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Touching wood for timber REITs

A mix of powerful factors have injected sap into REIT returns this year. Yet US interest rate rises could soon start tilting the balance toward their private peers.

The S&P 500 shot past the 2,500 mark for the first time in its history this month as the US Federal Reserve chief Janet Yellen hinted at a tightening of monetary policy, boosting treasury yields and US equities in the process. The index has since retreated, but it is still far higher than at the start of the year, just before Donald Trump’s inauguration lifted the spirits of corporate America.

Less noticed has been the strong performance of timber real estate investment trusts. The Forisk Timber REIT index, which tracks all publicly traded timberland-owning REITs, is up about 12 percent in 2017. That not only beats the S&P 500, it also vastly surpasses both the NAREIT All REIT index and NCREIF Timberland, which covers timber transactions in the private markets. Individual performances are even more impressive: Potlatch, one of the major timber REITs, is posting a return of more than 20 percent on the year. What’s driving such appetite?

Start with the permanent. Timber REITs have an edge over private alternatives in that they are more liquid: their shares can be bought or sold on a daily basis, while the direct acquisition of timber holdings typically requires longer time frames, higher overheads and starting capital. They also pay no corporate tax on their earnings, with taxes being levied instead on shareholders’ dividends. Forisk, the index provider, suggests this gives them an advantage over timber corporations.

Listed timber companies are also being buoyed by solid demand for wood. The main driving factor is the recovering US housing sector. Home builders are reporting a spike in housing starts: these are up 4 percent overall and 8 percent for single-family starts in 2017. This trend is fed by rising optimism among US consumers, rooted in growing employment and lower mortgage rates.

But timber REITs have also benefitted from more specific factors. First is what they did to shore up their value: maximizing operating revenues and consolidating higher quality portfolios, which led them to divest non-core assets and bolster cash efficiency. This divestment phase is on track to be completed. Second is a more arcane matter. In July, Vanguard, the world’s second-largest provider of exchange trade funds, asked shareholders to swap the index it uses for its $35 billion real estate ETS to a different index that includes timber REITs. Insiders reckon this is pushing hundreds of millions of fresh capital into the asset class.

Yet the outlook is more uncertain. While the economic recovery looks sturdy, other factors may prove to be one-off boosts. And timber REITs could soon be hitting a bump: markets currently put odds for a December US interest rate hike at 80 percent; timber REITs, which tend to trade on a multiple of cash yield, could be cast in a less favorable light than unlisted timber, which is typically backed by investors seeking to maximize total returns. REITs could find themselves under pressure to improve cash yields, making returns more volatile.

Historically, this has been the case. Only privately held timberland demonstrated positive returns each year of the period 2012-16, according to Forisk. This is in part because private valuations, done more periodically, tend to be less volatile; it is also because markets tend to discount the value of listed illiquid assets. Timberland REITs have a had a good run so far this year. Upcoming pressures, however, may prompt some assets to branch off and go private.

Write to the author at matthieu.f@peimedia.com