November 2011

Investments: Timberland

Timberland is defined as a forested area capable of growing 20 cubic feet of timber of merchantable quality per year and where timber production is not barred by legal or regulatory rules. Approximately 504 million acres, about two-thirds of the total forest lands in the United States, is considered timberland. Relative proximity to timber consumers - most often pulp and lumber mills - is a key consideration affecting the value of timberland due to the reduced transportation costs of the cut timber. Another factor affecting value is the location of the timberland; areas with more rain will experience faster growth.

Federal, state and local governments own approximately 40 percent of U.S. timberland, or about 200 million acres. The remaining 60 percent, owned by private entities and individuals, include timber real estate investment trusts (REITs) as well as timber investment management organizations (TIMOs). However, the large owners still represent less than 10 percent of privately-held timberland. (Plum Creek, which owns approximately 6.8 million acres of timberland, is the largest private landowner in the United States.)

Returns and Risks

Timberland is an attractive investment for long-term holders, such as pension funds, because the “timber crop” is renewable, as cut trees are replaced by new growth. So-called “biological growth” is fairly predictable, although it varies by species and region. For example, timber in the western United States grows an average of 2.4 percent a year, while northern timber grows at 3.4 percent and southern timber at 6 percent. By one estimate, biological growth is the most important factor in generating returns on investment, accounting for between 50 and 70 percent of total return.

The major physical risk to timberland is destruction from fire, pests and disease. Overall, the risk is minimal, accounting by one estimate for losses of less than one-half percent per year. The primary economic risk in timberland investment is that prices are highly volatile. If prices are at a low point when timber is harvested, anticipated profits may not be realized. Offsetting this is the option to hold off timber harvesting and sale until prices improve. In effect, timber can be “stored on the stump.”

There is also a risk due to new environmental restrictions or regulations imposed by federal, state or local governments. Tighter regulations or restrictions could impact a company’s ability to harvest timber in a cost-efficient manner and may put it at a competitive disadvantage.

Timber REITs

In recent years, timber REITs have been significantly affected by the downturn in the housing market and have shifted from saw-timber (raw material for manufacturing lumber and building houses) towards pulpwood (raw material for paper and paperboard) in an attempt to mitigate the impact on earnings. In addition, some timber REITs are looking to overseas markets, especially Asia, to increase revenues.

According to information published by the National Association of Real Estate Investment Trust, through August 31, 2011, the timber REIT sector had a year-to-date return of 4.64% and offered an attractive dividend yield of 3.82%. It should be noted that there is a lack of diversification within the timber REIT sector, as it currently consists of only four REITs.

Tax Benefits

As with traditional real estate, standing timber and timberland is a capital asset. Thus the usual rules relating to capital gain and loss apply to sales and exchange of timber. In addition, a timber owner's opportunity for capital gain treatment is significantly expanded by Code Section 631 to include the sale or exchange of cut timber. Thus the owner of timber or the holder of a contract to cut timber can elect to treat the cutting of the timber as a sale or exchange, whether the timber is held for sale or use in a trade or business, provided the timber or the contract has been owned for more than one year.

Furthermore, the disposition of timber pursuant to a contract under which the taxpayer retains an economic interest in the timber is treated as a sale or exchange if the timber was held for more than one year. In effect, Code Section 631 permits the portion of a taxpayer's gain attributable to the natural growth of the timber to qualify for capital gain treatment even if the taxpayer cuts the timber and holds it for sale in the ordinary course of business.

This article was written by Anthony La Malfa and originally appeared in BDO USA, LLP's "Real Estate Monitor" newsletter (Fall 2011). Copyright 2011 BDO USA, LLP. All rights reserved. www.bdo.com. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.