greater dependence on the housing starts generally, on the types of homes built (single family versus multi-family) and on the cost of money, as reflected in borrowing and mortgage rates available to builders and home buyers.

Photo courtesy of Green Hill Land and Timber - ghland.com

How many researchers does it take to change a light bulb? Actually, it just takes one, but you’ll have seven others standing around debating about the correct methodology. And that brings us to a challenge with investment data and research:  if we think a data set or analysis “should” exist, it often doesn’t. And if it does exist, it’s probably out of data (especially in forestry). Therefore, my team at Forisk views the systematic aggregation, tracking and analysis of facts related to timberland markets and wood bioenergy as fundamental to forestry investment research.

That said, what’s going on out there?

US Timberland Ownership Led by Private Firms

Part of Forisk’s timberland investment research focuses on how private timberland ownership changes over time. Estimates of the “investable universe” of timberland in the US range from 60 to 100 million acres; we count approximately 210 owners that each own and manage 25,000 acres or more for a total of ~82 million acres. Of these acres, 20% are owned by the four public timber REITs (Plum Creek, Potlatch, Rayonier and Weyerhaeuser) and 37% are managed by 27 US-based timberland investment management organizations (TIMOs). The 43% of acres associated with “other private” owners include forest industry firms, private individual and families, conservation groups and other non-forest industry firms and institutions.

The top 300 timberland owners and managers in the US account for nearly 84 million acres of private timberlands in the North, South, and West. The top 10 alone account for 32.5 million acres. Detailed analysis of these ownership groups highlight the continued shifting of acres to institutions, and the increased activity by private individuals and “family offices” in timberland markets.

Bioenergy Projects Looking for “Solid Ground”

The wood bioenergy sector in the United States continues its extended round of musical chairs. As of January 30, 2012, Wood Bioenergy US reports that projected wood demand for all announced projects in the U.S. dropped 7.4 million tons year-to-date, a 6% decrease since December 2011. This is largely attributed to the removal of several large biomass co-fire projects from the Wood Bioenergy US database, particularly in Ohio. Utilities claim that biomass remains uncompetitive with other alternative compliance options (note: natural gas). Also, some coal units are scheduled to shut down to meet EPA MACT requirements.

In liquid fuels news, the USDA granted ZeaChem a conditional commitment for a $232.5 million loan guarantee from the 9003 Biorefinery Assistance Program. The loan guarantee could help fund a 25 million gallon/year commercial biorefinery. ZeaChem plans to build the commercial biorefinery at the same site as its demonstration plant in Boardman, OR. Elsewhere, LanzaTech purchased the former Range Fuels site in Soperton, GA for $5.1 million in a foreclosure auction. The company plans to use wood residues to produce fuels and chemicals.

Enviva’s first shipment of pellets left from the Port of Chesapeake on December 31. The vessel, bound for Europe, contained 28,000 metric tons of wood pellets. Enviva began operations at the Ahoskie pellet plant in November. Two additional plants are in the planning stages in North Carolina and Virginia; both will also use the same port.

Meanwhile, demand for wood from traditional forest industry users has remained flat as manufacturers look to better housing news in 2012 and 2013. Also, the pulp and paper industry continues to enjoy strong markets and productivity.

Demand for Timberland Remains Strong

One fact continues to percolate up during our ongoing timberland market research: demand for timberland assets remains strong from institutional investors and forest industry firms. After decades of timberland divestitures, forest industry firms are reevaluating the options associated with acquiring timberlands to support raw material needs and to address the question “what’s the best use of our investment capital in 2012?”

Early in my investing career, I bought shares of Crown Pacific Partners, a timberland-owning firm headquartered in Portland, Oregon. During market declines in the late 1990s, the firm subsidized its shareholder distributions through borrowing and cash generated from non-organic business activities. In other words, the firm ate its seed corn. Crown Pacific filed for bankruptcy in 2003.

My shareholding experience with Crown Pacific influences my research to this day; it provided valuable lessons on the available (and unavailable) levers for cash generation and risk mitigation with timberland investment vehicles. At the end of the day, timberland owning firms – such as public REITs Plum Creek (PCL), Potlatch (PCH), Rayonier (RYN) and Weyerhaeuser (WY) – must embrace situations imposed by external markets and optimize firm performance for shareholders. How did timber REITs fare in 2011?

Big Decision in Tough Markets

Potlatch leadership dug deep in late 2011 to make the sector’s “stone cold decision of the year” to reduce dividends and harvest levels. These decisions by the PCH Board and senior management (1) placed long-term asset values and maximization over short-term yields and (2) embraced the realities of knowable, quantifiable impacts on wood markets relative to speculative forecasts of key demand drivers. Cheers.

Equity markets embraced the resulting 39% reduction in Potlatch’s yield. While share volume spiked on the day of the announcement, PCH’s share price declined 2.2% after two days of “post announcement” trading. This left its dividend yield at 4.1%, in line with the other public timberland-owning REITs. According to the FTR Index, the timber REIT sector now has a 4.0% dividend yield.

Timber REITs and Timberlands Outperform US Treasuries Long-Term

U.S. Treasuries remain a common benchmark for private timberland investments. Why? Relative safety and low risk over long time frames. However, U.S. Treasuries, thanks to a robust secondary market, are more liquid than private timberlands, making them convenient benchmarks for publicly-traded timber REITs, as well.

We also care about Treasury yields because when they increase, so do interest rates on fixed-rate mortgages. This increases the cost of buying homes and decreases the demand, and prices, of those homes, which can slow the economy. This coincides with another reason why timberland investors take such a strong interest in Treasuries:  they affect the costs of building and buying homes, which influence the supply and demand of forest products such as lumber, OSB and plywood.

On an annualized basis and year-to-date, how have timberland investment yields benchmarked to 10-year US Treasuries? For the ten year period from 2001 through 2010, both private (less liquid timberlands) and public (more volatile timber REIT stocks) investment vehicles outperformed US Treasuries: timber REITs returned 6.65% annually, private timberlands according to NCREIF returned 6.82% per year, and US 10-year Treasuries returned 3.99% per year on average.

Conclusion: Timber REIT Kudos for 2011

In 2011, timberland-owning REITs, as a sector and led by Rayonier’s 27% gain, outperformed the S&P 500. As measured by the Forisk Timber REIT (FTR) Index, publicly-traded timber REITs returned 5.69% versus 0.00% for the S&P. The FTR Total Returns Index, which accounts for dividend distributions, earned 9.62% in 2011.

With the recent run-up in row-crop farmland prices, savvy investors should be looking to similar investments that offer many of the same benefits of crop land ownership, without the hefty price tag. Timberland is just such an asset. In fact, timber is a crop. It just has a much longer production cycle. And here’s a secret…when you look at the asset classes held by the ultra-wealthy, almost without fail, you will see a heavy timberland flavor. Institutional investors, and high net worth individuals have already begun to take advantage of this opportunity. If you have not recognized this opportunity until now, it’s time to educate yourself on the benefits of timberland ownership.

Now I’ve mentioned the wealthy a couple of times here, but that does not mean you need 10 million dollars socked away to buy into a timberland asset. Those wealthy individuals had to start somewhere, and for the most part, they did not start out with millions to invest either. They started by making smart investments in assets that appreciated in value, or brought them income in some manner. Timberland will do both. It will work for the guy that can buy 40 acres, just like it will work for the investment group that owns 400 thousand acres. YOU have to start somewhere. As investors begin to substitute away from the higher priced good (Crop Land), the substitute good (Timberland) will appreciate in value. There’s no magic formula or fuzzy math here, it’s straightforward, basic level economics. When the value of a good goes up, so does the value of substitute goods. Timberland is a good substitute for crop land.

Why Timberland and Why Now?

Real Estate is a tale of two markets right now. Everyone knows that the larger real estate market, like our total economy, is not doing well. However, farmland seems to be breaking new record highs on an almost daily basis. Many factors contribute to that. Some of it is scarcity, some of it is commodity prices, some of it is advancement in the productive capacity of good farmland, some of it is capital from non-farm sources flowing into the ag land economy, and some of it is pure speculation.

Let’s focus on the last two, as these are the factors that are driving prices the most in the current market. Speculation. There’s a bad word, isn’t it? I beg to differ. Speculation brings liquidity to markets the world over. Unless you can predict the future 100% correct all the time, every decision you make is a speculative one. Without this speculation many of our markets would swing more wildly than they already do. Speculation will help put a bottom sagging markets. Speculation in the commodities markets helps farmers plan their crops, and protect their investments. Speculation has a purpose in a free-market economy. Speculation can propagate itself to unsustainable levels, as we have witnessed in so many “bubbles” in the last decade. Speculation that is based on provable numbers, and time-tested data is a better bet than speculation in a market because everyone else is doing it. The cropland market has a fair amount of speculative value built into it right now. Yesterday is when you should have invested it cropland. If you are going to profit from the appreciation in an asset based on the forward momentum of speculation, the time to do that is before it’s all the rage. Timberland is positioned well to take advantage of this right now. As the cropland numbers push higher, more people will see the value in substituting timberland for cropland. More people will grow uneasy with the run-up in cropland values and substitute away from it. Get into timberland now, and benefit from this economic law.

There’s also much more capital in the agricultural economy today than is traditionally present. People that would not know which end of a cow to feed, or that peanuts grow in the ground now are owners of farmland. Many of these people have invested in the land factor of production because they are substituting away from investments in the stock market that they have deemed more risky. They simply hold the property for the rental income, appreciation, and hedging ability of the asset. They rely on a traditional farmer to actually produce from the land. Until recently, this was a very uneasy partnership between the big money, city-slicker and the farmer. With the maturation of our ag markets, and the sheer volume of capital available from urban investors, they have grown to appreciate each other a bit more than in the past. Many of these same dynamics are at play in the timberland market. More investors are realizing the income, appreciation, and hedging properties of the timberland investment. This market will soon develop in much the same fashion as the cropland market has in the past couple of years. Plus timberland can be more easily managed by someone who has not been a farmer all of their life, or even someone who lives in a downtown loft apartment. It’s a bit more forgiving to the newbie than is cropland and you have the opportunity to time your harvest to highs in the wood fiber markets instead of taking the going price at the end of the growing season. This puts the investor in the position of profiting from the production aspect of timberland…not just sitting back and collecting rents from someone else trying to work out a profit using the land too.

Why is Timberland a Good Investment Substitute for Cropland?

Timberland has all of the qualities that today’s investors are paying premiums to obtain in the cropland market (income, appreciation, hedging). Timberland has a lower capital requirement per unit of production than cropland. Timberland has not experienced the recent run-up in prices that cropland has. Timberland can be more easily managed, in a hands-on manner, by the novice than can cropland. You can do all of this with timberland and still obtain rents on the timberland from outdoorsmen who wish to hunt on the property…while you are growing your timber crop. The numbers you need to make speculative investment decisions are available, proven, and time-tested. No fuzzy math. Just good solid investment sense. Get yours before it’s all the rage. Then profit from a timberland investment once everybody’s doing it. Get ahead of the curve instead of behind it. Buy Low. Sell High.

Recent comments by Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Blair regarding minimum down-payments of up to 20% for “qualified residential mortgages” (QRM) echoed discussions about residential housing markets at the UGA Timberland Investment Conference. Our Equity Research Team (Neena Mishra, CFA, Director of Equity Research; Dr. Tim Sydor, Forest Economist; and Dr. Brooks Mendell) met to discuss potential issues and implications from this on housing and stumpage (timber) markets:

According to National Association of Homebuilders (NAHB) Chairman Bob Nielsen, the plan would disqualify a number of potential home buyers, reducing home sales and resulting in 50,000 fewer housing starts per year. Changes in mortgage requirements affect housing starts, which in turn affect the forest products industry.

How might this affect timberland investors?  Using Forisk’s interactive Stumpage Forecasting models, we applied NAHB’s numbers. The net impact of fewer home  built reduces softwood lumber consumption by 1.5 to 1.9 billion board feet per year which could lower softwood sawtimber stumpage prices in the US South by $0.60-0.80 per ton based on direct effects alone. This does not include potential impacts on the shadow inventory of unsold homes and potential foreclosures in the pipeline.

In addition to affecting timber markets, the FDIC/Federal Reserve plan represents a significant shift in risk. From one perspective, any probability of default whether due to job loss or equity loss (so-called “strategic default”) is borne by the buyer in the form of the 20% down-payment. As written the requirement is indiscriminate, even including buyers with high FICO scores. Would rates actually decline as a result?

Requiring lenders to have “some skin in the game” is necessary but risk retention increases the cost of credit. Thus a line must be drawn to determine which loans are less risky and the less risky loans should carry lower rates of interest (possible only if no/very low risk retention by the banks). There is no doubt that QRM loans will carry a much better rate of interest, if the rules are imposed. Overall rates may or may not come down but QRM loans would clearly carry much better rates than non-QRM loans.

The picture is further clouded by the fact that the private securitization market for housing is gasping; securitization brings down the cost of credit and increases the availability of credit. Reviving the private securitization market would be difficult if very strict risk retention requirements are imposed. This is further exacerbated because current rules exempt FHA, Freddie Mac and Fannie Mae loans (while Freddie and Fannie remain in conservatorship) from any risk retention requirement. Currently about 90% of the loans are backed by these agencies, so the actual impact on the housing markets may not be that great. As such, the rules actually favor Freddie-Fannie, making their exit – an oft cited objective of reforming the mortgage markets and reducing tax-payer exposure – from the housing markets anytime soon nearly impossible.

The “80/20 rule” – also called the “Pareto principle” for Italian economist Vilfredo Pareto – posits that approximately 80% of your results or effects derive from 20% of the causes. Look around and examples materialize. 80% of your revenue comes from 20% of your clients. 20% of your job will take up 80% of your time. 80% of the time your newborn cries at night occurs due to 20% of the potential reasons. Pareto made the original observation in 1906 when he noticed that 20% of Italy’s population owned 80% of the land.

This management rule of thumb provides a means for quickly assessing profitability, risk, control and capacity in a business or an industry (which helps prioritize work). In the forest products and timber industries, we see examples of this rule in our research associated with timberland ownership, end product market share, and factors driving prices, especially at the local level.  However, nationally, industries may reflect more or less concentration. Let’s consider the use of wood in the United States.

In 2005, Forisk Consulting began collecting mill-specific wood demand and capacity data in the United States. Today, our team manages an ongoing research program that collects and confirms data on 3,196 announced and operating wood-using forest industry and wood bioenergy mills throughout the US. [One product that we provide to clients from this research is a mill database that supports shapefiles for analyzing wood baskets and timberland investments, and making maps for spatial analysis.]

In a given year in the US, approximately 2,300 forest industry firms consume ~500 million green tons of wood. Which firms use the most? The accompanying table includes the top 10 US companies based on potential wood use. The list includes wood use at full capacity for mills labeled as open in our database as of July 2011. Full capacity for the industry currently sits just short of 600 million green tons.

The top 10 comprise ~241 million tons per year of capacity (actual wood use represents 70-90% of this, depending on products produced and time period). The top 10, which represent less than 1% of the firms, account for ~40% of the wood using capacity. The top 10% of the firms (~230 firms), account for ~85% of the wood using capacity in the US forest products industry.

Last week, the Wall Street Journal reported on the rush of investors buying into publicly-traded real estate investment trusts (“Real-estate investors target neighborhood that is looking up,” Wall Street Journal, 11/15/11). According to Citigroup Global Markets, investors, year-to-date, invested 18% more capital into publicly-traded REITs than in all of 2010, and 400% more than in 2009. Holy groupthink, Batman!

This stampeding herd of buyers returning to public real estate markets reminds me of the African proverb “you can’t run and scratch your foot at the same time.” As a reluctant runner, I welcome an excuse to pause and scratch a puzzling itch or three. First, why the interest in REITs generally? Second, how does this look within the context of the overall market? Third, how do timberland-owning REITs score during this investment cycle?

REIT investments satisfy the hunt for yields. With capital looking for “relative” safety and valuing a return to fundamentals, public REITs attract investors eyeballing the steady cash flows and requirement to distribute earnings quarterly. Within the REIT sector, certain sub-sectors have outperformed the broader REIT market. According to NAREIT, total 2011 returns on apartment buildings and self-storage properties averaged ~10% and ~22%, respectively, through the first week of November. Nice.

However, a closer look at the numbers indicates the article made a mountain out of a molehill. Overall, REITs appear to be tracking the market.  REITs YTD through November 18^th returned -2.25% versus -3.34% for the S&P 500 versus….-2.69% for public timber REITs according to the Forisk Timber REIT (FTR) Index. While real estate often satisfies objectives to diversify portfolios, this has proven more difficult in the context of a European debt crisis, failing efforts to balance U.S. budgets, and lagging demand for homes and construction.

What about timberland investments? Year-to-day through Q3, according to NCREIF, equity investments in timberlands returned 1.06% and -0.35% in the third quarter. For reference, with dividends included, public timber REITs as measured by the FTR Total Returns Index generated 0.63%.

The FTR Index includes Plum Creek (PCL), Rayonier (RYN), Potlatch (PCH) and Weyerhaeuser (WY). As of 11/18/11, publicly-traded timber REITs comprise 4.99% of total public REIT capitalization.

How can timber REITs leverage their available capital, given the fact that they must distribute, and cannot retain, earnings? Over time, timberland-owning REITs have identified and employed multiple investment strategies to leverage available capital. These strategies include:

• “Recycling capital” through programs such as 1031 like-kind exchanges;
• Buying back company shares through repurchasing programs; and
• Organizing joint ventures (JVs) to share risk, access capital  and leverage expertise.

In the end, each of these represent approaches to enhancing returns from the same pool of internal capital and assets. In this post, I focus on JVs related to timberland.

Timber REITs, like their vertically-integrated forest industry predecessors and cousins, have structured JVs to invest in manufacturing assets and explore emerging bioenergy markets (for example, consider Weyerhaeuser’s JV with Chevron). However, unlike REITs that focus on commercial real estate, JVs specific to timberland assets remain relatively uncommon. One notable exception is Plum Creek’s (PCL) “Timberland Venture” with The Campbell Group (TCG), a timberland investment management organization (TIMO).

In October, 2008, PCL contributed 454,000 acres of Southern timberlands and TCG contributed $783 million in cash to Southern Diversified Timber, LLC (“the Timberland Venture”). In exchange, PCL received a $705 million preferred interest and a 9% common interest, while TCG received 91% of the Timberland Venture’s common interest.

PCL’s preferred interest entitles it to a cumulative preferred return equal to 7.875% per annum. TCG manages the JV’s timberlands, which are located in six states: Oklahoma, Arkansas, Mississippi, North Carolina, South Carolina and Georgia.

For PCL, the JV transaction was both earnings and cash flow accretive, while allowing the firm to maintain an interest in potential upside. Separately, PCL received cash of $783 million through a loan from the JV. The transaction, structured as such, provided certain tax advantages relative to standard divestiture, and supplied PCL with capital that was used, in part, to retire debt and repurchase stock.