Photo by Frank Rosenstein A Plum Creek Timber Company forest located in Arkansas.

Distinctive Qualities Might Allow for Timber REITs

By Jada A. Graves

One of the oldest industries in the United States, lumber and paper products has joined the REIT world in the 21st century. With the REIT conversion of Plum Creek Timber Company, Inc. (NYSE: PCL) in 1999, the lumber and paper products industry entered the REIT world. Other companies followed—Rayonier Inc. (NYSE: RYN) in 2004, Longview Fibre Company's (NYSE: LFB) announcement of conversion plans in 2005 and Potlatch Corporation (NYSE: PCH), which converted on Jan. 1, 2006.

As part of the specialty REIT sector, timber REITs have joined an assorted group of equity REITs specializing in movie theatres, correctional facilities and car dealerships, but these four REITs are even more specialized. With their unique assets and separate analysts, timber REITs have a distinct following and more investors have an opportunity to easily and efficiently access timber-focused investments.

Tall Timber

All four timber companies had long histories in the lumber and paper products industry before converting to a REIT. Mark Weintraub, a lumber and paper products analyst for Buckingham Research Group, covers all four companies and says turning to the REIT approach was an evolutionary step. A REIT format is beneficial for those lumber and paper products companies that are timberland-based, he says.

Plum Creek possesses more than 8 million acres of timberland across 18 states, in addition to 10 wood products manufacturing facilities.

Rick Holley president and CEO Plum Creek

"The existence of substantially timberland-based lumber and paper products companies lead to the emergence of timber REITs, which are highly focused on the land and its ability to sustain timber growth. Companies like Rayonier and Plum Creek were growing and seeking the breadth of REITs' investor appeal."

In 1999, Seattle-based Plum Creek Timber Company was the first forest products company to convert, 10 years following its birth as a master limited partnership. The company acquired forests across the nation, and now possesses more than 8 million acres of timberland across 18 states, in addition to 10 wood products manufacturing facilities.

Now that Plum Creek has such deep roots, president and CEO Rick Holley says the company is currently focused on maximizing the value of its existing land and timber assets, segregated into its northern and southern resources, manufacturing capabilities and, finally, its real estate business.

Plum Creek has had company in the specialty REIT sector since Jan. 1, 2004, when Rayonier converted. The company was first incorporated in 1926 as Rainer Pulp and Paper Company with a handful of West Coast timberland assets. The modern-day Rayonier owns or manages 2.5 million timberland acres in the United States and New Zealand, and in August 2006 agreed to purchase approximately 176,000 more timberland acres across six states in a transaction to close by the fourth quarter of 2006.

Rayonier has structured itself around three core businesses—timber and real estate, as well as a very strong and stable performance fibers business, with products used by customers in more than 50 countries for the development of textiles, cigarette filters, paints, pharmaceuticals and impact-resistant plastics. Rayioner uses taxable REIT subsidiaries to operate the non-timber activities.

Longview Fibre Company grew from a 1920s paper mill that utilized waste wood from Douglas fir trees in Wisconsin. The company manages more than 585,000 timberland acres spread across nine tree farms in the Pacific Northwest. Longview Fibre announced its intention to convert to REIT status in 2005. However, by the first half of 2006, the company had delayed its conversion and rejected two separate unsolicited takeover bids from the private equity firms Campbell Group and Obsidian Finance. In July 2006, Longview announced its intention to explore strategic alternatives, including becoming a REIT, but at press time it was uncertain what the company's fate would be.

"Over time, we will see increasing interest and greater understanding of timber REITs by the investment community, which should result in better performance of timber REIT stocks."

Mike Covey president and CEO Potlach

Potlatch Corporation, founded in 1903, is the oldest timber company to convert to a REIT. Chief Financial Officer Jerry Zuehlke says Potlatch operated as a C-corporation, but began exploring its REIT potential in the 1990s. "Our board decided that now was a good time for us to convert our timberland business into a REIT," he says.

The company currently owns and manages 1.5 million timberland acres in Arkansas, Idaho and Minnesota with a hybrid-poplar plantation in Oregon, and uses a taxable REIT subsidiary to operate 13 manufacturing facilities that produce wood and bleached pulp products.

Zuehlke says the company intends to grow its timberland capabilities. "We've always managed our timberlands on a long-term sustainable basis. In the future, we will magnify the REIT assets, yet still maintain the competitiveness of our other businesses."

Growing Assets

In some respects, a timber REIT is markedly different from its equity REIT counterparts. The most significant difference is, well, timber. "Trees are self-renewing. With air, water and sunshine, your assets are growing, literally, and that's different from any other asset out there," Weintraub says.

"Other equity REITs grow their asset base through capital investment, while our asset base grows biologically every day and doesn't depreciate," Holley says.

Lee Nutter, chairman, president and CEO at Rayonier, says "green" assets give the investor flexibility that buildings do not provide. Nutter uses one scenario specifically when speaking with the investment community about the differences in timber investing.

A Rayonier forester measures company trees in New Zealand, where Rayonier owns or manages more than 350,000 acres of forests.

Lee Nutter Chairman, president and CEO Rayonier

"With an office building, when there's a market downturn, you can end up in a lease that's not favorable—or worse, no lease at all," Nutter says. "However, in timber REITs, when the market takes a downturn, you can choose perhaps not to harvest some of your property. Then you come back a year later to more volume and more quality. It's a living asset, versus potentially acting as dead space. In a bad market, timber REIT income can be delayed but in a building REIT, if you don't receive income, you never get it back."

The chacter of Timber REITs' returns is slightly different from that of other equity REITs. REITs distribute at least 90 percent of taxable income as dividends, but timber REITs generate long-term capital gains income, Holley says. "To the extent that Plum Creek's capital gain income is not distributed to shareholders, the company would be subject to corporate tax. However, for all practical purposes, all the company's taxable income is distributed every year."

According to Jay Fredericksen, Rayonier's vice president of corporate relations, a traditional REIT has a much higher percentage of the dividend that is taxed at ordinary income rates. "In a timber REIT, because timber income is treated as capital gains, the maximum tax rate for the investor is 15 percent."

These subtle differences sometimes present challenges to the timber REITs when trying to attract investors, both from their adopted real estate investment world and the forest products industry, Holley says.

"We need to spend time explaining the fundamentals of our business to investors who are more familiar with traditional REITs, and explaining the REIT structure to investors who are familiar with the basic materials industry," he says.

"Investors shy away from uncertainty. If timber REITs are in their own sector, it becomes easier to inform investors of their benefits."

Scott Winer Director of Taxes Rayonier

"REIT investors have grown up with office building assets," Nutter says. "They've had to learn about a very separate segment of assets to become comfortable with the concept of investing in timber."

Finding a comfort zone has also been an issue for paper and forest products analysts who cover the timber REITs, especially when they find themselves learning about REIT structure nuances in order to inform clients. "Many of the investors I am speaking with are coming from an expertise in the forest products area, so our conversations are more of an education of what a REIT is all about," Weintraub says. "It's a process to get them comfortable with the underlying asset class."

Christopher Chun, a Deutsche Bank paper and forest products analyst who covers Plum Creek and Rayonier, agrees with Nutter and Weintraub. "They crossover into each other's territory, and analysts need to have a reasonable understanding of both areas to become comfortable with them," he says.

Institutional investors have long allocated part of their portfolios to timber to obtain the diversification benefits from this asset class. For example, Harvard's endowment has recently allocated 10 percent of its portfolio to timber. The REIT format allows individual investors to efficiently obtain the same diversification and performance benefits.

Timber REITs' growth strategy is focused on increasing its underlying asset base and to further strengthen financial performance through asset acquisition to ultimately generate more cash for the shareholders.

According to the Hancock Timber Resource Group, timber has actually beaten the stock market—with less risk—over the long run and it is uncorrelated to stocks. In addition, Hancock has concluded that timberland investing is relatively cheap and the price of timber has consistently beaten inflation.

The Sky's the Limit

It was seven years ago that Plum Creek become a REIT. Now there are four publicly traded timber REITs and several of private timber REITs. Both the niche's analysts and executives agree the future is boundless for this segment of the real estate industry, and that timber is now in a position to stand on its own as a sector, due to its individuality and growth potential. Scott Winer, director of taxes with Rayonier, says an independent sector can assuage investor concerns.

"Investors shy away from uncertainty. If timber REITs are in their own sector, it becomes easier to inform investors of their benefits," he says.

Compared to some of the other specialty REITs, timber REITs are very distinct, Nutter says. "The number of companies is steadily growing, and because of that we are receiving more visibility within the sector, and with investors."

Holley cites growth of the sub sector as well as the sector's distinctive features as reasons for Plum Creek and others to branch out. "Timber REITs have unique characteristics that set them apart from the other REITs in the specialty sector, so it makes sense for the timber REIT to have its own sector. Today, there is a critical mass in the category. By having a distinct category, investors would have a clear view of the financial performance of these distinct real estate assets," Holley says.

"I think over time, because the REIT approach is so effective and efficient, you're going to see more timber REITs. There will be a time when there are manufacturers and timberland owners, but very few who are both," he continues.

Mike Covey, Potlatch's president and CEO, says he agrees that timber REITs will achieve sector distinction, summing it up with his belief that REITs are the best way for shareholders to realize timberland assets' value. "Over time, we will see increasing interest and greater understanding of timber REITs by the investment community, which should result in better performance of timber REIT stocks," he says.