Most timber REIT distributions (related to income from the sale of timber) are treated as long-term capital gains and taxed at relatively lower 15% tax rates compared with ordinary dividends.  Recently, all four public timber REITs announced the tax treatment of dividends paid in 2011:

For Plum Creek (PCL), Rayonier (RYN) and Weyerhaeuser (WY), 100% of the dividends paid in 2011 will be treated as capital gains. For Potlatch (PCH) investors, $1.01188 per share (54.955878% of the total distribution) will be treated as return of capital, while the balance will be treated as capital gains.

Click here to learn more and register for “Applied Forest Finance” on February 9th in Atlanta, Georgia.

Last week, the New York Times published a take-down of government biofuel mandates (“A Fine for not Using a Biofuel that Doesn’t Exist,” 1/9/12).  For 2011, gasoline and diesel suppliers will pay ~$6.8 million in penalties because they failed to mix 6.6 million gallons of cellulosic biofuel into their motor fuels as required by law.  One problem: we can’t produce cellulosic ethanol at commercial scale.  So we’re fining firms for noncompliance when compliance remains unfeasible. (Say that five times fast….)

The article reaffirms from multiple sources the conclusion of our 2011 wood biofuels study:  substantial technical hurdles remain.  Even the executive director of the Advanced Biofuels Association acknowledged in the article that wood-based biofuel “was not yet ready for commercial introduction.”

Roiled and riled markets – and a recent phone call asking about the difference between timber REIT and timberland investments – provide an opportunity to revisit the differences between financial assets and real (hard) assets.  While real assets include consumable goods and productive factories and firms, financial assets - such as bonds or shares of publicly-traded firms – consist of claims on real assets.  Financial assets allow investors to save, diversify risk, borrow and, ultimately invest so that more real assets can be produced and consumed in the future.

“Aren’t shares in timber REITs similar to owning timberlands?”  Sorry, no.  Thanks for playing.  When you own shares in a timber REIT, you don’t own timberland.  You own a piece of a business, over which you have no control unless you are a major shareholder, that happens to generate revenue from selling trees and related activities.    In theory, shares of timber REITs rise over time because they account for the trees and other products being produced and sold.  As the economy improves, so do revenues and,  assuming stable margins, profits to shareholders.  In practice, the super liquidity of timber REIT equities also diminishes their diversification potential; timber REITs basically correlate to the S&P 500 over time.

Timberlands, on the other hand, are real assets.  The challenge of the asset class over the past five years reflects a run-up in prices that outpaced housing markets and GDP growth.  While interest in timberland assets remains extremely strong, we continue to reach for firm ground following a decade-long transfer of wealth from first-time buyers to early entrants exiting the timberland market.

Click here to learn more and register for “Applied Forest Finance” on February 9th in Atlanta, Georgia.

While the timber REIT sector performed well, individual firm performance varied.  Not including distributions, Rayonier (RYN) alone generated positive, stand-alone returns of 27.47%, which accounts for a mid-year 3-for-2 stock split.  The other three timber REITs generated negative returns of 1 to 4 percent.  The primary distinction between RYN and its timber REIT brethren is the relative size, magnitude and profitability in 2011 of its specialty performance fibers division.

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.  Over time, how have timberland investment vehicles performed against U.S. Treasury 10-year notes?  First, let’s take a (BRIEF) moment to revisit the world of bonds and government debt.

US Treasury Refresher

Treasury yields refer to the total amount of money you earn on U.S. Treasury bills (less than 1 year terms), notes (2 to 10 year terms) or bonds (longer than 10 year terms) sold by the U.S. Treasury Department to pay for the U.S. debt.  Remember:  Treasury yields fall when demand increases for Treasuries, which investors view as safe investments.  As with timberlands, when prices go up, expected returns on capital invested go down. Treasury yields change daily because few investors hold them to term.  Rather, investors resell them on the open market.

One reason we care about Treasury yields is 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 a second 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.

Usually, Treasuries with longer time frames have higher yields.  Why?  Because investors require higher rates of return for locking up their capital for longer periods.  The figure shows the “yield curve” as of December 22, 2011.

Yields remain abnormally low due to economic uncertainty. Investors accept these low returns in exchange for safety.   When shorter-term yields exceed longer-term yields to produce an “inverted yield curve,” it reflects near-term concerns of potential recessions.  Inverted Treasury yields occurred in April 2000, prior to the 2001 recession, and in January 2006, prior to the most recent recession.

US Treasuries versus Timberlands and Timber REITs

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 (see table).

Year-to-date, shorter term market volatility has punished equities and private timberland markets reflect the cresting of timberland prices over the past three years.   Still, for those holding public timber REITs, the positive cash flow associated with quarterly dividend distributions offset share price declines, as reflected in the FTR Total Returns Index.

After accepting the fact that we weren’t actually on a first name basis, I replied, “I would make it easy for users of wood to operate in your state without betting on any specific technology.”

The Lt. Governor liked the first half of the answer, but not the second half.  The fear of “missing out” on a “wood biofuels boon” has distorted policymaker views of wood market realities.  The sexy, explosive potential of reorienting US transportation fuels to rely on renewable “just-add-sun-and-water” raw materials has made fact-based discussions about the sector akin to strolling through a carnival fun house.

I remember, as a twelve-year old, looking from mirror to mirror at a county fair.  Tall and thin in this mirror; short and stumpy in that mirror.  We use mirrors both to show us what we want to see, and what we don’t.  And when we see what we don’t want, we either change our view, or change mirrors.

When it comes to liquid biofuels and cellulosic ethanol, multiple mirrors continue to reflect a consistent set of facts.  Our team has three years of research, a comprehensive US liquid biofuels study and ongoing market evidence that cellulosic ethanol faces the thorniest of practical challenges in an increasingly difficult context.  So, what are the facts?

• No cellulosic ethanol facilities operate at commercial scale.  Wood Bioenergy US tracks every announced and operating wood-using bioenergy project in the continental United States.  As of December 7, 2011, this represented 456 projects.  Of these, 39 are liquid fuel projects.  How many are operating at commercial scale?  Zero.
• Cellulosic ethanol faces unsolved technology hurdles.  The lack of wood biofuels projects is consistent with the results of our study “Transportation Fuels from Wood: Investment and Market Implications of Current Projects and Technologies.”  For 36 cellulosic biofuel projects, we estimated an 11 year lag between when the projects expect to operate and when our technology analysis indicates the technology could overcome hurdles and be viable at commercial scale.
• Government subsidies and EPA mandates failed.  The Wall Street Journal (“The Cellulosic Ethanol Debacle,” 12/14/11) recently detailed the failure of subsidies and mandates to spur progress and, by implication, facilitate deceit and unrealistic projections.

Finally, the context for these projects has become increasing stark.  In a US market environment where gasoline use has been declining this year and where supplies of natural gas have been increasing, the political urgency and investment potential of these projects dissipate.

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.  From this point of view, Potlatch’s (PCH) recent announcement to reduce dividends and harvest levels reflect sound, investment-strengthening decisions to protect long-term shareholder interests.  Decisions by the PCH Board and senior management (1) place long-term asset values and maximization over short-term yields and (2) embrace the realities of  knowable, quantifiable impacts on wood markets relative to speculative forecasts of key demand drivers.

PCH actions reinforced key messages we shared with clients in 2011 based on our equity research:

• Analysts have “over forecasted” stumpage prices.  The pine grade stumpage markets in the South face measurable pressure for 2+ years.
• Georgia-Pacific’s decision to close its Crossett, AR facility moved the needle.
• Among the timber REITs, PCH is one of the two most directly exposed to US housing numbers.  Our January 2011 research detailed this relationship.  CEO Mike Covey has been explicit regarding PCH dependence on US housing numbers, and how it affected Board discussions related to the dividend.

Equity markets appear to have embraced the PCH 39% reduction in its 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 (see table).  According to the FTR Index, the timber REIT sector now has a 4.0% dividend yield.

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.

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.

Wood Demand: Pine sawtimber demand declined ~1% across the South, primarily driven by curtailments at plywood mills. While demand declined less than expected, pine sawtimber prices, according to Timber Mart-South, declined 5.1%, more than expected. Dry weather and selling by timberland owners eager for cash flows may have pushed prices to new lows. Pine pulpwood demand increased 1.7% in the South and demand for hardwood pulpwood held steady in Q3 2011; stumpage prices for both products declined.  We continue to monitor softwood lumber and pulp prices, and the proposed lower design values for SYP lumber.

Wood Bioenergy Markets:  Industrial pellets for export to European utilities lead all bioenergy activities. For example, F.E. Wood & Sons plans to build a 300,000 ton/year pellet plant in West Baldwin, ME. German Pellets plans to build a 500,000 metric ton/year pellet plant in Woodville, TX. Westervelt Renewable Energy held a groundbreaking ceremony at its 250,000 metric ton pellet plant site in Aliceville, AL in October.

Forest Finance:  As demand for pulpwood increases in select local markets, forestland owners have called to ask “when should I clearcut for pulpwood versus manage for sawtimber?”  We published research commissioned by NAFO that addresses this issue at a regional level (click here).  In February, I will detail the step-by-step financial analysis required to answer this question for specific timberland ownerships and markets as part of our Applied Forest Finance course on February 9, 2012 in Atlanta.  For more information, click here.